Are ESOPs Good Retirement Plans?
Research Shows That ESOPs Provide Retirement Benefits that Are Both Much Larger and Much More Equitably Distributed than Most Other Retirement PlansFor a quick side-by-side comparison of retirement security in ESOPs versus 401(k) plans, see the table at the end of this article. For a more detailed review of this topic, see Corey Rosen, "Do ESOPs Need Reform? A Look at What the Data Show," Tax Notes, June 22, 2015.
IntroductionPerhaps the most common and politically important question about ESOPs is whether they are too risky to be a good retirement program for employees. ESOPs inherently increase the concentration of retirement assets in a single security—company stock— and critics contend that this reduced diversification makes ESOPs too risky. Even worse, employees depend on the same company for both their paychecks and their retirement accounts.
This is an understandable concern, but it rests on an assumption that turns out to be incorrect in most cases. The diversification argument assumes that companies with ESOPs are substituting the ESOP for a diversified retirement plan. That turns out not to be true. ESOP companies are slightly more likely to have a secondary retirement plan (even defined benefit plans), than non-ESOP companies are to have even just one plan. Moreover, many mature ESOPs begin to diversify some of the assets in the plan over time. So for the very large majority of cases, the real choice is between non-ESOP participants, who have $X in diversified assets, versus ESOP participants who also have $X in diversified assets, but who have, in addition, $Y in company stock. In practice, ESOP participants are actually better off by a considerable margin in terms of retirement assets. Moreover, by their design, ESOPs are particularly better for lower income and younger employees than typical 401(k) plans.
Consider the following facts:
- Based on Department of Labor filings, companies on average contribute 50% to 100% more to ESOPs than non-ESOP companies do to 401(k) plans.
- Most of the money in a 401(k) plan comes from the employee. With few exceptions, all the assets in an ESOP come from the company.
- Research by the Department of Labor shows that ESOPs not only have higher rates of return than 401(k) plans and are also less volatile.
- ESOPs lay people off less often than non-ESOP companies.
- ESOPs cover more employees, especially younger and lower income employees, than 401(k) plans
- ESOP companies are somewhat more likely to offer secondary retirement plans than conventional companies are to offer any plan
ESOP Contributions Are LargerWhich is riskier: a $100,000 account balance all in company stock or $50,000 diversified 401(k) plan? ESOP accounts tend to be larger than 401(k) accounts partly because contributions by the company to the ESOP average about 6% to 8% of pay per year. Non-ESOP companies contribute about 4% of pay per year into their 401(k) plan according to the 401(k) Plan Help Center, but that only goes to those who actually defer into the plan, typically about two-thirds to three-quarters of the eligible employees. As we will see below, ESOPs are actually not more volatile than 401(k) plans, but even if they were, there is considerable room for a downside in an ESOP before the risk equals that of a diversified plan.
ESOPs Are More Likely to Offer Secondary Retirement Plans Than Other Companies Are to Offer Any PlanIn a survey by PlanSponsor Magazine in 2013, 95% of ESOP companies offered 401(k) plans compared to 86% for respondents overall. ESOPs were also slightly more likely to offer defined benefit plans and profit sharing plans. Survey respondents tended to be larger companies and more likely to offer some kind of retirement plan than companies in general.
In a 2010 project funded by the Employee Ownership Foundation, the NCEO did an extensive analysis of ESOP companies using data from the U.S. Department of Labor Form 5500 reports. We looked at every ESOP company for which data are available compared to all retirement plans. The study found that ESOP companies are 20% more likely to offer a second defined contribution (DC) plan than non-ESOP companies are to offer any DC plan at all.
ESOPs Cover More PeopleESOPs, by their terms, include all employees meeting minimum service rules whether they defer any income or not. 401(k) plans, the most common retirement plan, only cover employees who defer into the plan. What they get then depends on what they defer, typically a 50% match up to about 6% of pay. So younger, lower income employees not only are more likely to be uncovered entirely, but are also getting a lower percentage of their pay contributed by the company than higher income ones. In most ESOPs, by contrast, all employees get the same percentage of pay.
It is also important to note that according to the Employee Benefits Research Institute, 47% of the full-time adult workforce does not participate in any retirement plan. A plan with diversification risk but significant assets is far better than no plan at all.
What Is at Risk Is Rarely Employee MoneyThe vast majority of ESOPs are funded entirely by the company. ESOP participants often accumulate very large account balances, typically well over six figures after 10-15 years. If that value sharply declines, then employees obviously have suffered a real loss. But this is a very different kind of loss than would be the case in a 401(k) where most of the money came from the employees.
