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The Employee Ownership Update

Corey Rosen

January 12, 2004

(Corey Rosen)

New 401(k)/401(m) Rules Simplify Integrating ESOPs and 401(k) Plans

In recent years, it has become more common for companies (particularly publicly traded companies) to integrate their 401(k) plans and ESOPs, using the ESOP to make their corporate match and, in many cases, allowing employees to invest in company stock as an option for their deferrals. Companies usually do this to take advantage of the unique tax-deductibility of dividends paid on ESOP shares. If companies are matching in and/or allowing deferrals into company stock anyway, designating the company stock portion of a 401(k) plan as an ESOP makes the plan more tax efficient. Other companies that have separate ESOPs for other purposes may choose to designate the ESOP contribution as the match to employee deferrals in the 401(k) plan.

Until recently, however, companies had to separately test the ESOP and 401(k) portions of their plans for purposes of applying the Actual Deferral Percentage test and Actual Contribution Test (tests to make sure that highly compensated employees do not contribute or receive too much in the plans relative to other employees). This was an expensive administrative hassle and could cause plan qualification problems if highly compensated employees tended to invest more in company stock than other employees. The result would be a different contribution pattern in the ESOP than the 401(k) plan that could be great enough to cause problems. Under recently proposed rules (Reg-108639-99, July 17, 2003), companies can now aggregate this testing. The rules also would allow companies to aggregate separate ESOP and 401(k) plans to meet testing rules.

The new rules still would require that the two plans be separately tested to see if they meet the required eligibility rules under Code Section 410(b). In addition, the rules would add a new specification that dividends distributed to employees or reinvested in company stock (but not those used to repay a loan) would not be included in the definition of a "Cash or Deferred Arrangement" within a qualified plan, meaning these amounts would be excluded from testing rules in combined ESOP/401(k) plans.

The proposed rules do not allow "good faith compliance" until the final rules are issued, so these new procedures cannot be used until those regulations are finalized.

New Study Shows Employees Still Value Options

In the most comprehensive study to date on employee attitudes towards stock options, Gerry Ledford, Matthew Lucy, and Peter LeBlanc of Sibson Consulting have found that stock options appear to be a very powerful employee benefit. As part of the "Rewards of Work" study cosponsored with WorldatWork, a large national sample of employees was surveyed in both 2000 and 2003. The 2003 study looked at responses from 1,105 employees, of whom 169 received options. Seventy-five percent of the respondents said that the stock option plan "sends a message that every employee is an owner"; 53% said that stock and stock options "increase my loyalty to the company"; and 38% said "I work much harder because I want my stock and options to increase in value." While 38% may not seem a high percentage, given that many employees are not susceptible to any kind of financially induced behavior change at work (they already work as hard as they can, or they are just hard to motivate period), it is actually very impressive that four out of ten employees can be induced to change. Given the often lackluster efforts of companies to communicate plans (at least compared to most ESOP companies), a surprising 70% of the respondents thought their company did a good job of communicating the plan, and two-thirds thought that the distribution of stock options between management and non-management was fair. These numbers were statistically indistinguishable from responses in 2000, despite the dramatic fall in stock price.

The impact of options on turnover provided somewhat mixed data. Just one-third of the respondents said that stock options were a critical factor in choosing a company to work for, but stock ownership turned out to be the most compelling inducement studied to get people to change jobs. One-fourth of the respondents would leave their jobs for just $500 worth of stock; half would leave for $1,000. But these data apply to all employees sampled, not just those with ownership. For employees who do own stock, it would be much harder to use equity to lure them to another company. It would, for instance, take $10,000 to induce employees who already own stock to move. Together, these results suggest that ownership is both a powerful lure to those without equity and a strong glue for those with it.

As would be expected, the greater the value of options, the stronger the response. If the value of options is greater than one year's pay, for instance, 52% of employees say they work harder because of it, while if it is less than half, only 33% do.

The results are strikingly consistent with those the NCEO found in its 1980s survey of 3,700 ESOP participants reported in the book Employee Ownership in America. Using very similar questions, we found that ESOP participants had somewhat more positive views of ownership that options recipients, but the difference was not large.

New Survey Reveals Option Plan Changes in 2003

A newly released survey from Sibson Consulting and WorldatWork of 336 publicly traded companies shows that eligibility for option awards dropped from 37% of nonexempt employees in 2002 to 27% in 2003. For sales staff, 67% of employees were eligible in 2002, compared to 57% in 2003. Managers, professionals, and executives retained the same percentage of eligibility. Being eligible for an option does not mean an employee gets a grant, however. Historically, about half to two-thirds of eligible non-management employees actually receive grants.

The decline in eligibility, as well as changes in market values, largely explains a decline in options value of 20% or more in 29% of the companies for nonexempt employees and a 5%-19% drop in 11% of the companies. But the value of options for nonexempt employees remained the same in 27% of the companies and went up in 20%. A similar pattern obtained for sales, professional, and management staff. At the executive level, 47% of the grants kept the same value, with somewhat more decreasing than increasing.

The market's recovery, plus the common practice of issuing options regularly to smooth out stock price volatility, led to only about 17% of the companies having 75% or more of their options underwater, and another 17% with 50% to 74% underwater. Even in strong markets, about a third or more of options are underwater, so these data reflect a move back to more typical times for option values.

The study, The State of Stock Options 2003, is available for $29.95 from WorldatWork (www.worldatwork.org).

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