Owners' Page: Is an ESOP Really a Good Retirement Plan?

Yes, as long as it follows common best practices.

While there are some great retirement plans offered by companies, the overall data are pretty dismal. Only 48% of all private sector employers offer any kind of retirement plan, but about 80% of those with more than 50 employees offer such plans. Some companies still offer traditional pension plans that pay out a percentage of your highest pay for the rest of your life, but these are increasingly rare. Just 15% of private industry workers have access to this kind of plan. Most of these are in large companies and/or unionized companies.

Most retirement plans now, however, are 401(k) plans. According to the Bureau of Labor Statistics, 70% of employees in the private sector have access to a retirement plan, but just 54% of eligible employees participate (some surveys show even lower numbers). That is because 68% of all 401(k) plans require employees to contribute their own money, and some employees don’t contribute at all. The lower the wage, the lower the participation rate. Only 25% of the lowest-paid workers participate, compared to 52% of those in the next 25%. Employers typically budget about 3% of pay for 401(k) and similar plans, much of it based on a matching formula. Just over half of all employees work for an employer who contributes 50 cents on each dollar deferred or less, usually up to a maximum. So, if you put in $1,000, your employer might put in $500. Nine percent of workers work for an employer with a larger maximum, but 38% work for an employer with no match at all—it’s all your money. Overall, about two-thirds of the funds in 401(k) accounts come from employees.

Because 401(k) plans are usually based on employee deferrals, and because higher-income people defer more, their benefits are skewed upwards—in other words, higher-paid people receive a higher-percentage contribution from the company than lower-paid people.

Why ESOPs Are Different

In the vast majority of ESOPs, the employee contributes nothing. ESOP companies generally contribute more to their plans than companies do to 401(k) plans, typically from 4% of pay up to significantly greater amounts. So, if your employer is putting in 4% of pay or more, your plan is more generous than typical 401(k) plans. ESOPs distribute contributions based on relative pay, not what you defer. So, if the company contributed 5% of pay to the ESOP, everyone gets 5% contributed to them. In 401(k) plans, lower-paid people would typically get less than that. ESOPs thus tend to be much better plans for people who have a hard time contributing to 401(k) plans.

Are ESOPs Too Risky?

Critics of ESOPs say they are too risky. If the company stock drops significantly, employees will have inadequate assets for retirement. By contrast, 401(k) plans and other retirement plans that employers offer have to be diversified—they are or can be invested in a variety of things. Diversification is a good thing—it means that if one investment fails, you still can do well with others. The risk that you will end up with major losses is much lower than if you are only invested in one investment, no matter how good that investment is. However, there are some things to consider here. First, when you get to age 55 and have 10 years in the plan, you can start to diversify your ESOP. Second, most ESOP companies offer a 401(k) plan, and you can (and should!) still invest in that, just as you would if there were no ESOP. It is still a great deal, because your money is not taxed before it is invested. That typically means you automatically make a first-year return on your investment of 30% or more just because you did not pay taxes. ESOP companies are somewhat more likely to offer a secondary retirement plan, in fact, than most companies are likely to offer any kind of plan at all.

Finally, there is a less obvious (but very important) factor. Your retirement plan won’t do you much good if you don’t have a job and have to spend that money just to get by. The good news about ESOPs is that ESOP companies lay people off at one-third to one-fifth the rate of non-ESOP companies. This more stable employment means you stay in your job, see your benefits vest and, usually, receive salary increases as you go along rather than being laid off and starting over again. You may have to wait in a new job to be able to join a retirement plan, and you may need to start vesting again. But nothing is guaranteed, so it is generally positive news. Overall, ESOP participants end up with about three times the retirement assets as employees not fortunate enough to be in ESOPs. This statistic will vary a lot from company to company, though. Although it’s not common, some ESOPs do go bankrupt or see dramatic declines in stock value. So, don’t just assume that the money will be there. Save what you can in a 401(k) or other savings vehicle.

Planning for Retirement

Think about what you will need to retire, and make a plan. There are lots of useful tools online that help you calculate your retirement needs and what to expect from your retirement plans. The NCEO offers a series of recorded one-hour webinars, each one geared towards a different stage of your ESOP career, that can help you create the right plan for you.