A Share of the Wealth
Employees want a piece of the action. According to Morgan Stanley at Work’s “2021 State of the Workplace Financial Benefits Study,” 75% of employees agree that equity compensation and stock ownership are the most effective ways to motivate employees. Such programs could also provide a retention benefit: 86% of employees said they will be more apt to stay at their company if it places greater emphasis on equity compensation.
According to the National Center for Employee Ownership (NCEO), employee stock ownership plans (ESOPs)—qualified plans in which workers are given ownership in the company—are the most frequently adopted form of employee ownership program in the U.S.
Corey Rosen, founder of NCEO in San Rafael, California, says the most common reason for establishing an ESOP is to facilitate succession planning in a privately held business. Some owners will be ready to exit their business entirely, while others want to share ownership with employees but stay on in some post-transfer capacity. ESOPs are designed to ease those transfers. “Congress has been extraordinarily generous to ESOPs in providing tax benefits to them, to the owners and to the company,” Rosen says.
From the employee’s perspective, an ESOP looks like a 401(k) plan. All full-time employees of ages 21 and older may participate. The ESOP allocates shares to participants’ individual accounts, subject to vesting rules. There are limits on the company’s deductible contributions to its ESOP and on the amounts the plan may allocate to participants’ accounts. When employees with an ESOP account balance leave, they receive their account value as a stock distribution or cash equal in value to the stock.
Despite the potential benefits to owners and employees, there are relatively few ESOPs among U.S. companies. NCEO reports that, as of year-end 2019, there were 6,482 ESOPs, with a total 13.9 million participants. Both of those figures are down slightly from 2014, which had 6,717 plans, with 14.05 million participants. Privately held ESOPs are far more numerous than publicly traded company ESOPs: in 2019, 5,880 vs. 602, respectively. But the larger public companies’ plans had the most participants: about 11.9 million vs. 2.04 million for private firms.
In contrast, as of this past September 20, the Investment Company Institute (ICI) reported, there were about 600,000 401(k) plans with 60 million active participants and $7.3 trillion in assets.
Identifying ESOP Candidates
The owner’s motivation for exiting his business will determine whether an ESOP is a good fit.
Rosen cites a hypothetical case in which the owner of a closely held company is considering retirement. Creating an ESOP is one option. But this individual is also weighing selling to another company or to a private equity (PE) firm. An outright sale to either would have both advantages and disadvantages, Rosen maintains. “Maybe you’ll get a good price, but, in many cases, some of your employees won’t be kept. Maybe the company will be moved. Maybe some of the values you’ve built in[to] your company will be changed.”
Tom Scalici, co-founder of Cornerstone Advisors Asset Management LLC and Cornerstone Institutional Investors LLC in Bethlehem, Pennsylvania, has a unique perspective on ESOPs. Besides advising clients on the plans, his firm transitioned to an ESOP in 2016 and is now 100% employee owned. He and his business partner were in their mid-40s and looking to establish a succession plan that would share ownership with the younger employees. They considered options such as selling them a minority interest but realized that an ESOP matched well with their goals.
“We could get more money if we sold the company to a strategic buyer, but it would change the culture of the organization,” Scalisi says. “And it would disrupt the lives of the majority of our employees and ultimately our clients. For all those reasons, we felt an ESOP was the best solution for us.”
Alignment with the owner’s transition goals is an essential first step, but a successful ESOP also requires the company to meet certain financial conditions. As Rosen points out, although an ESOP is a defined contribution (DC) plan that shares many rules with 401(k) plans, ESOPs are funded by the company instead of the employees. Therefore, the company should be “reasonably consistently profitable,” he advises.
Company size matters, too. In a book published by NCEO, “An Introduction to ESOPs: How an Employee Stock Ownership Plan (ESOP) Can Benefit Your Company, Its Owners and Its Employees, 19th Edition,” author Scott Rodrick recommends that the company be in the top corporate tax bracket and have, at minimum, 20 employees and a payroll of at least $250,000. Companies below those thresholds probably will find the cost of establishing and maintaining an ESOP too great relative to the advantages, he says.
