«Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock SHLOMO BENARTZI* ABSTRACT About a third of the assets in large ...»
THE JOURNAL OF FINANCE • VOL. LVI, NO. 5 • OCT. 2001
Excessive Extrapolation and the Allocation
of 401(k) Accounts to Company Stock
About a third of the assets in large retirement savings plans are invested in company stock, and about a quarter of the discretionary contributions are invested in
company stock. From a diversification perspective, this is a dubious strategy. This paper explores the role of excessive extrapolation in employees’ company stock holdings. I find that employees of firms that experienced the worst stock performance over the last 10 years allocate 10.37 percent of their discretionary contributions to company stock, whereas employees whose firms experienced the best stock performance allocate 39.70 percent. Allocations to company stock, however, do not predict future performance.
ROUGHLY A THIRD OF THE ASSETS in large retirement savings plans are invested in company stock ~i.e., stocks issued by the employing firm!. In extreme cases, such as Coca-Cola, the allocation to company stock reaches 90 percent of the plan assets. From a diversification perspective, it is even more puzzling that Coca-Cola employees allocate 76 percent of their own discretionary contributions to Coca-Cola shares. This strategy seems dubious, and it is in complete contrast to Markowitz ~1952! and Sharpe ~1964!, who predict that people will hold well-diversified portfolios. This paper examines whether excessive extrapolation of past returns could explain at least part of the discretionary allocations to company stock.1 The empirical analysis utilizes a unique database of SEC filings that describes the variation in investment elections across companies for 1993.
There are at least two reasons why the allocation to company stock is an interesting topic to study. First, the costs of insufficient diversification can be substantial. For example, with the assumption of a constant relative risk aversion of two, Brennan and Torous ~1999! find that the certainty equivalent of investing one dollar in a single stock over a 10-year period is only 36 cents! In the case of company stock, the costs of insufficient diversification * The Anderson School of Management at UCLA. I would like to thank David Aboody, Brad Barber, Toni Bernardo, Michael Brennan, Sean Hanna, Steve Hansen, Jack Hughes, Pat Hughes, Marilee Lau, Terry O’dean, Andrei Shleifer, Charles Swenson, Brian McTigue, Richard Thaler, Ivo Welch, and conference participants at MIT, Stanford, UCLA, Yale, and the NBER for insightful comments and suggestions. I would also like to thank the Institute of Management Administration for funding and John Hancock Financial Services and Morningstar for data.
There is a widespread belief that employees invest in company stock because they receive a discount, but retirement saving plans do not offer a discount on company stock.
1748 The Journal of Finance are probably higher, because employees select a stock that is presumably correlated with their human capital, and as a result, they stand to lose both their retirement savings and their jobs if the company fails.
Second, there is a worldwide trend toward investment autonomy. This trend is evident in the migration from defined benefit pension plans to defined contribution savings plans. This trend is also evident in the current debate on social security reform. At one extreme are proposals that would mandate the allocation of assets between stocks and bonds, and possibly other investment categories. At the other extreme are plans that would allow individuals to elect their own asset mixes. One of the advantages of investment autonomy is that it can accommodate differences in individual preferences. Those who are extremely risk averse can select conservative investments, whereas those who prefer more risk can select aggressive investments. It is unclear, however, whether most people can do well as their own money managers ~see Benartzi and Thaler ~1995, 1999, 2001!!. Studying allocations to company stock provides an opportunity to examine whether individuals construct well-diversified portfolios or highly concentrated portfolios.2 This paper documents that, under certain circumstances, individuals have a strong tendency to construct portfolios that are highly concentrated in company stock. The tendency for employees to put their own contributions into company stock is stronger when the employer’s contributions to a 401~k!
plan must be invested in company stock. That is, when the employer’s contributions are automatically directed to company stock, employees invest more of their own contributions in company stock. Using questionnaires, I show that this phenomenon is consistent with an endorsement effect: employees interpret the allocation of the employer’s contributions as implicit investment advice.
Employees could have a variety of reasons for investing their retirement savings in company stock. This paper focuses on one explanation that draws from the seminal work of Tversky and Kahneman ~1974! on representativeness. Applying representativeness to company stock, employees might conclude that abnormally high past performance is representative of future performance, even though stock returns are largely unpredictable. In other words, employees might excessively extrapolate past performance.3 To test the excessive extrapolation hypothesis as it applies to company stock, I formed five portfolios on the basis of past buy and hold returns and examined the allocation of subsequent contributions to company stock.4 The analysis is based on the allocation of discretionary contributions to ensure that the allocation ref lects employees’ own choices. When portfolios were Another interesting question is why employers offer company stock in retirement savings plans, but this question is beyond the scope of this paper.
Huberman ~1997! discussed company stock holdings and raised the possibility that the disproportionate allocations might be attributed to a familiarity bias. I explore this explanation in Section II.C.
The unique database that is used in this paper is described in Section I.
Excessive Extrapolation and the Allocation of 401(k) Accounts 1749 formed on the basis of one-year returns, the low-returns portfolio had an average allocation of 21.10 percent to company stock versus 23.70 percent for the high-returns portfolio. As the portfolio formation period increased, so did the difference in allocation. When portfolios were formed on the basis of 10-year returns, the low-returns portfolio had 10.37 percent allocated to company stock versus 39.70 percent for the high-returns portfolio. Thus, the results are consistent with employees extrapolating past returns far into the future. ~I also find that allocations to company stock are uncorrelated with subsequent returns, hence, ruling out an information-based explanation.!
