Employer Stock in Pension Plans: Economic and Tax Issues

CRS Report for Congress
Employer Stock in Pension Plans:
Economic and Tax Issues
September 4, 2002
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Employer Stock in Pension Plans:
Economic and Tax Issues
The loss of retirement assets held in Enron stock by Enron employees has
stimulated proposals to restrict the holding of employer stock in retirement plans, and
other proposals to regulate these plans. Stock in the Enron plan came from firm
contributions in the form of stock that was not allowed to be sold and from voluntary
investment by employees. This report focuses on rationales for providing employer
retirement plans and for holding (or not holding) employer stock in these plans, both
from the perspective of the private sector and of government policy.
Retirement plans fall into two types: defined benefit plans, where a pension
based on earnings and years of service is provided; and defined contribution plans,
where individuals receive benefits based on accumulated principal and interest.
Either plan can hold employer stock, but holdings are limited to 10% of assets in the
case of defined benefit plans. These plans receive tax subsidies, as do employee
stock purchase plans and certain types of stock options.
The analysis suggests that there are economic reasons that firms and employees
may engage in pension and profit sharing (or stock ownership) plans even in the
absence of tax subsidies. Pension plans, primarily defined benefit plans, may be
attractive for administrative and risk-reduction reasons, for dealing with inadequate
investment in on-the-job training, and for smoothing the retirement of older workers.
Stock options and stock ownership plans may be useful for addressing inconsistency
in objectives between shareholders and managers and worker monitoring problems,
although these benefits are not likely to accrue to stock ownership by the rank and
file of large companies. These employee stock ownership plans may also deter
hostile takeovers, which may undermine economic efficiency and stockholder
interests. Stock contributions are also popular because they do not reduce cash flow,
which has both benefits and costs from an economic efficiency perspective.
Government subsidies to plans may be justified to increase retirement incomes
and access to annuities because of a shortfall in optimal savings and certain economic
problems with self selection in purchasing annuities. These objectives also underlie
the justification of Social Security. Pursuing these goals may actually conflict with
another worthy objective, on-the-job training. However, objectives that are
addressed via employee stock ownership do not appear important in shaping the
nature of large, broadly-based, retirement plans. Diversification of plan assets and
prudent investment portfolios do appear consistent with rationales for government
Attempts to address this issue might take several forms: restrictions on shares
of employer stock in plans, prohibiting employer stock contributions or lifting
restrictions on sale, denying a tax deduction on employer contributions until they
could be sold, and requiring independent investment advice. The last proposal is not
costless and could undermine participation for small firms. For administrative and
other reasons, it may be rational to impose share restrictions on allocations of
contributions, rather than on assets. There are no plans to update this report.

Basic Types of Plans...............................................2
Private Rationales for Pension and Profit-Sharing Plans....................2
Administrative Savings, Insurance and Risk-Pooling..................3
Human Capital Investment.......................................3
Facilitating Retirement..........................................3
The Principal-Agent and Worker-Monitoring Problems................4
Minimizing Cash Flow Effects...................................5
Rationales for Government Intervention................................5
Implications for Reform Proposals....................................7

