Home > Reference Desk > News & Commentary >

Should ESOPs Be Subject to Stricter Diversification Rules?

By Corey Rosen, NCEO Executive Director

January 8, 2002

In the wake of the Enron debacle, there have been a number of proposals to require greater diversification in employee stock ownership plans (ESOPs), as well as 401(k) plans. Enron, in fact, operated both kinds of plans, although the 401(k) plan was much larger and covered more people. The most prominent of these proposals has been made by Senators Barbara Boxer (D-CA) and John Corzine (D-NJ). Current ESOP law allows employees who are 55 years old and have 10 years of participation in the plan to diversify up to 25% of their company stock balance in the ESOP, rising to 50% at age 60. The Boxer-Corzine bill would impose a variety of new rules on 401(k) plans and, in addition, accelerate the onset of ESOP diversification by requiring that ESOPs offer employees the right to start diversifying out of their company stock allocations once they reach age 35 (instead of 55) and have 5 years (instead of 10 years) of participation in the plan.

What the Research Tells Us

What does the research tell us about how this would affect ESOPs? To understand this issue, it's necessary to start by understanding there are two distinct ESOP universes: private company ESOPs and public company ESOPs. Fewer than 5% of all ESOPs are in public companies. Almost all these plans are integrated with the company's 401(k) plan and are used to fund the company's match to employee deferrals in the plan. In effect, these ESOPs are really not much different from a company's simply matching employee deferrals directly with company stock, without having a formal ESOP. In private companies, ESOPs are sometimes integrated with 401(k) plans, but their principal purpose is something very different. In most cases, the ESOP is used to provide a market for shares of an owner looking to retire or diversify in a successful business. The remaining ESOPs are generally used as an employee incentive that is an add-on to other benefits. Integrating the ESOP with the 401(k) may be a matter of administrative convenience or a way to encourage greater employee deferrals, but is almost an afterthought of the ESOP, not its principal purpose.

Diversification rules for public company ESOPs would mean that it would be somewhat less attractive to contribute company stock to the 401(k) plan through an ESOP match, but probably not dramatically so since most employees would probably not diversify very quickly, if at all. When they do diversify, moreover, there is a public market to handle the sale of stock. Private companies, on the other hand, face a much different scenario. They have to come up with the cash to buy the shares. While this is not a problem in most ESOPs if the requirement occurs at termination, retirement, or within existing diversification rules, it could be a barrier for some companies thinking about ESOPs if they now face a scenario in which they will have to start cashing people out much sooner. That's because most ESOPs are funded by loans to buy out owner's shares. Companies who need to pay off the loan and, either while still paying it or very soon thereafter, have to start paying off diversification elections, could find themselves in a cash crunch. That would harm the company overall and the remaining employee owners as well.

If some companies decided that this was just one more hassle in dealing with ESOPs, that would be unfortunate for all the employees who thus won't get to be employee owners. The research on ESOPs in private companies is very clear: employees in an ESOP are more likely, not less likely, to be in other kinds of retirement plans, have much greater retirement assets than they would otherwise, and get paid more.

Data from Joseph Blasi and Douglas Kruse of Rutgers University show that private ESOP companies are much more likely to have 401(k), profit sharing, and pension plans than non-ESOP companies. It's thus misleading to suggest that ESOPs cause a lack of diversity; in fact, the presence of an ESOP signals companies are more likely to have other kinds of plans, meaning the ESOP is mostly gravy. For instance, 20% of ESOP companies have defined benefit plans, 33% have 401(k) plans, and 33% have profit sharing plans (these are often integrated with a separate 401(k)), and 14% have other retirement plans. Comparable non-ESOP companies do much worse. Only 5% have pension plans, 6% have 401(k) plans, 8% have profit sharing plans, and 2% other kinds of plans.

Data from Washington State are even more telling. A massive study there indicated that ESOP participants get 5% to 12% higher wages than comparable employees in comparable non-ESOP companies, have three times the total retirement assets, and have as much in total diversified investments in the ESOP and other company retirement plans as do comparable employees in comparable non-ESOP companies. So discouraging ESOPs would mean fewer employees would be getting these compensation benefits. If a company were sold to someone else, rather than to an ESOP, employees would end up, in general, with lower wages, less retirement benefits, and no more even in diversified retirement assets.

The Bottom Line

ESOPs have been a great success in private companies. Changing the law to make them less attractive to employers would be a great disservice to employees. 401(k) plans should be diversified retirement plans and do need to be changed. ESOPs are ownership plans. The data for private companies, where 95% of the ESOPs are, show they function just that way, with companies offering separate retirement plans. It's a law that has worked just as Congress intended.

These views represent those of the author, not necessarily the NCEO, which does not take positions on legislation.

^^Top of Page