Diversification for 401(K) : Common Sense

If you have been following your 401 at all, and read anything about investing, you will know that putting all your 'eggs' in one basket is foolish. Take a minute and review your investments, and if you don't understand the system, locate someone that can help you make the right decisions on investing.

Twenty years from now you'll be glad you did.


The Case against Company Stock in 401(k)s
Source: Alex Brill, "The Case against Company Stock in 401(k)s," American Enterprise Institute, April 2011.

Given that some employees have 401(k)s heavily invested in company stock and given the inefficiencies of nondiversified investment, policy measures for protecting workers from this kind of risk are worth considering.

Policies guiding 401(k) diversification would address two related issues: the risk from being overly invested in one's employer, and the risk from being too invested in any other single stock. While the policy objective is clear and straightforward -- ensure adequate 401(k) plan diversification -- implementing it may prove more difficult, says Alex Brill, a research fellow at American Enterprise Institute.

The 401(k) accounts that pose the greatest risk are accounts heavily invested in company stock and held by older workers. To avoid another Enron, rules would need to be established to bring current 401(k) plans into compliance with new diversification protocols. This would require mandating that employees sell company stock and buy more diversified assets.

But this may result in the exact outcome the policy is attempting to avoid -- forcing workers to sell company stock when it is inopportune.

One way to address this problem is to establish rules governing future 401(k) contributions and to prohibit workers from purchasing additional company stock with existing plan assets. This policy is likely more workable but would not address the most pressing risks of current and near current retirees.

Short of mandating diversification, establishing default 401(k) settings to promote investment allocations that exclude company stock (and possibly narrowly constructed mutual funds) could help steer workers toward more sensible investing. A related option is to impose diversification requirements in 401(k) plans similar to those imposed on mutual funds themselves.

While there is a clear precedent for these diversification criteria, one drawback is the difficulty for employees to rebalance their portfolios on a regular basis. These problems could be avoided if the worker's 401(k) assets were invested only in mutual funds.