As an additional test of the excessive extrapolation hypothesis, I asked Morningstar.com subscribers to rate the performance of company stock over the last five years and the next five years. Despite the fact that individual stock returns are largely unpredictable, the respondents’ ratings were positively correlated ~ r 0.52!, which is consistent with the extrapolation hypothesis. The survey provided an opportunity to explore other behavioral explanations such as optimism and overconfidence. I found that only 16.4 percent of the respondents realize that company stock is riskier than the overall stock market. And among those with a high school education or less, a mere 6.5 percent believed that company stock is riskier than the overall stock market.
In the next section, I discuss the database that is used in this paper, and I provide descriptive statistics on company stock holdings in retirement savings plans. In Section II, I explore the role of excessive extrapolation in company stock holdings. Section III summarizes the results.
I. Data A. Sample Selection Retirement savings plans that offer employees the choice of investing their own contributions in company stock must file an annual report with the SEC. The annual reports, which are labeled 11-k filings, are the primary source of information in this paper. There are certain filing exemptions, however, the most common one for 401~k!-type plans being the “market test.” According to the market test, a retirement savings plan that purchases shares of the company stock on the open market is exempt from filing an annual report. I estimate that roughly a third of the plans buy shares on the open market, and the remaining two-thirds issue shares.5 Unfortunately, data on plans that buy shares on the market are unavailable, so I only examine plans that issue shares. Consequently, the results reported in this paper may or may not generalize to plans that purchase shares on the open market.
Similarly, in a private conversation with the author, Marilee Lau, chairperson of the Department of Labor Advisory Council on Employee Welfare and Pension Benefit Plans, estimated that 40 percent of the plans buy shares on the market. More details on the number of plans that are exempt can be obtained from the author upon request.
1750 The Journal of Finance Table I Sample Selection Criteria This table describes the sample selection criteria and the remaining number of firms. The sample includes S&P 500 firms that sponsor at least one retirement savings plan with the following features: ~a! employees have the option of investing their own contributions in company stock, and ~b! company stock shares are issued by the firm rather than bought on the market. When a firm sponsors multiple retirement savings plans, I focus on the largest plan.
Plan information is collected from the 1993 annual reports, which are available from the SEC and are known as “11-k” filings.
From a research perspective, there are at least two advantages to 11-k filings relative to other publicly available databases. First, the filings supplement information on the allocation of assets with data on the allocation of contributions. The problem with the allocation of assets is that it does not always ref lect employees’ choices, because employees forget to rebalance their portfolios ~Samuelson and Zeckhauser ~1988!!. Thus, a positive correlation between past returns and the allocation of subsequent plan assets may ref lect reluctance to rebalance portfolios rather than excessive extrapolation of past performance. To mitigate this concern, I focus on the allocation of plan contributions ~i.e., the f lows into the plan!. None of the other databases, including the Department of Labor’s Form 5500 Tapes, IOMA’s Quarterly Survey of Company Stock Performance, Money Market Directory of Pension Funds, Nelson’s Directory of Plan Sponsors, and Pensions and Investments’ Annual Survey of the Top 1,000 Funds provides information on the allocation of contributions.
The second advantage of 11-k filings is the breakdown of contributions made to the plan into employees’ versus employers’ contributions. In addition, the notes to the financial statements indicate whether or not the employer’s contributions must be taken in the form of company stock. Without this crucial information, it would be impossible to measure the extent to which employees ~as opposed to employers! are investing in company stock.
The sample of 11-k filings that is used in this paper is described in Table I.
Since the filings are expensive to purchase and have to be coded manually, I focus on a subsample of the population. In particular, I examine the retirement savings plans of the S&P 500 firms, and thus, small firms are not included in the sample. Nonetheless, the S&P 500 sample is representative of firms with company stock holdings, because most company stock holdings Excessive Extrapolation and the Allocation of 401(k) Accounts 1751 are associated with large companies. The U.S. Department of Labor ~1997!, for instance, reports that plans with more than 10,000 ~1,000! participants account for 64 percent ~95 percent! of the nationwide company stock holdings.
Information on the retirement savings plans of the S&P 500 firms was collected for fiscal year 1993. The choice to focus on 1993, as opposed to a more recent year, enables the analysis of subsequent investment performance. One concern is that company stock holdings vary with time; hence, 1993 does not necessarily represent more recent years. To alleviate this concern, I compare the 1993 and 1995 allocations using a subset of the firms. When allocations are measured as a percentage of combined employee0employer contributions, the correlation between the 1993 and 1995 figures is 0.94; when allocations are measured as a percentage of employee contributions, the correlation is 0.90.
Thus, the allocation to company stock changes very slowly over time.
Of the S&P 500 firms, 219 filed an 11-k during 1993. When firms report multiple retirement savings plans, I focus on the largest plan. On average, the largest plan covers 87.13 percent of the company-wide plan assets and
88.16 percent of the plan participants. Smaller plans are excluded to minimize data collection costs and to avoid specialized plans such as those in place for foreign subsidiaries. Retirement savings plans that combine ESOPs are also excluded, since it is often difficult to decompose company stock holdings into allocated and unallocated shares. Of the remaining 156 plans, one was eliminated because it offers preferred stock ~as opposed to common stock!, and another was eliminated because it did not disclose information on asset allocation. The final sample includes 154 plans with information on the allocation of assets and 136 plans with information on the allocation of employees’ and employers’ contributions. Occasionally, the analysis also requires information on the number of plan participants, which was collected from the Department of Labor’s Form 5500 Tapes. It is important to note that none of the sample plans offers a discount on company stock.