A crisis that started in Seattle is likely to spread across the country in the coming months as thousands of Washington Mutual employees come to grips with the money they lost because they held the bank’s stock in their 401(k) accounts. That stock became worthless when the bank failed late in September.

hese people are learning harsh lessons that should be heeded by anyone who holds company stock in a retirement plan. A lot of people are in that boat.

Here are a few interesting figures from Financial Engines, an online company that specializes in employee retirement plans: In 401(k) plans that offer company stock as an investment option, 36 percent of the participants have invested more than a fifth of their savings in shares of the companies they work for. Older workers, who should be taking less risk, seem to be taking more. One-quarter of 401(k) participants 60 and older have at least half their accounts invested in company stock.

It should be obvious why that’s so risky. Workers don’t have much choice about relying on the same company for their income and their benefits. But when they rely on the same company for a big chunk of their retirement, they are placing extremely heavy bets.

Many people also own company stock outside their retirement plans, an equally bad idea in my view.

Most of those people are understandably confident. They know the company and the industry. Or do they? Hundreds if not thousands of Washington Mutual employees thought they knew the company they worked for. A year ago, Washington Mutual was a profitable company, the nation’s largest thrift institution, and had just moved its headquarters into shiny new digs in downtown Seattle. From those offices, executives presided over more than 2,000 retail branches spread from Washington state to Florida. The company had more than 40,000 employees, including 3,500 (many with relatively high pay) in downtown Seattle.

Early this year, very few of the bank’s employees, even executives, would have given even a 10 percent probability to the following scenario:
•    The 100-year-old company, once widely known as “the friend of the family” in the Northwest, would be dragged down by its aggressive subprime mortgage loan portfolio.
•    Month after month the stock price would fall until, with the speed of late summer lightning, a liquidity crisis led to a multi-billion-dollar run on the bank.
•    With stunning swiftness the federal government would declare the bank a failure, making the stock worthless.

Yet that’s what happened. 

The Puget Sound Business Journal reported that when the company collapsed, a total of 17.6 million shares were owned by the bank’s employees. What was that stock worth? At the approximately $44 price in June 2007, it would have been worth about $770 million. By October 2007, at $28 a share, it would have been worth about $490 million. Now the stock is de-listed and trading over the counter at 16 cents a share, making it worth about $2.8 million.

Many Washington Mutual employees – probably most who are not executives – will keep their jobs and their benefits. But whatever wealth they had in the company’s stock has vanished. If they were counting on it for retirement, they are plum out of luck. What happened is that risk came home to roost.

Washington Mutual was not the first seemingly stable company to crumble – and it won’t be the last. Right now General Motors and Chrysler, American industrial icons if such a thing ever existed, are petitioning the government for billions in bailout money and talking about merging with each other in order to survive.

The tragedy is that so many of the very smart people who work at Washington Mutual, Chrysler, General Motors and others have not learned some obvious lessons from the prior collapse of companies like Enron and Worldcom, to name just two.

In Seattle, Washington Mutual seemed to be plagued with an overabundance of overconfidence. Only after the company’s share price fell to $4.05 (they once traded for 10 times that price) did the company put a 20 percent limit on the Washington Mutual Stock Fund in the company’s 401(k) plan.

Many employers encourage workers to buy company stock in their retirement plans. Sometimes 401(k) contributions are matched, and bonuses paid out, in the form of company stock. Employers put a positive spin on the practice. “It’s an opportunity for people to identify with and appreciate the company,” said Joe Devine, global head of employee benefits at Monsanto.

One thing that big companies don’t say in public is that filling retirement plans with company stock is a real benefit to executives as it creates a steady demand for the shares and props up share prices. As long as the price keeps going up, everybody seems to benefit. But when things go sour, the cheerful faces can quickly turn to scowls.

It’s understandable that loyal employees feel comfortable owning their company’s stock, especially when they can buy it at a discount or receive it “free” through a retirement plan’s matching program. But no matter how you receive it, your company’s stock can be a ticking time bomb in your portfolio.

My advice, Part I

Zero is the best percentage of your retirement plan that should be invested in your company’s stock. That’s right, zero. If you receive company stock as a matching contribution, sell it whenever you can and put the proceeds to work diversifying your portfolio. Before the meltdown of Enron, many companies restricted the sale of company stock held in 401(k) plans. Since then, those restrictions have eased at many companies and disappeared at others.

That’s good news to workers who take the trouble to manage their 401(k) investments. Unfortunately, many employees apparently just don’t want to be bothered. According to one study, only 19 percent of 401(k) participants made any changes to their portfolios in 2007.

My advice, Part II

If you have a retirement plan, figure out the best way to diversify your assets, taking into account the other parts of your portfolio, such as IRAs. Then rebalance your accounts once a year to bring the real percentages back into line with your target percentages. That will mean selling the things that have been performing well and buying more of those that have been lagging. And it will mean you keep your risk under control.

If you own company stock outside your retirement plan, reduce it to a small part of your portfolio. Better yet, sell it all. Even if you may have to pay taxes on capital gains by selling company stock, it can be a good idea. You can be sure that thousands of Washington Mutual employees would happily pay capital gains taxes if they could go back and sell the stock they once owned in that company.

They waited. I hope you won’t.

Tom Cock is a financial educator for Merriman Berkman Next