An Employee Stock Ownership Plan (ESOP) is a popular road to employee ownership for many organizations, but is often misunderstood by plan participants, which tends to diminish the effect the ESOP can have on a company’s culture. How should you as a plan sponsor communicate the value of the ESOP to your employee-owners, to better realize its full worth?
First, let’s summarize why plan participants tend to undervalue their ESOP contributions:
The amount of their contribution is inconsistent from year to year, or is unknown
They don’t understand the ESOP, or how ESOPs in general work
There is a tendency to prefer spendable income
Following from this, how can you maximize the value of an ESOP to your employees?
CLEARLY communicate the value of the benefit. Here are some ideas.
- Consider having total compensation statements created.
- Illustrate projected account balances to your participants, helping them understand how what the employer contributes now impacts their retirement later.
- As a part of this conversation, be sure to hit on the tax advantages of ESOPs. Like a 401(k) plan, an ESOP enables participants to defer federal income taxes. However, unlike 401(k) contributions, ESOPs are not subjected to payroll taxes or PA state income tax.
- If predictable and consistent, share the contribution percentage with new hires.
- Think about communicating contribution increases as raises.
- Show the growth in a participant’s account as months of wages.
- For leveraged ESOPs, be sure to show the value of shares being released instead of the value of the contributions.
Develop a strategy to allow level contributions.
If your contribution percentage changes from year to year, employees may assume the worst when comparing to other job offers. There are fundamentally three basic ways to make your contributions more level (beyond the initial loan repayment phase of a leveraged ESOP).
- Review your repurchase obligation study, and consider making level contributions to build up a cash reserve in the plan itself for repurchasing stock in the future (“recycling” method).
- Build up a reserve on the company books to redeem shares that are distributed, and then re-contribute a set percentage that is more level (“redemption” method).
- You can also plan to re-leverage at some point in the future, but this is a less common approach.
Understand and communicate the impact on the 401(k) plan.
Most ESOP companies also offer a 401(k) plan. It is important to communicate how these two plans work together for retirement security, and should not be considered in a vacuum. For example,
- Offer employee education on both plans, together where possible.
- Consider forcing diversification elections into the 401(k) plan to keep balances saved for retirement.
- Ensure there is adequate education on maintaining an appropriate mix of investments, given that the goal of the ESOP is to invest primarily in employer stock.
- Communicate that the ESOP is not meant to replace 100% of income in retirement.
- Note that if you have a level contribution strategy, that will help participants understand how much they need to save through the 401(k) plan.
- Show employees the combined effect of the ESOP and 401(k) on retirement outcomes, income replacement ratios, etc.
Make sure participants understand how the typical installment distribution pattern of ESOPs is different from the lump-sum option in 401(k) plans.
An ESOP is a valuable retirement benefit for participants. However, some participants don’t understand the benefits of an ESOP and may discount its value. Plan sponsors should take initiative to educate their participants on the value and impact of their ESOP on their financial and retirement well-being.