Understanding your ESOP

ESOPs are a type of qualified retirement plan. They are not as common as other qualified plans, such as 401ks and 403bs, but you may be offered the option to participate in an ESOP at some point in your working career. Learn how ESOPs are unique and the planning opportunities that come along with them.

What is an ESOP?

ESOP stands for Employee Stock Ownership Plan. These plans give employees ownership, or stock, in their company. It is mostly used by private companies, but public companies can also use them.

With an ESOP, the employer buys shares on behalf of the employee and places the shares in a Trust. These plans are typically employer-funded and governed by ERISA (the Employee Retirement Income Security Act). If you leave a company, you are allowed to roll the vested balance of your ESOP over to an IRA, as with a 401k or 403b, and the unvested balance is forfeited to the company.

Why are ESOPs utilized?

ESOPs are used as a business succession tool.

The first ESOP created was by the owners of Peninsula Newspapers in 1956. Both owners were in their 80’s and wanted to retire, receive value for the company they built, and ideally sell it to the employees. The employees, however, did not have the money to buy the company from them outright. They approached Louis Kelso who proposed the first iteration of what eventually became known as an ESOP. The attraction of an ESOP is that company culture and key employees are kept intact (which would seem less likely if the company were to be sold to an outside company) and employees are incentivized to have a long-term perspective with regard to company decisions and profitability.

The problem with ESOPs.

Lack of Diversification

When you work for a company, your wages and insurance (life, disability, medical) are often dependent on your employer. If the company does not do well, you could lose all of those vital benefits. If you invest 100% of your retirement savings into the company as well, as with an ESOP, you could be wiped out financially. It has happened before with big companies, such as Kodak, and it can happen again. The Pension Benefit Guaranty Corporation (PBGC), which provides insurance for most private defined benefit plans, such as a pension, does not insure defined contribution plans such as ESOPs.

Lack of Liquidity

Most ESOPs are private shares and there is not a readily available market for them. Similar to other qualified plans, you can’t start distributing from the account until after you terminate employment. If you happen to leave when the company is not doing great and there is a large round of layoffs, for example, the share price could be depressed right when you are required to sell. There may also be a delay in receiving your money - if you leave for a reason other than your normal retirement age, a disability, or death, you may not begin receiving ESOP distributions until six years after termination.

The ESOP election that you should take advantage of.

The Tax Reform Act of 1986 instituted a welcome change to ESOP purchases made after 12/31/1986 with IRC 401(a)(28)(B) by requiring diversification options for qualified participants. Qualified participants are those that are age 55 and have 10 years of plan participation. Qualified Participants must be allowed to diversify up to 25% of their balance each year over a 5-year period, then 50% on the 6th year. Diversification could be a distribution, rollover to another qualified plan, or the ability to invest in at least three (3) other investment options within the ESOP.

3 Important steps to take if you have an ESOP at work.

1) Diversify the funds as soon as you are eligible.

Diversification is spreading your money out among a variety of different asset classes so you do not have too much exposure to one asset class, sector, or company. Many people understand the importance of doing this, but it can be hard, especially if your company has done well and made you a lot of money. Employees can be the biggest advocate for their employers and they may strongly believe in the leadership and mission of the company, but leaving everything in one pot makes you extremely vulnerable.

2) Invest in another qualified plan if allowed.

With the clients I have worked with that have an ESOP, all of them also had the option to save to another qualified plan, such as a 401k. Take advantage of that option to diversify your retirement assets and save as much as possible to other vehicles.

3) Consider discounting the ESOP balance in your financial plan.

When working with your financial planner, discuss with them if you would like to discount the ESOP balance in the event you leave and lose the unvested balance, the company valuations change and you lose money, or the company fails and you lose everything. Maybe you don’t want to include the ESOP at all to be conservative. You can run different scenarios to make sure you have a plan that you feel comfortable with.

Read your plan documents.

Read through the ESOP documents provided to you by your employer. It will include details such as the vesting schedule of your contributions and distribution options if you leave the company.

Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning and ongoing impact-focused investment management in San Diego and nationwide. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.