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Home > ESOPs > Articles Online > Administrator's Notebook >
Because the Tax Reform Act of 1986 required more rapid minimum vesting than had been the case under ERISA, the typical ESOP today is equipped with one of two vesting schedules. After 1986, the law required that all qualified plan sponsors adopt either "five-year cliff" or "seven-year graduated" vesting schedules. Under the five-year cliff, a participant is 0% vested until completing five years of vesting service. At that point, the participant becomes 100% vested, hence the name "cliff" vesting -- all or nothing. Under the seven-year schedule, participants must be at least 20% vested after three years of vesting service and must advance at least 20% more for each year of vesting service thereafter, allowing 100% vesting after seven years. The seven-year graduated approach (or some variation incorporating the characteristics of an earlier schedule and meeting the requirements of the law) seems to be the most common, but the distribution of the two schedules seems pretty even.
With regard to the timing of forfeitures, the IRS has indicated that it is improper to forfeit non-vested benefits before the vested benefits have been distributed (or at least five breaks in service have occurred). Given that, in the past, plan sponsors have generally preferred to forfeit non-vested benefits as soon as possible after an employee terminates (even though in many cases that is still quite a delay.) Again, though, in this area the distribution of plans that forfeit as early as possible versus those in which the forfeiture is delayed is pretty even.
Our experience has been that for most companies, the two vesting schedules result in essentially the same total vested account balance and repurchase liability, but they do seem to affect the segment of the population benefiting most. In virtually every case, the five-year cliff causes benefits to accrue more rapidly to higher compensated longer service employees than does the seven-year schedule. In any case, both should be tested before a decision is made because once you have chosen a schedule, you're pretty much stuck with it.
With regard to forfeiture timing, the basic discussion revolves around the problems associated with tracking terminated employees versus the ease of reinstating benefits where a participant terminates and is rehired. Usually, the former has won out in the past, but other wrinkles result here from the new coverage and discrimination tests that may tip the scale the other way. Under the final regulations, terminees whose benefits are forfeited are frequently included in the gross population for discrimination testing, but are not included in determining the group of employees benefiting under the plan. Companies with even moderate turnover could find themselves discriminatory when they are required to count certain terminees as employees, but because of a rapid forfeiture provision may not count them as employees benefiting under the plan. This should certainly be considered when determining the timing of forfeitures.
There is also a repurchase liability-based argument to be made for delaying forfeiture as long as possible. Essentially, the point is that a share of stock sitting in the account of a non-vested terminee is not a liability (unless, of course, you rehire the person involved.) Delaying the forfeiture reallocation the full five breaks-in-service creates a large pool of stock in this category and can have a significant impact on your overall repurchase liability. On the other hand (and there always is at least one other hand), if the ESOP is terminated, you may wind up having to fully vest all these ex-employees and distribute benefits to them that would otherwise have gone to current employees.
Per recent NCEO studies (and consistent with our experience), typically the ESOP is used by the company to repurchase distributed shares, and, in general, distributions are delayed for some time after termination (often as long as possible under the law) to slow down repurchase cash flow. While these positions seem to make sense to a large number of ESOP sponsors, there are serious issues to consider regarding both these policy decisions.
Often, when you take into account that any share the ESOP buys will have to be bought again later, the pre-tax advantage of using the ESOP to repurchase shares diminishes. In many cases, the company (and the remaining ESOP participants as well) may be much better off retiring distributed shares even if they are later recontributed to the plan.
By the same token, delay of distributions may or may not give the best outcome. If your stock is appreciating, the longer you wait the more it costs to buy the shares back. If the appreciation occurs at a rate which exceeds earnings on other investments, you may well fall behind in your funding strategy.
In any case, these policies should be investigated and formalized as soon as they reasonably can be so that you avoid getting stuck with unlivable results.
On a final note, if you are in the very beginning of establishing an ESOP, the next few months will likely be almost overwhelming. There is tremendous expense in time and money and emotional energy involved in getting through the maze of requirements, but at the other end, you will be pleased with the result of employee ownership. ESOP companies can be very exciting and profitable places to work.
Copyright © 2002 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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