Benefits May 24, 2019

ESOPs More Valuable Than Just a Retirement Savings Vehicle

Employee stock ownership plans (ESOPs) have been shown to provide a higher retirement savings balance than other plan types, and recent research suggests they can also help narrow gender and racial wealth gaps.
Reported by
Art by David Huang

Studies have shown that companies that sponsor employee stock ownership plans (ESOPs) see positive results for revenue and employee productivity, but more recent studies show ESOPs provide greater retirement savings for employees and can reduce wealth inequality.

Loren Rodgers, executive director of the National Center for Employee Ownership (NCEO) in San Francisco, says, “It looks like there’s been an uptick in ESOP activity according to our service provider friends.” He says there are segments of the market that have different reasons for offering an ESOP to employees. The No. 1 reason, according to Rodgers, is the seller wants to get ready to retire and isn’t comfortable with a profit maximizer or a competitor taking over the business because he knows at least some of the executive team will lose their jobs and he wants to preserve the legacy of the company.

Get more!  Sign up for PLANSPONSOR newsletters.

In another segment, a buyer is hard to find—either the company serves a small niche and there’s not much interest except by employees, or a female or minority-owned business wants to keep it so. The third segment just sees offering an ESOP as a business strategy to make employees owners.

In 2017, the NCEO reported that as of 2014, there were 6,717 ESOPs in the United States, holding total assets of more than $1.3 trillion, and covering more than 14 million participants. According to Rodgers, one reason there are thousands of ESOPs is the sellers get tax benefits—a major tax advantage is sheltering the corporate income from taxes.

ESOPs provide higher retirement savings

In 2018, the NCEO reported that ESOP participants have an average retirement balance of $170,326, more than twice the $80,339 that other workers have saved. Even for ESOP employees making less than $25,000 a year, their balances average $55,526, compared to the $22,447 that their counterparts have saved at other companies.

Rodgers explains that employees have double the retirement savings balance for two reasons: Almost always the ESOP is added to another retirement savings vehicle, and for those using an ESOP as an ownership transition vehicle, they sell shares at a higher price.

In addition, NCEO research finds the larger retirement savings balance may be due in part to a larger than average contribution rate by employers. “On average equities are among the highest performing class of securities, so employees can see a greater growth of assets,” Rodgers says.

In addition, the average tenure for employee owners is about 20% higher than for non-employee owners, NCEO research found.

Rodgers adds that employee-owned companies tend to provide a more generous benefit package overall—health benefits, flex time, parental leave, tuition reimbursement—benefits that help with employee’s financial lives.

Closing the wealth gap

In the first-ever national study of low-income and moderate-income workers at employee-owned companies, researchers discovered ESOPs enable families to significantly increase their assets, shrinking—though not eliminating—gender and racial wealth gaps. The research by the Rutgers Institute for the Study of Employee Ownership and Profit Sharing suggests employee ownership can reduce wealth inequality in the U.S.

According to the study report, “Building the Assets of Low and Moderate Income Workers and their Families: The Role of Employee Ownership,” analysis from the study suggests that employee-owned firms stitch together five specific elements that work in tandem to enable workforce asset building, including: Building ESOP account equity and financial knowledge; Expanding workforce capabilities through on-the-job training, external education, and internal mentoring; Enabling asset preservation and personal investments; Increasing access and inclusion by gender, race and ethnicity; and Improving health and well-being through quality of work life experience and balance.

Douglas Kruse, distinguished professor and associate director of the Rutgers Institute for the Study of Employee Ownership and Profit Sharing (also a former senior economist in President Barack Obama’s White House Council of Economic Advisers), based in New Brunswick, New Jersey, says unlike defined contribution (DC) retirement plans, typically only employers make contributions to ESOPs. The study report explains that companies use credit to fund the ESOP’s purchase of company shares and the company pays back the loan. As the loan is repaid, the company distributes the shares to all employees in their ESOP accounts. “This ability to build an asset without depleting resources from a family budget is critical for low- and moderate-income households,” the report says.

Because of this, according to Lisa Schur, professor, Rutgers School of Management and Labor Relations, based in New Brunswick, New Jersey, employers can include everyone in the company including the lowest-paid who may feel they do not have the resources to contribute to a DC plan.

