The Case of the Disappearing ESOP
Employee Stock Ownership Plans (ESOPs) once presented attractive opportunities for business owners in terms of tax benefits, exit strategies, and employee performance incentives. Many business owners believe employees are better positioned to take over and manage a company than outsiders when the owner decides to move on or retire. Granting employees ownership in the company they work for is also thought to result in greater employee loyalty and performance.
However, the lingering fallout from the Enron and WorldCom scandals has some investors and business owners spooked on the safety of ESOPs as employee retirement plans. The U.S. Department of the Treasury has subsequently more closely reviewed how truly safe ESOPs are in the hands of corporations.
What they’ve determined is not good news for corporations with ESOPs. The agencies and offices involved in the oversight of ESOPs have uncovered distressing findings of speculative investments made by some corporate officers in some companies. But in fact, findings show that the irregularities may be much more prevalent than many originally thought.
Although ESOP proponents such as the National Center for Employee Ownership (NCEO) continue to tout the benefits of ESOPs for both employers and employees, many companies have gravitated toward Defined Contribution Plans in place of ESOPs, particularly to 401(k) plans. Although ESOPs are still around and participants of ESOPs have actually increased in the past 20 years, the number of companies offering ESOPs has decreased.
Can ESOPs harm employees?
In Enron’s case, many employees’ retirement savings were invested almost exclusively in Enron stock. One woman, Debbie, not only lost her job but $40,000 in retirement savings as well. Of course, it’s obvious now that retirement plans invested solely in one company’s stock are under diversified and thus inherently risky.
But ESOPs present other opportunities for conflicts of interest to occur, which are interestingly not regulated by the Employee Retirement Income Security Act of 1974 (ERISA). For example, when an employer decides to form an ESOP, ERISA limits do not apply to the conduct of plan fiduciaries when making plan formation decisions. Therefore, employers can mandate that employees invest their retirement contributions solely in company stock, and employees have no options for recourse or complaint.
Additionally, many companies with ESOPs are not publicly traded, so accurately pricing the value of company shares is difficult. Although independent fiduciaries and valuation firms are hired to prevent the obvious conflict of interests that may arise from insiders pricing share valuations, these third parties often have their own reasons for wanting to please company owners.
To be certain, not all corporations with ESOPs cause harm to their employees, and there are many who advocate for the benefits of ESOPs, including employees’ sense of ownership in the company they work for as well as the possibility of higher returns on retirement investments. Nevertheless, ESOPs do present risks for both employers and employees when mishandled.
What does this mean for corporations with ESOPs?
Regardless of when or how the wheels of government and regulation move, the direction is obvious to most retirement plan administrators. Business owners who are seeking to avoid government scrutiny of their corporate ESOPs (and the underlying investment strategy) are moving in the direction of offering Defined Contribution Plans, such as the 401(k).
In a Defined Contribution Plan, the investment risk shifts from the employer and moves toward the employee because investment decision-making responsibilities are now placed more directly into the hands of the employee. For many employers, the resulting decrease in liability adds a significant level of relief.
Once the decision to change from an ESOP to a Defined Contribution Plan is made, two issues immediately come into play for the corporation:
It may take time for the officers of the company to liquidate the ESOP assets into cash equivalents.
The government now requires a review of Plan assets prior to the distribution of any of the assets from the ESOP, which can take up to 2 years.
To account for this long period of time, some employers and plan administrators form liquidating trusts to hold the ESOP assets while they establish new 401(k) Plans. Most employers and employees have a good idea of the value of each employee account, but the closing value cannot be assigned until the government concludes the audit and gives its final authorization.
Until the final cash figure is assigned and determined, the employee only has a “beneficial interest” in the ESOP, meaning they are not holding stock certificates, shares, or cash. Normally this would not be an issue, but traditional broker-dealers cannot hold “beneficial interests” because they are deemed non-traditional assets.
This is where the role of an independent plan administrator comes into play.
How Chicago Trust Administration Services Can Help
An independent plan administrator (i.e., a plan administrator with no broker-dealer affiliation) will hold the “beneficial interests” during the government audit. These interests are held like all other non-traditional assets until the overseeing government authority provides authorization for disbursement.
When disbursement is authorized, the original ESOP will be allowed to close, and Plan distributions can begin. Once the new Plan – whether a 401(k) or other Defined Contribution Plan, such as a SIMPLE IRA – is in place the “beneficial interests” are assigned a value and the assets are transferred to the new Plan.
Get in touch
We hope this basic information will help you understand the changing role of ESOPs and their relationship to self-directed retirement planning. At Chicago Trust Administration Services, we have the experience and the ability to help you transition from an ESOP to a Defined Contribution Plan.
If you have any questions or concerns about your company-sponsored retirement plan, please call us for more information and we’ll put our “detectives” to work. You can reach us by calling 312-869-9394 or emailing steve@ctasira.com to schedule a free 20-minute consultation.