By far, the most common way people invest in the stock market is through a retirement account like a 401(k), 403(b), or IRA. Investing in equities is no longer a way to “get ahead” but a way to not fall behind. If you are not going to be receiving a corporate or municipal pension in retirement, then the only other option is to invest part of your earnings into a tax-deferred investment account. Many retirement accounts offer diversified mutual funds that allow you to invest in hundreds, if not thousands of individual companies. But what about the company that you work for? Can you or should you invest it?
If you work for a large publicly traded company and are contributing to your 401(k) then chances are you are already invested in it through the mutual funds mentioned above. But even then, some of these corporations will allow employees to purchase individual shares through stock options that act as a discount to the market price. However, most people work for small private businesses which are not publicly traded and don’t typically offer an equity stake. But in some rare cases an employee may be able to contribute to an Employee Stock Ownership Plan or ESOP. These qualified retirement plans are often used by employers as a corporate -finance strategy to align the interests of their employees with those of their shareholders.
ESOPs can be complicated. The amount which you can contribute, accumulate, and withdraw can all vary from plan to plan. Some will allow you to diversify out of the ESOP each year and into a 401(k) all while maintaining tax-deferred status. This amount too, will vary plan to plan, and even year to year. Usually, at the end of every fiscal year the sponsoring firm (the employer) of the ESOP will have the company audited by an independent third party to determine what the shares are worth. Because sponsoring firms are not publicly traded, the market for their shares is very small and thus a fair-market-value is difficult to obtain. This is known as liquidity risk.
As a financial advisor and fiduciary, I get asked very frequently about ESOPs and whether an employee should contribute. It’s a question that poses a serious dilemma for me. I typically know nothing about the company! Whether you should work for or invest in a company are two different things, of course. The best advice I can usually give is that you invest no more than 10% of your retirement assets in your company. This goes for a small local business or a mega-cap corporation.
Sometimes people love their work and love working for their company. This is a wonderful thing, no doubt. But it can also cause employees to make emotional decisions when it comes to their ESOPs or stock options. Therefore, it is so important to have guardrails in place to help cope with your biases. A 10% allocation is my recommendation, but you may feel 15% is more appropriate. The important thing is to be deliberate about how you set your guardrail and have the discipline to abide by it.