She says the study also showed many employee-owned companies specifically have training like ESOPtober, related to employee ESOP accounts. Some companies had more formal programs set up than others. Schur says one company had the chief financial officer (CFO) talking to employees informally. “So better education is provided to employees about ESOPs than other retirement plans,” she says.

According to Kruse, the ESOP education covers fundamental ideas of retirement planning. “They teach employees ‘Here’s the amount we put in, and here’s how it may grow over time,’” he says. “But companies are careful not to make strong predictions.”

“Employee-owned companies provide more financial transparency to employees. “Education about finances, debt and balance sheets, savings, investments, returns, and profits (open book management at differing levels) all contribute to employees’ understanding of their companies, and how some of these issues translate into their own personal financial management,” the report says.

“Many employers are worried about employee engagement. We found lower-income workers are more engaged when they have ESOPs. It gets everyone thinking in similar terms about how to make the company do well,” Kruse says, citing the example of one employee suggesting that the company use Fed Ex rather than direct mail to save on costs.

Schur says the financial education didn’t just stop with employees, as some reported they taught their family members about financial issues and saving for retirement.

The study confirmed what Rodgers said about ESOP companies offering better benefits overall. Employees reported their companies provided internal mentorship and career coaching, helping them develop skills and income through advancement on the job without cutting into family time. Employees also reported being offered tuition for formal education and training.

Another way ESOPs help narrow the wealth gap is offering employees a way to pay for expenses without increasing consumer debt. According to Kruse, some employees had more confidence about borrowing from the ESOP since they had other retirement savings.

Schur says a number of employees talked about borrowing from the ESOP for a health emergency, paying for children’s education, or buying their child a car. One person put down payment on trailer. “It enables access to money for wealth transfers to families that wouldn’t have the wealth without an ESOP,” she says.

“There’s a lot of talk about growing inequality in the U.S. Besides income inequality, wealth inequality is more striking. There’s even negative wealth among workers of color. ESOPs are a way to build wealth that can make a tremendous difference in retirement security as well as possibly decreasing the wealth gap,” Schur concludes.

Compliance May 20, 2019

What to Know About Financial Audits Filed with Form 5500s

Plan sponsors required to file a financial audit along with their Form 5500 should know how regulators use the information and how to pick the best auditor.
Reported by
Art by Ryan Peltier

Any retirement plan with 100 or more participants must be independently audited by a certified public accountant (CPA) firm and include those findings along with the annual Form 5500 it electronically files with the Department of Labor (DOL), which in turn, shares it with the Internal Revenue Service (IRS).

It is imperative that plan sponsors work with qualified CPA firms since the “2015 Assessing the Quality of Employee Benefit Plan Audits” from the DOL found that 39% of plans that were audited had either unacceptable or major deficiencies, says Anne Morris, employee benefit plan practice leader at Windham Brannon in Atlanta. And the auditor must use Generally Accepted Accounting Principles (GAAP), says David Guadagnoli, a partner at Sullivan & Worcester in Boston.

The Form 5500, which includes the audited financial statements, is used by the DOL, IRS and, in the case of a defined benefit plan, the Pension Benefit Guaranty Corporation (PBGC), Guadagnoli adds. “The idea is that Congress felt that the plan administrator, the government and participants needed financial statements reviewed by an independent auditor to make sure retirement plans are properly managed for participants,” he says.

Essentially, “the whole idea of the audit is to ensure that a plan is being run in accordance with its plan documents,” adds Jennifer Moore, director of 401(k) audit service at PriceKubecka LLC in Addison, Texas. The agencies also want to make sure that “plan participants aren’t being defrauded,” adds Robert Forni, a partner at Ropers, Majeski, Kohn & Bentley in San Francisco.

There are two main types of audits that are permissible: limited scope and full scope, Morris says. A limited-scope audit is more focused on the participants in the plan, to ensure that their accounts are correct, whereas a full-scope audit delves into more detailed testing of the plan investments, Morris says.

To qualify for a limited scope audit, “the qualified institution holding the assets of the plan [must] certify the ‘completeness and accuracy’ of the reports,” Morris says.