Employer Stock in Pension Plans:
Economic and Tax Issues
The Enron bankruptcy caused many employees to lose a large portion of their
retirement savings that was invested in Enron stock. Approximately 60% of Enron’s
401(k) plan was in Enron stock. Some of the concentration was because Enron
matching contributions were in stock, and that stock could not be sold until age 50
or upon leaving the company. However, a large fraction was due to employees
choosing to purchase Enron stock. (The loss was somewhat exacerbated because of
a blackout period when individuals were not allowed to trade because of a change in
plan administrators.) Critics have also argued that Enron officials were touting the
soundness of the stock as an investment (and deducting stock contributions at full
value) even as they were aware of looming problems for the firm. While the Enron
case was probably the most publicized instance of employee loss of retirement assets
due to holdings of company stock, it is not an isolated case.
Several legislative proposals have been advanced to address these problems
including dramatically shortening (to three years) the required holding time for
company donated stock, restricting the amount of employer stock held in 401(k)
plans, and requiring firms to provide independent investment advice. Critics of
these proposals have argued that some of these restrictions, particularly those
restricting the ability of firms to contribute in the form of stock, would lead to
reduced employer contributions. Moreover, proposals that might seem reasonable
for large firms but that add cost and complexity (such as providing investment
advisors), may reduce the participation of smaller firms in 401(k) plans.
This report provides an economic perspective on the issue, focusing on the
potential rationale for government intervention into employer retirement and profit
sharing plans. Readers are referred to another CRS report that contains a more
detailed discussion of the Enron bankruptcy, the general issues associated with the
holding of employer stock by retirement plans, and legislative proposals: CRS Report
RL31507, Employer Stock in Retirement Plans: Investment Risk and Retirement
Security, by Pat Purcell.
The next section of this report discusses briefly the kinds of retirement and
profit sharing plans firms use. The following section discusses why pension and
profit sharing (or stock ownership) plans might exist even without government
intervention. Understanding those rationales is key to understanding the behavioral
response to government regulatory changes, and determining whether government
policy should further encourage or restrict such plans. The next section discusses
economic rationales for government intervention and the final section discusses
implications of these rationales for possible legislative revisions.

Basic Types of Plans
A broad range of plans that involve benefits to workers not in the form of cash
currently exist, including a wide variety of plans that are for retirement purposes (and
that employees cannot receive until they leave the firm). These plans receive tax
benefits in that contributions and earnings are not taxed to individuals until received
as pensions (or payments on separation). These plans fall into two basic types:
defined benefit plans (where workers are guaranteed a certain benefit related to
earnings and years of service) and defined contribution plans, where employees
receive benefits based on the size of assets and accumulated earnings. For most types
of plans, contributions to these plans are typically made by employers, and thus do
not permit employees to choose between them and cash wages.
For a variety of reasons, defined benefit plans, which once dominated the
pension landscape, have been in a decline over the past quarter of a century and
defined contribution plans are on the increase. This rise in defined contribution plans
particularly reflects a popular form of defined contribution plan: a 401(k) plan, where
individual accounts are maintained, both employers and employees contribute, and
employee contributions are voluntary. Employees have some choice in the allocation
of their own contributions. Employer stock may be one of the choices; employer
contributions may also be made in the form of employer stock.
While all pension plans are subject to regulations of some type, the restrictions
are greatest for defined benefit plans. Defined benefit plans are also covered by
pension insurance, which insures against total loss of assets. Some of the restrictions
on plans, particularly defined benefit plans, were designed to insure sound
investments and to make sure that the plans were not simply a tax shelter for high
ranking employees and managers. Only defined benefit plans have restrictions on
the amount of employer stock that can be held (10%). For defined contribution
plans, employees bear the risk of loss of investment or low returns. Some types of
plans with retirement features (Employee Stock Ownership Plans, or ESOPs) must
hold assets primarily in the form of employer stock. Plans may be combined.
Tax benefits are also provided for acquiring employer stock that is not restricted
to retirement plans. These benefits include benefits for stock options and stock
purchase plans: the former are generally directed to high ranking employees and
managers, while the latter are generally available to all employees.1
Private Rationales for Pension and Profit-Sharing
Why should firms pay employee compensation in the form of pension or profit
sharing plans (or other fringe benefits) rather than in cash? Does the existence of
these plans hinge solely or largely on tax benefits? In this section we briefly discuss