ESOPs and ESOP Participants Often Diversify Over TimeOnce ESOPs have bought all the shares they are going to buy, companies often start putting cash into the plan. Mature ESOPs often have 20% or more in cash. In addition, by law employees with 10 years or more in the plan who are at 55 or older can diversify up to 25% of their company stock, and five years after they start doing this, can diversify up to 50%.
ESOPs Are Less Volatile and Have Better Rates of ReturnData from the Department of Labor for retirement plans with 100 or more participants show that ESOPs outperformed 401(k) plans in 15 of the 20 years between 1991 and 2010 and underperformed in only three (two were the same). ESOPs were also less volatile during that time as measured by standard deviation scores for the periods 1991-2000, 2001-2010, 2006-2010, and 2008-2010 (the periods the DOL analyzed).
The table below provides a summary of the findings:
Return Rates and Volatility in ESOPs versus 401(k) Plans
|Mean Rate of Return||7.8%||9.1%|
There are two reasons for this difference. First, almost all ESOPs are in closely held companies. By law, they must have an annual independent appraisal. The appraisal technique typically projects earnings over the next 3-5 years and then calculates a risk-adjusted present value to use as the key element of valuation. This then tends to average out future volatility. Second, ESOP companies tend to be managed for the long term. Equities in 401(k) plans are typically in public companies where quarter-to-quarter performance is the key issue. As we have seen in the last two decades, the stock market can be extremely volatile, partly as a result.
ESOPs Lay People Off Less Than Conventional CompaniesGeneral Social Survey data from 2002, 2006, and 2010 indicate that employee ownership plan participants are one-third to one-fourth as likely to be laid off as non- participants. For many people, job security is the most critical issue for retirement security.
The Bottom LineIn the analysis of Form 5500 data discussed above, we concluded that looking only at defined contribution plan assets originally contributed by the company, ESOP participants have approximately 2.2 times as much in their accounts as participants in comparable non-ESOP companies with DC plans. They are somewhat more likely to have a 401(k) plan or other retirement plan as well. We could not include defined benefit plans in this analysis because of how they are funded, but the PlanSponsor data indicate that ESOPs are actually more likely to have these plans than non-ESOP companies.
Overall, then, ESOPs make a substantial contribution to retirement security. They are not without risk, but the percentage of participants who end up with their retirement at risk is a tiny fraction of those who end up with a greatly enhanced retirement package. That is particularly true for the millions of employees with no retirement plan at all.
The table below provides a quick summary of the key differences comparing ESOPs to the most common form of retirement plan, the 401(k) plan.
ESOPs Versus 401(k) Plans for Retirement Security*
|Contribution rate from company to the plan||6% to 8% of pay per year for all eligible employees.||4% of pay of those eligible employees making deferrals per year (about two-thirds to three-quarters of eligible employees defer into the plan).|
|Rate of return||Department of Labor data indicate ESOPs had a 9.1% annualized rate of return from 1990-2010.||Department of Labor data indicate 401(k) plans had a 7.8% annualized rate of return from 1990-2010.|
|Volatility||Department of Labor data show that ESOP returns were less volatile between 1990 and 2010 than 401(k) plans.||Department of Labor data show that 401(k) plan returns were more volatile between 1990 and 2010 than 401(k) plans.|
|Diversification in the plan||Mature ESOPs tend to partly diversify over time and participants can choose to partially diversify at age 55 and 10 years of participation.||401(k) plans are generally, but not always, well diversified.|
|Secondary plans||ESOP companies are slightly more likely to have a 401(k) or pension plan than non-ESOP companies are to have any retirement plan.||Most companies with 401(k) plans do not have secondary plans.|
|Coverage of younger and lower income employees||All employees meeting minimum age and service requirements are in the plan and receive contributions based on a percentage of pay or more level formula. Employee contributions are rarely required.||Most 401(k) plans require employees to make deferrals to get company matching contributions; lower paid and younger employees are the least likely to defer and defer and lower percentages of pay.|
|Job security||Employees in employee ownership plans are one-third to one fourth as likely to be laid off as non-plan participants.||Employees not in employee ownership plans are three to four times as likely to be laid off as employees in these plans.|
|Bottom Line||ESOP participants have approximately 2.2 times as much in their accounts as participants in comparable non-ESOP companies with DC plans||Most of the money in a 401(k) plan comes from the employees, not the company. Median account balances for 401(k) participants age 55-64 are only $120,000 (2012 data from Center for Retirement Research at Boston College).|