Rodrick estimates that setting up an ESOP likely will cost a company with 20 employees “$75,000 to $150,000 or more on legal fees, stock valuation—assuming [the stock] is not publicly traded—administration and other costs. Fees will be higher for larger companies and if the ESOP is even partially leveraged. … Administrative fees might start at $2,500 or more per year and increase with the number of participants.”
Transferring ownership to an ESOP is not an all-or-nothing decision, says Scalici, though tax considerations factor into determining the percentage moved. It is beneficial to sell at least 30% of the company to capitalize on some tax benefits that are available to ESOPs, but subsequent transfers are flexible. “A number of ESOPs will start as a partial sale, and [later the owner] sells the balance of the stock,” he says. “[In other cases, owners] will sell 49% so they still maintain equity control of the organization and then sell the other 51% at some point in the future.”
Setting Up the Plan
The complexity of setting up an ESOP varies with the format. The first step is establishing an ESOP trust. The next is deciding how to fund the trust, and at this stage it can get complicated. In a non-leveraged ESOP, the company contributes cash, stock or both to the trust. The ESOP subsequently uses cash contributions to buy company stock from the business or the shareholders.
Leveraged ESOPs involve a lender, and the cash flows and loan repayments are more complex than for non-leveraged plans. Depending on the selected structure, either the company or the plan can borrow funds. If the company borrows the money, the ESOP in turn will borrow from the company and use that money to buy shares from the stockholders. A different twist on the loan arrangement is for the ESOP to borrow from the lender with the company providing a repayment guarantee.
The variety of funding methods provides flexibility in structuring the ESOP. In Cornerstone Advisors Asset Management’s case, the owners realized the younger employees could not afford a significant amount of stock on their own, so the ESOP was funded through multiple strategies. Scalici and his partner employed a lateral transfer, whereby participants could use a portion of their 401(k) plan balance to buy stock, for about 6% of the sales proceeds. The two also took a bank loan—a fixed-term note that covered about 34% of the proceeds. The final piece was a seller’s note, which was an IOU from the company to the owners for the remaining 60%. “The combination of payments was structured this way so as not to burden existing employees with personally having to assume these obligations,” Scalici says.
ESOP or KSOP?
Most traditional ESOPs operate as a standalone plan that the sponsor provides in addition to a 401(k), says Jerry Ripperger, national vice president, stock plan services consulting at Principal Financial Group in Des Moines, Iowa. However, the similarities between ESOPs and 401(k) plans allow sponsors to combine the two into what is known as a KSOP. In Ripperger’s experience, it is usually public companies that offer KSOPs while private companies maintain the ESOP and 401(k) separately.
As most ESOPs, the basis for KSOPs, are at private companies, this may explain why the latter are relatively rare.
“Many companies have both an ESOP and a 401(k) plan,” says Rosen. “A KSOP simply combines the two plans into a single plan document and is administered as a single plan with an ESOP and 401(k) features. Employers may use the ESOP portion to match employee deferrals and/or allow employees to buy company stock with their deferrals,” he says. “Because private companies, unlike public companies, rarely want to base their contributions to the ESOP on employee deferrals and almost never allow employees to buy stock in a 401(k) plan, they have little incentive to combine the plans. Whether plans are combined or not, the tax treatment is the same.” Similarly, “companies may count their contributions to the ESOP toward the 401(k) safe harbor rules whether the plans are combined or not.”
The Adviser’s Role
ESOPs’ technical demands such as for the potential use of leverage, the tax treatment and the company valuations distinguish these plans from other DCs. Nathan Voris, director, investments, insights and consultant services with Schwab Retirement Plan Services Inc. in Richfield, Ohio, says, as a result of ESOPs’ complexity, he encounters few advisers with the expertise to manage both 401(k)s and equity plans for clients. Nonetheless, he says having capabilities in both areas is becoming increasingly important. First, over one-third of participants in Schwab’s 2020 Equity Compensation Participant Survey said equity compensation was the main reason, or one of the main reasons, that they took their current job. Second, ESOP expertise can help advisers “differentiate their practice and add more value to the sponsor,” he says.
