Employee Stock Purchase Plan (ESPP) and 401K Retirement Plan Annual Enrollment and Contribution for 2009 Review

The current economy has contributed much to an especially volatile stock market. Adding fuel to the fire is the advice from market gurus which are poles apart. On the one hand you have the Oracle of Omaha, Waffen Buffet insisting US stocks are cheap and is a steal at current prices while at the other end experts such as Diane Garnick warns US stock market is far from a bottom and advices staying away from it until a clear “up-cycle” is established. Even a novice investor can evaluate that on a relative basis US stocks are fairly expensive compared to European and other Emerging Market counterparts leaving one to wonder whether Buffet’s call is prompted primarily because Berkshire Hathaway’s (Warren Buffet’s company) holdings are heavily tilted towards US equities. The latter call has a couple of different problems:

• It discounts the possibility of a V-shaped stock market recovery – being on the side-lines will result in missing most of the rally, and
• In a protracted stock market recovery, opting out results in underperformance as even with a slight increase, investors staying in the market usually beat lower-risk investment options such as treasuries when dividends are included.

Circumstances being such, it is not easy for average Americans to decide on their contribution, if any to their employer sponsored plans, primarily ESPP and 401K. ESPP is straightforward (participating at the maximum level is the best option) as the following characteristics and associated strategies make it almost impossible to lose money in that venture:

1. The ESPP stock is purchased at a discount to the market price. Some plans even have an option that guarantees same-day-sale profit, even if the stock price slips on the day of the purchase, a
2. The discount is based on the lower of the market price at the beginning of the offer period and the purchase date. The “lower of” provision allows for more profit if the stock price has risen during the offer period. Thus, it is in effect stock ownership that is exempt from downside risk during the offer period.
3. The immediate selling strategy allows for high returns with low risk, the Holy Grail in investing.
4. The long-term capital gains realization strategy allows for high tax-optimized returns with somewhat higher risk.

As for strategy, one option is to adjust the percentages upwards or downwards depending on whether the company is undervalued or overvalued respectively at the beginning of the offer period. A corresponding adjustment in the other direction will have to be made during the next offer period in the same calendar year so as to realize the benefit of participating at the maximum level.

401K enrollment, on the other hand is a different ballgame altogether. The chief concern with 401K is that the onus is on the employee to choose investment selections and contribute. This is a far cry compared to pension plans, where the employer shouldered the responsibility completely. Expecting average Americans to be financially savvy and being able to choose investment options is a tall order. The pension protection act of 2006 is aimed at alleviating some of this responsibility, and provides the following related provisions:

1. Removes barriers that prevent companies from automatically enrolling their employees in defined contribution plans: The provision recognized the fact that one-third of eligible employees did not participate in these plans. Over time, this provision should allow dropping this number well below 10%. Companies generally implement this provision by making 401K contributions an “opt-out” benefit. In other words, if employees do not want to enroll, they have to “opt-out” of it explicitly, – should they choose to do nothing, they are automatically enrolled.
2. Ensures that employees and retired personnel have more information about the performance of their accounts: Companies support this provision by providing an investment advice benefit, usually for a nominal fee.
3. Gives workers greater control over how their accounts are invested: This has relevance with respect to the Qualified Default Investment Alternative (QDIA), which automatically takes effect in the absence of investment direction from the participant – the provisions make sure that workers are kept informed on their selections such as if they had selected them on their own. Further, it also provides for the ability to transfer out of QDIA investments without undue penalty. Making available life-cycle funds or target-retirement funds is one popular way companies have chosen to implement this provision.

These provisions are aimed to make it comparatively easy for a worker to adopt a passive investment strategy. Life-cycle funds or target-retirement funds is an especially attractive alternative in this regard. The only adjustment one could consider for next year in the face of a large market correction is to opt for a more aggressive life-cycle fund choice – a fund that aims for retirement 5-10 years before your perceived retirement date. As for the amount of contributions, it is simple – try to max-out on these contributions, given the tax benefits – if unable to do so, the next best option is to contribute the percentage that allows for complete employer matching if applicable.

As indicated in our 401K updates, we have been choosing investment choices on our own with a 40-40-20 asset allocation between domestic, international, and bond investment choices. While using an asset allocation plan (AAP) such as this is a good option, one cannot afford to be asleep at the switch – need to monitor your choices and make adjustments periodically. We are seriously considering switching to life cycle fund choices next year as that would allow for a much more passive strategy.

Related Posts:

1. Flexible Spending Accounts (FSA) – Great Benefit with a few caveats!.
2. Writing Covered Calls against Employer Stock Plan Shares (ESPP, Restricted Stock, and Stock Options) – A Primer.
3. Employee Stock Purchase Plan (ESPP) and 401K Retirement Plan Annual Enrollment and Contribution Review.
4. Employee Stock Purchase Plan (ESPP) - Immediate Selling Strategy.
5. Realizing Long-Term Capital Gains With Stock Based Compensation.
6. Stock Based Compensation Tax Optimization Strategies.

Last Updated: 01/2009.