Employee accounts in an Employee Stock Ownership Plan (ESOP) are primarily invested in employer stock. In ESOPs that hold non-publicly-traded stock, when an active employee elects to diversify or a former employee requests a distribution, because there is no ready market for the stock, employer stock is sold and payment is made to the participant in cash. This obligation on the part of the company or the ESOP to repurchase stock is known as the Repurchase Obligation. The company may satisfy this Repurchase Obligation by buying the shares and removing them from the ESOP (Redeeming), or the shares may be purchased with the available cash held in other employee accounts (Recycling). Here are some of the basics you should consider when evaluating your Repurchase Obligation:
As the value of the stock within the ESOP increases, a common concern with the Repurchase Obligation is the uncertainty of how much stock will need to be repurchased in future years. As an example, there may be a group of long term employees all expected to retire at the same time. To manage this risk, the company needs to project estimated future distributions, consider possible plan design changes, and finally accumulate a reserve to smooth out the cost.
The first part to managing Repurchase Obligation Risk is to estimate the value of projected future distributions. Some companies run simple projections on their own and others hire professionals for more support. In either case, it is important to update these projections periodically and remember that actual experience will vary from what is projected.
The projected distributions from the study may be higher or lower than desired. If that is the case, the company may want to consider making changes to the plan. As an example, if distributions are higher than desired in the near term, a plan may want to increase the distribution wait time (subject to regulatory limits). Plan design professionals are able to assist in brainstorming different options and calculate the impact on projected distributions.
The final piece to managing Repurchase Obligation Risk is to create a reserve (assets set aside for a future stock repurchase). If shares are being recycled, contributions to the plan that are in excess of distributions result in employees having part of their accounts invested in non-employer stock investments. These non-stock investments function as a reserve, as they may be used to repurchase employer stock from former employees in future years. The reserve may also be held outside the plan rather than inside employee accounts.
The reserve serves two purposes. The first is to allow for a consistent contribution from year to year. In years where the contribution is higher than the repurchase obligation the reserve grows, and when the contribution is lower than the repurchase obligation the reserve shrinks. A smoothed contribution is easier for employees to understand and to value. It is also easier on the budget. The second purpose of the reserve is to prepare for distribution bubbles. If distributions are expected to be higher than typical for a few years, a reserve can be accumulated ahead of time to offset the higher repurchase obligation.
Every ESOP is unique. There is not a one–size-fits-all solution for managing Repurchase Obligation risk. The timing and scale of a company’s repurchase obligation projection depend on a number of factors, including the available budget and number of employees. Similarly, the appropriate reserve amount will vary depending on the company’s risk tolerance and the volatility of projected distributions.
Questions about your Repurchase Obligation or interested in learning more about ESOPs? Contact our experts directly!
Trevor Bare, FSA, EA, MAAA