Equity ownership can also boost employees’ financial well-being. In the Schwab survey, equity compensation, of all types, comprised an average 32% of employees’ net worth, ranging from 21% for Baby Boomers to 43% for Millennials.
Scalici says Cornerstone’s ESOP is growing faster than its 401(k) plan, with the company stock’s return exceeding the broader market’s results. “If I look at our plan today, I’d say there’s almost a 50-50 split between the value of the ESOP and that of the 401(k) plan,” he says. “At least in our situation, that [ESOP]’s been a big, a big plus.”
As a retirement As a retirement plan adviser, you had several plan sponsor clients bemoan losing valued employees last year. In each case, the departing workers cited a more attractive compensation package at the new job as an important factor in deciding to leave. Your clients are questioning whether it would help recruitment and retention efforts if they expanded their nonqualified deferred compensation (NQDC) plan to cover key employees such as those they lost.
Brian Bobeck, of Cornerstone Advisors Asset Management LLC and Cornerstone Institutional Investors LLC, would answer “yes.” He believes “key employee” is a subjective term that depends on a company’s industry and even the particulars of the company. For example, an employee might not be in line for a corner office but still be essential to the organization. Bobeck cites the construction industry, where a good project manager can be difficult to find and even more difficult to keep. “Those folks need to be considered for an NQDC plan,” he maintains. “The NQDC is as much about the recognition as the dollars. I’d argue, in some cases, the mere inclusion in the plan is more important than the dollars.”
It seems that employers agree about giving a larger role to NQDC. A recent survey by Principal found that more than 30% of plan sponsors think about increasing employee eligibility for NQDC plans, according to
Mark West, national vice president of business solutions at Principal in Des Moines, Iowa. Also, nearly 20% of sponsors consider increasing their plan’s employer contribution. “Historically, less than 4% of employees were eligible [to participate in] the nonqualified deferred compensation plans we administer,” says West. “As NQDC plans continue to be a strong recruiting and retention tool in a tight labor market, we’re seeing increased interest to expand participant eligibility among the plan sponsors we work with.”
Mike Shannon, senior vice president of nonqualified consulting at Newport Retirement Services in Orlando, Florida, says, in the past 24 months, Newport has seen an expansion in participant eligibility and a more creative use of plan design features among companies of all sizes. Historically, plan sponsors have not always included in their nonqualified plans highly compensated employees (HCEs) who are outside of the traditional senior company management group, Shannon says. But due to increased competition for non-management, high-priced talent, more organizations are opening their NQDC plans to other personnel who are equally critical to the company’s success.
Restrictions remain on NQDC participation, though. West cautions that NQDC plans must still meet Employee Retirement Income Security Act (ERISA) guidelines to qualify under the “top hat” exemption. Specifically, a plan may include only “highly compensated or key management employees,” but ERISA does not clearly define these terms, and most guidance comes from a few federal court cases. “As it stands currently, the sponsor works with its legal counsel to determine which employees are eligible to participate,” West says. Some general variables an employer might consider when aiming to expand employee eligibility are income levels, the percentage of the workforce that could enroll in the plan and the roles of the participants within the company, he says.
Shannon emphasizes that a plan must be restricted to a select group of management or highly compensated employees. The NQ plan consulting community generally agrees that a sponsor may allow up to approximately 10% of its employees to be eligible for participation in its NQDC plan and still be considered a select group of management or HCEs. “Some court cases indicate this percentage may be as high as 15% or 18%,” he adds. “But the higher one goes, the greater the risk that the plan may lose its status as a top hat plan and certain exemptions under ERISA.” —EM
Art by Claudi Kessels