1 See CRS Report RL31458, Employer Stock Options: Tax Treatment and Tax Issues, by
Jack Taylor.

several reasons that firms might desire to pay compensation, or that individuals might
like to receive it, in the form of pensions or stock. The first three reasons are largely
associated with defined benefit pension plans while the last two are associated with
profit-sharing or stock ownership plans. Defined contribution plans not in the form
of stock may, indeed, have largely arisen from a desire to exploit tax benefits, as it
is difficult to discern another reason for using them.
Administrative Savings, Insurance and Risk-Pooling
One reason for the popularity of these retirement plans might be that collective
plans, such as pension plans, could be considered desirable because of administrative
savings and risk reduction. Pension plans are also often constructed to provide
insurance elements, such as disability and survivor payments and life annuities.
Insurance of this nature is often not efficiently provided in private markets because
of adverse selection. (Adverse selection occurs when individuals sort themselves out
due to private knowledge of risks. For example, a person with a terminal illness
might desire to buy life insurance but would not purchase a life annuity.)
While administrative savings could apply to any plan, risk-pooling and
insurance elements would tend to apply most strongly to defined benefit pensions
plans with diversified assets and would not apply to stock ownership plans which
tend to increase risk. Administrative and risk reduction benefits have probably
declined over time with the current availability of large mutual funds and the benefits
are particularly less important for defined contribution plans that do not have unique
elements of insurance and risk reduction associated with defined-benefit plans.
Human Capital Investment
Investment in human capital is generally under-provided in a market economy,
because individuals cannot engage in involuntary servitude or commit to a certain
form of employment to insure that future earnings are used to repay human capital
investments. These problems apply both to general education and to certain types of
on-the-job training. Returns to on-the-job training that teaches skills specific to the
firm can only be exploited by remaining with the firm. However, returns to on-the-
job training that teaches skills transferable to other jobs can be realized by either
staying with the firm or moving to another firm. It is in the interest of the firm to
retain employees when the firm has invested in their training and whose net product
is low or even negative in the early period of the career. Defined benefit pension
plans that are not quickly vested, and whose benefits become greatest when spending
a long career with a company, can be used to allow firms and employees to mutually
exploit gains from these types of human capital investment. (Government pension
regulations which require early vesting and portability as ways to protect worker
retirement security and guard against tax sheltering may, however, have eroded this
Facilitating Retirement
Pension plans may also be a way of encouraging employees to retire as their
marginal product falls, without undermining morale by firing older workers who have

become less productive (or, these days, placing the employer in the position of
potentially violating the law). Defined benefit pension plans are particularly effective
because workers who have reached full retirement and remain at work forgo their
pensions, and their net wage is reduced, creating a powerful substitution effect that
encourages retirement while also offsetting lost income. Defined contribution plans
permit retirement but do not create as powerful an incentive to retire and thus do not
perform this function as well.
The Principal-Agent and Worker-Monitoring Problems
Another problem that large firms with many stockholders and/or employees face
is the problem of a misalignment of shareholder and worker interests. In the case of
managers, this problem is often referred to as the principal-agent or agency cost
problem: managers who run the company as an agent for shareholders may make
decisions that do not necessarily maximize stockholder profits. Moreover, large
firms may find it difficult to monitor the performance of workers; in particular they
cannot easily distinguish between the effects of work effort versus outside influences
on productivity. One way that firms may attempt to remedy this problem is through
use of stock options (which provide employees an incentive to increase the firm’s
value) and stock ownership plans, which provide some alignment with the
shareholders’ objectives. Of course, in theory, this approach would not be
particularly beneficial for the rank and file employees of large firms, where additional
work effort by any one employee would have a negligible effect on the value of that
employee’s stock. Stock options and ownership could have an effect on top
management, whose actions have important consequences, and on closely held firms.
Moreover, many managers believe that employer ownership boosts employee loyalty
and morale.2
Employee stock ownership can also work against shareholder interests and
economic efficiency. Firms where employees hold a large fraction of stock are more
impervious to hostile takeovers, as employees and managers may otherwise fear loss
of pay and jobs in such a circumstance. However, threats of takeovers are also a
market mechanism that may keep the principal-agent problem under control and both
takeover threats and actual takeovers may lead to a more efficient company.
Reducing takeovers may be advantageous for managers and workers but may not be
desirable socially.

