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The Employee Ownership Update

Corey Rosen

April 17, 1995

(Corey Rosen)

New Research on ESOPs as a Retirement Benefit

In one of the largest studies on ESOPs ever, two academics compared ESOPs to diversified plans. Michael Conte and Rama Jampani of the University of Baltimore found in the study that when looked at in terms of rate of return on plan assets, ESOPs in do better in absolute terms than diversified defined contribution plans, but do worse when adjusted for risk.

The study was based on Form 5500 filings between 1981 and 1990. Companies with defined contribution plans (profit sharing, 401(k), and ESOP plans, mainly) must file these reports annually or, if there are under 100 participants, every three years, with the Department of Labor. There were 21,129 diversified defined contribution plans, 2,760 ESOPs, and 1,450 ESOP-like plans (plans that invested primarily in employer stock but did not formally file as ESOPs). The typical ESOP was 80% invested in employer stock.

Looking at return in excess of the three-month treasury bill rate, the study found that ESOPs had a geometric mean return of 5.13% per year above the T-bill rate, while diversified plans had only a 3.4% return. ESOPs also beat the S&P averages. ESOPs in private companies had a 3.8% "excess" rate and public companies a 6.4% rate. Return rates also varied with size. ESOPs in employers with fewer than 500 employees had a 2.37% rate of return, while larger companies had a 6.9% return. While leverage had no effect in public companies, in private companies, leveraged plans had a 2.06% return and non-leveraged plans a 4.07% return. The geometric mean score is similar to the average, but, for technical reasons, provides a more accurate measurement of returns when looking at investment performance.

ESOPs, of course, are largely undiversified. When the numbers are adjusted for non-diversification risk, however, performance numbers become murkier. In private companies, ESOPs do somewhat worse than private company diversified plans do. They also do worse in smaller public companies with under 10% ownership. In public companies, as well as the largest private firms and smaller public firms with over 10% ownership, ESOPs do better than diversified plans in companies of similar descriptions. The statistical measures here are complex and difficult to describe briefly, but the differences were not very large in any of the categories.

The poorer performance in private companies when adjusting for risk is not surprising. Many of these companies are taking on substantial non-productive debt to buy out an owner. Valuation techniques also tend to "smooth" year to year variation, which can lower the statistical measures of risk-adjusted return. Finally, it makes intuitive sense that putting most of your retirement assets in an undiversified investment in a small private company would not be as wise a choice as putting it in a diversified portfolio.

The study did not assess, however, the total compensation effects of ESOPs. In private firms, the higher risk of the investment portfolio may well be more than offset by the fact that these companies typically contribute a great deal more to the ESOP than they would to another benefit plan, if, indeed, they would even set such a plan up.

Finally, the study looked at plan terminations due to bankruptcy, finding that only .8% of all ESOP terminations over the 10-year period were due to company failure. Most terminations were in public companies that ended their plans when the tax-credit ESOP was eliminated.

Polaroid Case Casts Doubt on Mirror Voting/Tendering

A federal judge has ruled that a trustee cannot follow employee directions on unallocated shares in an ESOP, nor use mirror voting on shares for which no directions are received. (Trustees can follow employee directions on allocated shares.) Instead, trustees must use their independent judgment to determine what is in the best interest of plan participants as plan participants and not as employees.

The case grew out of an ESOP at Polaroid that borrowed money to acquire 20% of the company's stock around the time a hostile takeover bid materialized. The plan called for the trustee to follow plan participant instructions concerning tendering and voting all shares. Unallocated and uninstructed shares were to be voted or tendered in the same proportion as allocated shares for which directions were received.

The court ruled this violated ERISA, which directs the trustee to use independent judgment for the best interest of plan participants. If the ruling holds up to possible further challenges, it would mean that ESOPs would become ineffective as public company takeover deterrents, and could even increase the risk of unfriendly acquisitions in private and public firms. Because trustees must focus on the interests of plan participants as plan participants, they will want to maximize plan asset value. While they can look to the long term in defining that, a high control premium could be hard to turn down.

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