The NUA Benefit and Optimal Investment in Company Stock in 401(K) Accounts

29 Pages Posted: 27 Feb 2007

See all articles by Mukesh Bajaj

Mukesh Bajaj

LECG, LLC; University of California, Berkeley - Haas School of Business

Sumon C. Mazumdar

Law and Economics Consulting Group (LECG), LLC; University of California, Berkeley - Haas School of Business

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Rahul Surana

Law and Economics Consulting Group (LECG), Inc.

Date Written: February 10, 2007

Abstract

It is widely believed that contrary to standard asset allocation theory, employees irrationally hold concentrated investments in company stock in their 401(k) plans thus bearing firm-specific risk that could otherwise have been diversified away [See for example, Benartzi (2001)]. However, in measuring any such lack of diversification costs, a unique tax benefit associated with such investments (available to those who choose the Net Unrealized Appreciation [NUA] strategy) has been hitherto ignored. We analyze an employee's optimal allocation of retirement assets among alternative investments, including company stock, in the presence of the NUA tax benefit. The employee has a standard power utility function and seeks to maximize expected utility from her after-tax wealth upon retirement. Based on simulations, we find that, even when company stock is stochastically dominated by investments in the market index, the employee will allocate a non-trivial part of her retirement funds to company stock for a wide range of parameter values. Consistent with empirical evidence, the allocation to company stock is greater for employees closer to retirement and when the company's stock has experienced substantial gain in value.

Keywords: NUA, 401(K), Retirement, Investment in Company Stock

JEL Classification: G23, G11

Suggested Citation

Bajaj, Mukesh and Mazumdar, Sumon C. and Nanda, Vikram K. and Surana, Rahul, The NUA Benefit and Optimal Investment in Company Stock in 401(K) Accounts (February 10, 2007). Available at SSRN: https://ssrn.com/abstract=965808 or http://dx.doi.org/10.2139/ssrn.965808

Mukesh Bajaj

LECG, LLC ( email )

2000 Powell Street, Suite 600
Emeryville, CA 94608
United States
510-450-6736 (Phone)

University of California, Berkeley - Haas School of Business

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

Sumon C. Mazumdar

Law and Economics Consulting Group (LECG), LLC ( email )

2000 Powell Street, Suite 600
Emeryville, CA 94608
United States
510-450-5493 (Phone)

University of California, Berkeley - Haas School of Business

Finance Department
Berkeley, CA 94720
United States

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

Rahul Surana (Contact Author)

Law and Economics Consulting Group (LECG), Inc. ( email )

Suite 600
2000 Powell Street
Emeryville, CA 94608
United States

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