2 There is an extensive literature on the effects of employee ownership. See Douglas Kruse,
“Research Evidence on Prevalence and Effects of Employee Ownership,” Presented in
testimony before the Subcommittee on Employer-Employee Relations, Committee on
Education and Workforce, U.S. House of Representatives, Feb. 13, 2002; Chris
Doucouliagos, “Worker Participation and Productivity in Labor-Managed and Participatory
Capitalist Firms: A Meta Analysis,” Industrial and Labor Relations Review, Vol. 49, Oct.

1995 (which includes an extensive list of references); Linda A. Bell and David Neumark,

“Lump-Sum Payments and Profit-sharing Plans in the Union Sector of the United States
Economy,” The Economic Journal , Vol. 103, May 1993.

Minimizing Cash Flow Effects
Providing compensation in the form of stock is often considered cheaper
because it does not reduce current cash-flow. Such an approach may be particularly
attractive to new and fast growing firms, where access to capital markets is difficult
and initial profitability is low. This motive may lead to more economic efficiency
if capital markets consistently overestimate expected risk. It may lead to less
efficient markets if the dilution of stock makes information on the firm’s profitability
more difficult to assess by investors.
Rationales for Government Intervention
The previous section has suggested private motives even in the absence of tax
benefits for defined benefit pension plans and for stock ownership plans, but there
does not appear to be a strong private rationale for defined contribution plans not
held in the form of employer stock. Clearly another reason for pension and profit
sharing plans that may play a crucial role in encouraging these plans, particularly
defined contribution plans not invested in employer stock, is the tax benefits
associated with them. Amounts contributed to a pension plan and their earnings are
not subject to tax until received as pensions, usually many years into the future. The
combination of deferral of tax on the initial contribution and deferral of tax on
earnings is the equivalent of an exemption of earnings from tax, and is thus a
valuable tax benefit.
Why should the government intervene with tax subsidies (and regulations) to
shape the compensation package? And why should it intervene with mixed signals,
including both benefits for and restrictions on ownership of employer stock in
pension plans?
The first set of rationales for supporting pension plans are also are among the
reasons for establishing Social Security: adverse selection in annuity markets and
failure of individual optimization (failure to save a desirable amount).3 Adverse
selection in annuity markets occurs because individuals expecting to have a shorter
life span will avoid the annuities market, thereby making the annuities unattractive
for the average individual. This rationale would justify tax subsidies to pension plans
that provide retirement annuities, early vesting, and mandates for broad coverage of
employees. (The latter rule is probably necessary in any case to prevent the tax
benefits from becoming a tax shelter for highly compensated employees.) Of course,
it is not clear that individuals do not save enough, and it is not clear why using
resources (in the form of reduced taxes) to encourage a private pension system that
covers about half of workers should be preferred to devoting those resources to an
expansion of Social Security.
The entire pension system has been shifting away from plans that address these
goals: many defined contribution plans have a lump-sum payoff option, and defined

3See CRS Report RL31498, Social Security Reform: Economic Issues, by Marc Labonte and
Jane G. Gravelle.

