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A Detailed Overview of Employee Ownership Plan Alternatives

401(k) Plans

Section 401(k) plans allow employees to defer part of their pay on a pretax basis into an investment fund set up by the company. The company usually offers at least four alternative investment vehicles. Because the law requires that participation in the plans not be too heavily skewed towards more highly paid people, companies generally offer a partial match to encourage broad participation in these voluntary plans. This match can be in any investment vehicle the company chooses, including company stock. There is a limit of 25% of eligible pay that the company can contribute to the plan on a tax-deductible basis. This limit is reduced by other employer contributions to defined contribution plans.

There are several factors that favor the use of a 401(k) plan as a vehicle for employee ownership in public firms. From the company's perspective, its own stock may be one of the most cost-effective means of matching employee contributions. If there are existing treasury shares or the company prints new shares, contributing them to the 401(k) plan may impose no immediate cash cost on the company; in fact, it would provide a tax deduction. Other shareholders would suffer a dilution, of course. If the company has to buy shares to fund the match, at least the dollars being used are used to invest in itself rather than other investments. From the employee standpoint, company stock is the investment the employee knows best and so may be attractive to people who either do not want to spend the time to learn about alternatives or have a strong belief in their own company. Balanced against these advantages, of course, must be an appreciation on both the part of the employee and the company that a failure to diversify a retirement portfolio is very risky.

For closely held companies, 401(k) plans are less appealing, although very appropriate in some cases. If employees are given an option to buy company stock, this can often trigger securities law issues most private firms want to avoid. Employer matches make more sense, but require the company to either dilute ownership or reacquire shares from selling shareholders. In many closely held businesses, the first may not be desirable for control reasons and the second because there may not be sellers. Moreover, the 401(k) approach does not provide the "rollover" tax benefit that selling to an ESOP does, and the maximum amount that can be contributed is a function of how much employees put into savings. That will limit how much an employer can actually buy from a seller through a 401(k) plan to a fraction of what the ESOP can buy.

401(k) contributions cannot be leveraged either, so a sale of company stock would have to proceed slowly in annual increments. For example, if a company can get 60% of its workforce to participate in a 401(k) plan, and they put up 5% of pay (a reasonable but fairly high amount in practice), the company might match this on a dollar for dollar basis, but this would still only come to perhaps 4% of payroll (assuming 401(k) participants tend to be higher paid than nonparticipants).

401(k) plans and ESOPs can also be combined, with the ESOP contribution being used as the 401(k) match. This can work on either a nonleveraged or leveraged basis. In the nonleveraged case, the company simply characterizes its match as an ESOP. That adds some set-up and administrative costs, but allows the company to reap the additional tax benefits of an ESOP, such as the 1042 rollover. In a leveraged case, the company estimates how much it will need to match employee contributions each year, then borrows an amount of money such that the loan repayment will be close to that amount. If it is not as much as the promised matching amount, the company can either just define that as its match anyway, make up the difference with additional shares or cash (if the loan payment is lower), or pay the loan faster. If the amount is larger, the employees get a windfall. Combination plans must meet complex rules for testing to determine if they discriminate too heavily in favor of more highly paid people.

Despite the advantages of 401(k) plans as an ownership vehicle, there are important disadvantages as well. These plans are meant to be diversified retirement plans and, as such, do not have the same fiduciary protection for plan trustees and corporate boards as do ESOPs. Heavy concentration of employer stock in a 401(k) plan is harder to defend in court, and in the last decade, well over 100 class-action lawsuits have been filed over company stock in the plans. The result has been that companies and employees are moving away from employer stock as a primary asset in 401(k) plans.

Moreover, the law now requires that in public companies, employees be able to move their 401(k) holdings out of company stock at any time if they have used their own money to buy shares or any time after three years for shares contributed by the employer.

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