The Tax-Conscious Adviser

Robert N. Gordon

401(k) plans shouldn't jump the gun divesting firearm stocks

By Darla Mercado

Jan 20, 2013 @ 12:01 am (Updated 12:23 pm) EST

Rahm Emanuel
Rahm Emanuel Bloomberg

Plan sponsors may want to hold off if they are thinking of selling stocks of controversial companies such as firearms manufacturers, despite the fact that some public pension plans are reviewing their holdings of such stocks, some financial advisers say.

New York is the latest state to freeze such investments. The New York State Common Retirement Fund confirmed last Tuesday that the fund — which has $150.1 billion in assets — is halting its investments in publicly traded commercial-firearm manufacturers.

The move follows last Monday's call by Chicago Mayor Rahm Emanuel for five city pension funds to determine whether the fund managers hold equity or debt instruments from companies that either sell or make assault weapons. The review is the first step toward dropping the investments from the plans.

But financial advisers and attorneys who specialize in the Employee Retirement Income Security Act of 1974 warn that other employers should think twice before making similar decisions, particularly if such divestments could put a dent in a retirement plan's returns.

“From a plan standpoint, the primary purpose is to provide for the retirement benefits of the participants and beneficiaries,” said Richard K. Matta, principal at Groom Law Group. “Any other considerations have to be secondary.”

STRONG RETURNS

Indeed, companies such as firearms manufacturers Smith & Wesson Holding Corp. (SWHC) and Sturm Ruger & Co. Inc. (RGR) have had strong returns, beating the broader S&P 500.

As of Jan. 14, trailing total annualized returns for Smith & Wesson were 71.46% for the one-year period, 24.16% for the three-year period and 8.75% for the five-year period. Sturm Ruger also experienced strong total returns of 39% over one year, 72.73% over three years and 48.08% over five years.

By comparison, trailing total returns for the S&P 500 were 16.69% for the one-year period, 10.92% for the three-year period and 3.03% for the five-year period.

As a result, removing such holdings — as well as “vice” stocks — could create a damper on returns. The Vice Investor Fund (VICEX), for instance, returned 23.17% last year, 16.73% for the three-year period and 2.43% for the five-year period.

“All the work we've done on the subject suggests that if you go socially conscious, you should expect to underperform the S&P,” said Michael Francis, president of Francis Investment Counsel LLC. “That's not to say there aren't products out there that are consistently outperforming, but the overall impact has been a detractor to returns.”

Mr. Francis noted that he hasn't received any recent questions from plan sponsors about investments that are connected to the firearms industry, but typically, hospitals and other nonprofit groups are the ones that prefer to invest in a socially conscious manner.

FIDUCIARY ROLE

On Jan. 9, the California State Teachers' Retirement Systems said that it would start divesting from firearms companies that manufacture weapons that are illegal in the Golden State. Since then, several large funds have followed suit.

But employers seeking to replace their firearms stocks or other controversial holdings need to consider the rationale for the switch, such as whether the fiduciary is making a prudent call that the divestment is financially safer, Mr. Matta said.

The Labor Department requires that such alternatives chosen by fiduciaries be either equal or superior to whatever investment they replace.

Finding which investments are tied to controversial industries might not be easy, particularly when taking a closer look at the underlying stocks inside funds offered in a 401(k), said George Fraser, managing director at Retirement Benefits Group LLC.

“How do you determine the relationship that those stock companies have with the gun companies?” he asked. “You may end up down to three mutual funds.”

As a result, it may make better sense for employers to draw a line between social policy and the returns that they seek for their workers, said Marcia Wagner, managing director at The Wagner Law Group.

“An underfunded pension plan should have one goal in mind: "What assets should we invest in to diminish the underfunded status?'” she said, noting that the caveat is that plans invest in accordance with the law.

dmercado@investmentnews.com Twitter: @darla_mercado

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