benefit plans have been increasingly displaced by defined contribution plans. 401(k)
plans, which have become very popular, allow voluntary, not mandatory,
contributions. Outside of certain defined benefit plans, the current systems have
simply become primarily ways to obtain tax benefits.
Of course, arguments are made that these tax benefits have encouraged saving,
but neither economic theory nor empirical evidence has confirmed that view.4 In any
case, this rationale suggests that prudence in investment is important to encourage.
In that case, many of the proposals for revision, including limits on employer stock
holding in any type of pension plan, and reducing or eliminating any required holding
period, might be justified. Of course, such an approach also suggests that employee
stock ownership plan subsidies be discontinued or modified.
Some of the rules made to insure safe and broadly available worker pensions
have been in conflict with solutions to other economic problems. For example, as
noted earlier, a market economy tends to under-invest in human capital. There are
obviously massive government interventions through direct spending, low-interest
loans, and tax benefits to provide for formal education and training. Pension rules
may, however, have undermined the use of defined benefit pensions for encouraging
spending on on-the-job training. For example, rules mandating early vesting are in
conflict with objectives to increase on-the-job training (objectives that might be
worthy of pursuit by the government as well), although they may be appropriate to
increase pension coverage and employee security. Similarly, non-discrimination
requirements have been used to prevent the use of the tax subsidies as a tax shelter
for highly compensated employees and increase coverage, even though on-the-job
training benefits may not be uniform across employees. Diversification of assets is
consistent, however, with both government and private rationales for defined benefit
pension plans.
Economic problems arising from principal-agent costs or worker monitoring
costs may be argued to justify government subsidies to stock ownership plans to
increase efficiency beyond what private markets may do. However, they are unlikely
to be addressed by ownership of employer stock among rank and file employees of
large companies, where most tax subsidies for pensions are directed. Moreover,
encouraging practices that make companies resistant to takeover may reduce rather
than increase economic efficiency. Nor is it clear that stock ownership plans benefits
in preserving cash flow outweigh the possible negative effects of using stock as
compensation on stockholder information. Thus, the justification for government
subsidies to stock ownership is not really established.

4Considerable research on tax benefits for retirement, often focused on individual retirement
accounts and 401(k) plans, has found mixed results. For a summary see CRS Report
RL30255, Individual Retirement Accounts (IRAs): Issues and Proposed Expansion, by Jane
G. Gravelle.

Implications for Reform Proposals
As discussed above, the discussion of justifications for government intervention
based on economic problems suggests rationales for traditional pension plans,
particularly those with defined benefits, but do not necessarily suggest a justification
of tax subsidies for plans such as 401(k) plans, where participation by employees is
voluntary. These subsidies may not even increase retirement saving. However, given
that subsidies do exist, there does appear to be a case for increasing the safety of
investments by limiting investment in employer stock, while the rationale for
supporting employer stock ownership plans appears weak.
If limits on ownership are to be imposed, how should constraints work? It
would appear better for administrative and other reasons to impose the limits on the
share of contributions made rather than the share of assets. A reason for limiting the
share of assets in employer stock in defined benefit plans is in part because of
pension insurance and because of limits on excess contributions, issues that do not
exist for 401(k) plans. In the case of a defined contribution plan, a successful
employer stock may simply become a larger part of the asset base because it is
appreciating rapidly and forced sales may not be sensible. Other legislative changes
might be requirements that employees be able to sell employer contributed stock
immediately or within a few years (which is proposed in some legislation),
disallowing deductions for stock contributions until employees are allowed to sell,
or even prohibiting these types of contributions altogether. It is not clear whether
these restrictions will be successful, however, if ESOPs remain as an option.
Another legislative proposal that has been made to increase the security of
individual investment plans (which might be used instead of explicit restrictions) is
to require firms to provide investment advice, since firm managers may have a
conflict of interest. Of course, investment advice is not costless, and it could
significantly discourage the use of these plans in the case of small firms. Moreover,
virtually any independent investment advisor would counsel against holding a large
part of retirement assets in a single stock, but many advisors would suggest taking
on general stock market risk. If explicit restrictions are imposed on ownership of a
single stock, such individual advice might not be necessary. Alternatively, a general
public information campaign may be considered. Moreover, the publicity associated
with the Enron bankruptcy, along with other firm failures and the decline in the stock
market, may be adequate to alert individuals to the need for portfolio diversification.
One criticism that has been made of these proposals is that firms may respond
by reducing their contributions. It is not clear that such a reduction would occur or
should be a problem if it did (and many contributions are currently made in cash
rather than stock). If stock contributions have any value, then they are likely to
substitute for cash wages. It is not clear that policy should be concerned about
employer matches in a risky asset as a substitution for cash wages, particularly when
the participation is voluntary, both on the part of individuals contributing to plans and
firms setting up plans. The beneficiaries in both cases are only part of the population
(and the more affluent part). An argument could be made that the revenue derived
from increased taxes on cash wages might be better used for other purposes.