Most companies with an employee stock ownership plan (ESOP) either sponsor a separate 401(k) plan or combine ESOP and 401(k) components together under the umbrella of a single plan arrangement known as a KSOP. The combination of plans offers employees the ability to diversify the investment of their retirement savings through the 401(k) arrangement while enjoying the benefits of ownership through the ESOP. However, many administrative and legal issues arise, and it is crucial for both companies and service providers to understand them, beginning in the plan design stage. The new fee disclosure rules that became effective in 2012 only added to those issues. This publication, written by three experienced practitioners with backgrounds ranging from law to administration, discusses a wide range of essential issues and the best practices for dealing with them.
Table of Contents
An Introduction to ESOP/401(k) Combinations
Key Differences Between ESOPs and 401(k) Plans
Important Considerations for the Company Sponsoring Both Plans
Employer Contribution Deduction Limits
Annual Addition Limits
"Highly Compensated Employee" Definition
Multiple Plan Coordination
Vendor Fee Disclosures
Participant Fee Disclosures
General Design Options
Side-by-Side Plans—Minimal Integration of Features
Match in the ESOP
Safe Harbor Contributions in the ESOP
Considerations in Designing the Second Plan
Adding an ESOP When a 401(k) Plan Already Exists
Adding a 401(k) Plan When an ESOP Already Exists
Stand-Alone Plan or KSOP?
Appendix A: ERISA Section 408(b)(2) Vendor Fee Disclosure Rules
What Does This Mean for an ESOP (or KSOP) Sponsor?
Appendix B: ERISA Section 404(a)(5) Participant Fee Disclosure Rules
Items to Be Included in Initial and Annual Disclosures
Action Items for Affected ESOPs or KSOPs
About the Authors
From "Important Considerations for the Company Sponsoring Both Plans"
Under the terms of ERISA Section 404(a)(5), which also went into effect in 2012, plan participants are entitled to receive annual and quarterly fee disclosure statements if any accounts in a plan permit self-directed investment. The fee disclosure requirements of the typical 401(k) plan are provided by the TPA or investment platform provider for the plan. It is important to note that the fee disclosures may apply to an ESOP if any ESOP accounts are subject to self-directed investment. This would include ESOPs that permit eligible participants to diversify a portion of their employer stock accounts and invest the proceeds in three or more diversified investment options that are provided in the ESOP. This would also include ESOPs that segregate the accounts of terminated participants into cash or other non-employer stock investments and then permit participants to self-direct the investment of segregated funds.
What about an ESOP that provides diversification elections are handled solely through liquidation of employer stock in the ESOP and transfer of proceeds to a separate 401(k) plan? Because of the transfer limitation, it can be argued that the ESOP employer stock becomes a "designated investment alternative" because a diversification-eligible participant must choose between staying invested in stock or investing in the options provided in the 401(k) plan. In this case, a Section 404(a)(5)-compliant fee disclosure notice should be provided annually to diversification-eligible participants along with their diversification election forms. This creates some disclosure challenges, including the need to derive historical rate-of-return data for the employer stock and compare that rate-of-return information to an appropriate benchmark. The benchmark could be the Russell 3000, for example, or any other benchmark that company management deems appropriate.
While the participant fee disclosure rules clearly apply to the participant-directed 401(k) component of a KSOP plan, DOL Field Assistance Bulletin 2012-2, Question and Answer 1, taken literally, may cause consternation for some KSOP sponsors. Question and Answer 1 deal with a plan that provides a combination of both participant-directed investment and trustee directed investment. Such a plan is a "covered individual account plan" that is subject to the participant fee disclosure rules as a whole. That generally means the annual participant fee disclosure statement given to participants should include the 401(k)-related disclosures that are required, including the applicable investment disclosures for participant-directed accounts, plus disclosures concerning any fees or expenses that may be deducted from ESOP accounts that are subject to trustee-directed investment. To meet this requirement, an ESOP addendum may need to be attached to any disclosure statement that is prepared for the 401(k) component of the plan.
See appendix B to this publication for additional information.
From "Considerations in Designing the Second Plan"
As discussed above, the company's contribution deduction limit applies to the total of all contributions it makes to its 401(k) plan and ESOP. If the company has historically funded a match in its 401(k) plan, will that continue? Or should all funding be directed to the ESOP? How will 401(k) participation be affected if a match is either eliminated or redirected into the ESOP? If the company contributes as much as possible to the ESOP, will that cause certain individuals to exceed their Section 415 annual addition limits? Assume an individual participant has annual compensation of $160,000 and is making annual salary deferral contributions of $17,500 in 2013. Assume a match of 50% of the first 6% of compensation deferred, or $4,800. With an annual addition limit of $51,000, that means this employee's allocations in the ESOP cannot exceed $28,700, or roughly 18% of his or her compensation.
Therefore, it is important to run projected contribution estimates before deciding on the final provisions of a stock acquisition note. A plan sponsor should fully consider its estimated deduction limit and the possibility that large contributions could cause some participants to have excess annual additions that require correction.