“The areas of focus and testing in both types of audits include: contributions (employee and employer), distributions, participant eligibility testing, and investment income allocation to participant accounts,” she continues. “During the audit, samples of participants are selected in these areas and then tested. Tests are included to recalculate employee and employer contributions and to ensure the participant deferral percentages are correct and that the participant was allocated the correct amount of earnings based on the investments they have chosen in their account.” Distributions, vesting and forfeitures are tested, as well, Morris adds.

The audited financial statement package always includes an auditor opinion letter at the beginning from the accountant explaining the scope of his work, Guadagnoli says. This is followed by the financial statements and any necessary explanatory footnotes.

“The financial statements show changes in assets and liabilities over the preceding year, such as employer contributions, employee contributions, expenses and distributions,” Guadagnoli says. The organization of audited financial statements will look pretty much the same for every retirement plan, he says. However, a plan that holds illiquid assets, such as limited partnerships, real estate or private equity, may require more information relating to valuation, he says.

Should the audit find that, for instance, employee contributions were not made in a timely basis, the DOL expects plan sponsors to “calculate what the employees lost out on and pay that back into the plan to make them whole,” Moore says.

The DOL is not only concerned that contributions are made on a timely basis; it wants to see that “if any tasks were done incorrectly, that the proper steps were taken to fix the issues,” says Tom Foster, national spokesperson for workplace solutions at MassMutual in Enfield, Connecticut.

The financial audit may uncover red flags for regulators. These include “not keeping plan documents up to date, not following plan documents, incorrect definitions of compensation, not remitting contributions in a timely basis, not filing Form 5500 on time, and not overseeing hardship withdrawals and loans properly,” Forni says. If these mistakes are made, it can trigger further audits by the IRS, DOL or both, he says.

DOL’s rule on when to send in 401(k) deferrals “is a little ambiguous,” Moore concedes. That is why her firm believes it is a best practice to submit the payments at the same time the sponsor submits their payroll taxes, she says.

“Another relatively new DOL focus is missing participants,” Morris notes. “Missing participants are those who have not kept their address information current and could result in participants losing track of their benefits and account information. It is the plan sponsor’s responsibility to make an attempt to track down these missing participants, and the DOL will question how this is being done.”

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

Use of the Data

“The Form 5500 series and audits are important compliance, research and disclosure tools for the DOL and a source of information and data for use by other federal agencies, Congress and the private sector in accessing employee benefit, tax and economic trends and policies,” Foster says.

“The DOL uses the information by data mining to determine if there are patterns that can help show which types of plans might commonly be non-compliant,” he continues. “The DOL also uses the information to determine the scope and breadth of retirement plan offers and uses among companies in geographic locations, by size and by other indicators such as industry.”

Qualities of a Sound Auditor

As to what to look for in a CPA firm, it is important to find one that specializes in retirement plan audits, as “this is a complicated field,” Forni says. “It isn’t going to be your run-of-the-mill CPAs.”

Morris recommends that sponsors look for firms that have conducted at least 100 audits. That said, the DOL will be concerned if it finds that the auditing firm conducts too many audits a year, Moore adds. In addition, the American Institute of Certified Public Accountants (AICPA) has a Plan Audit Quality Center that offers ongoing education on retirement plan audits, she adds. All PriceKubecka accountants that conduct retirement plan audits undergo this annual training, she says.

Sponsors should ask several questions of a potential auditor, such as whether they work with plans similar to theirs, Foster says. “What is the cost of the service and what, specifically, do they cover? Who in the firm will be performing the majority of the day-to-day work and what are their qualifications and experience? Who will review and have final sign-off on the audit and what are their qualifications and experience?”

It is also important to ask whether accountants at the CPA firm can be reached via phone to answer questions, Moore says.

CPA firms’ fees for retirement plan audits “vary significantly,” Guadagnoli says. “You can pay relatively little or a fair amount of money. It depends in part on the market you are in and your own negotiations with the auditor.”

It may not be in the best interest of sponsors to simply look for the least expensive retirement plan auditor, as that could lead to errors and the possibility of needing to hire yet a second auditor, Moore says. “You may not get as good of an audit, which could set you up for fiduciary risk.”

«