Investments of Company Stock in 401(k) Plans: Impacts of Bankruptcy Risk and Holding Restrictions * Investments of Company Stock in 401(k) Plans: Impacts of Bankruptcy Risk and Holding Restrictions

Abstract The recent past has seen a wave of conversion from defined-benefit to defined-contribution pension plans. Among the corporate defined-contribution plans, 401(k) plans are the most popular. The majority of the plan sponsors either encourage or require employees to invest in company stocks. The imposed stock holding brings about welfare losses due to the lack of diversification and sub-optimal asset allocations. More importantly, as the lessons of Enron have taught us, employees can even lose a significant portion of their retirement safety net when the company goes bankrupt. How does bankruptcy risk affect employees' optimal asset allocation? How much is the employee's welfare loss from bearing the bankruptcy risk when required to invest in company stock? How much is the combined welfare loss due to both holding restrictions and bankruptcy risk? All of the questions are extremely important in today's world of pension management, yet none of them has been addressed in the literature to date. This study fills this important gap. Using a utility maximization model with a CRRA preference, we find that holding restrictions and bankruptcy risk both have an important bearing on optimal allocation and welfare losses. The total welfare loss can be easily as high as 50% of the stock value. For a typical firm, the welfare loss due to bankruptcy risk amounts to 20% to 30% of the stock value. Investments of Company Stock in 401(k) Plans: Impacts of Bankruptcy Risk and Holding Restrictions Abstract The recent past has seen a wave of conversion from defined-benefit to defined-contribution pension plans. Among the corporate defined-contribution plans, 401(k) plans are the most popular. The majority of the plan sponsors either encourage or require employees to invest in company stocks. The imposed stock holding brings about welfare losses due to the lack of diversification and suboptimal asset allocations. More importantly, as the lessons of Enron have taught us, employees can even lose a significant portion of their retirement safety net when the company goes bankrupt. How does bankruptcy risk affect employees' optimal asset allocation? How much is the employee's welfare loss from bearing the bankruptcy risk when required to invest in company stock? How much is the combined welfare loss due to both holding restrictions and bankruptcy risk? All of the questions are extremely important in today's world of pension management, yet none of them has been addressed in the literature to date. This study fills this important gap. Using a utility maximization model with a CRRA preference, we find that holding restrictions and bankruptcy risk both have an important bearing on optimal allocation and welfare losses. The total welfare loss can be easily as high as 50% of the stock value. For a typical firm, the welfare loss due to bankruptcy risk amounts to 20% to 30% of the stock value