The ABC’s of an ESOP

Over 11,000 companies offer their employees some type of ESOP, which stands for Employee Stock Ownership Plan.

Typically, an employer will offer the ESOP as all or part of the retirement plan for its workers as an incentive for company loyalty, higher productivity, and greater employee participation in the workplace – but many employees are not familiar with the ins and outs of how an ESOP operates.

When an ESOP is established, it is set up in the form of a trust, which is then divided up into individual accounts for the employees. Every year, the company contributes shares of company stock to the trust that is divided up among the employees based on a formula which usually takes into consideration pay level and/or years of service.

Vesting in the ESOP

Before an employee can receive any value from the ESOP, they must “vest,” which means meeting a minimum years of service requirement (commonly 5 years of service). Once an employee has vested, they are still not typically able to receive any value from the account until they either terminate employment, retire, become disabled, or die.

Since it takes several years for an employee to vest, and the employee does not make contributions to the plan themselves, many put the ESOP plan on the back burner and don’t pay much attention to the plan until they leave their employer. However, it is very important for the employees to understand that a potentially large portion of their overall net worth could be allocated towards their employer’s stock.

With the lessons many employees learned from Enron, a good rule of thumb is to keep exposure to your own company’s stock, or any one stock for that matter, to no more than 10 to 15 percent of your overall portfolio.

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So how can this be accomplished if the ESOP cannot be accessed while still actively employed? When an ESOP participant has at least 10 years of service AND has reached age 55, the employee must be given the option of diversifying up to 25 percent of their ESOP account. This cumulative 25 percent option continues until age 60, when it then increases to the ability to diversity up to 50 percent of the ESOP account.

Educating about the ESOP

A common option offered to accommodate this is to allow the eligible employee to receive a distribution that can be rolled into an IRA to maintain the tax deferral of the amount and which will allow many different investment opportunities. Without education on the ESOP itself or asset allocation in general, many employees do not take advantage of this window of opportunity to diversify their retirement nest egg and can be devastated at retirement to find out their company stock has taken a hit due to poor market conditions.

So here’s the ABCs of ESOP education:

  • A – is for annual contributions: How much do I get? When do I vest?
  • B – is for balance sheet, or how the company is valued from a pricing perspective?
  • C – is for considering if diversifying is needed once the eligibility has been met at age 55 and 10 years of service.

This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.

Linda Robertson is an experienced financial planner with FinancialFinesse.com, the nation’s leading provider of unbiased financial education programs to corporations, credit unions and municipalities with over 400 clients across the country. Her focus is on retirement and tax planning, and her background includes positions with NationsBank, H & R Block, and Metropolitan Life. Contact her at linda.robertson@financialfinesse.com .

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