Are ESOPs Too Risky to Be Good Retirement Plans?

ESOPs inherently increase the concentration of retirement assets in a single security—company stock— and critics contend this reduced diversification makes ESOPs too risky. Even worse, employees depend on the same company for both their paychecks and their retirement accounts.

While this critique seems to make sense theoretically, the data about ESOPs indicate ESOP participants are generally far better off in terms of retirement security than employees in non-ESOP companies. 

There are several reasons for this:

ESOP Contributions Are Larger

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 compared to about 4% of pay per year in 401(k) plans. Employees rarely invest their own money in an ESOP, but most 401(k) assets are from employee contributions.

ESOP Sponsors Are More Likely to Offer Other Retirement Plans Than Others Are to Offer Any Plan

According to PLANSPONSOR’s 2013 Defined Contribution Survey, 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.

Based on a 2010 analysis of Form 5550 data, 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 People

ESOPs, by their terms, include all employees meeting minimum service rules whether they defer any income or not.  Most 401(k) plans, the most common retirement plan, only cover employees who defer into the plan.

ESOPs and ESOP Participants Often Diversify Over Time

Once 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 age 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 Return

Data from the Department of Labor for retirement plans with 100 or more participants show 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.

The table below provides a summary of the findings:

Source: Private Pension Plan Bulletin Historical Tables and Graphs, U.S. Department of Labor Employee Benefits Security Administration, November 2012

There are two reasons for the seemingly surprising volatility 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 three to five 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, whereas the public companies whose stock is typically in 401(k) plans tend to manage quarter-to-quarter.

ESOPs Lay People Off Less Than Conventional Companies

General 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 employees with companies that do not offer an ESOP. For many people, job security is the most critical issue for retirement security.

The Bottom Line

In 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.

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 ay risk is a tiny fraction of those who end up with a greatly enhanced retirement package.

 

Corey Rosen, founder of the National Center for Employee Ownership

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.