Pairing ESOPs With 401(k)s Can Heighten Retirement Outcomes

As medical and technological advances continue to improve health outcomes, average life expectancy continues to rise. According to the Society of Actuaries (SOA)[1], for a couple currently in their 30s retiring in average health at age 65, there’s a 25% chance that at least one spouse will live to be 100—spending almost as many years in retirement as in the workforce.

Meanwhile, more defined benefit (DB) plans are being terminated as defined contribution (DC) plans take their place. Plan sponsors are seeking other ways—in addition to the traditional 401(k)—to meet growing retirement needs and set their employees up for success after years of valued service and loyalty.

One option companies turn to is the employee stock ownership plan (ESOP). Most companies already offer a 401(k) plan, and except for small companies—those with less than 20 employees—an ESOP can serve as a strong complement.

As you weigh the options for your company, here are a few points to consider about how the ESOP and 401(k) plan can work together to produce better retirement outcomes.

Not your average retirement plan

Though ESOPs and 401(k)s are both qualified retirement plans, there are a few key differences. While a 401(k) is strictly a retirement savings vehicle, an ESOP is dual-purpose: It provides an avenue for retirement savings and serves as a business succession plan.

With an ESOP, you offer much more than compensation or an employer match—you offer a stake in the company. Employees invest primarily in company stock for shared ownership of the business. This fosters greater buy-in from them, driving business success and generating more revenue to fund both the ESOP and 401(k) plan.

To decide if an ESOP will work for your business, ask yourself: Who do you want to lead the company when the current leadership retires? Are you open to treating all employees like owners?

The importance of diversity

From a retirement planning perspective, there are two key differences between a 401(k) and an ESOP: where the accounts are invested and how they’re funded. With a 401(k) plan, the participant typically has investment choice, but, with an ESOP, the participant is primarily invested in company stock.

It’s important for participants to consider all of their assets, including company stock, when electing how to invest in their 401(k). Because the ESOP is primarily centered around company stock, a diversified approach to your 401(k) investments is key to withstanding market volatility and risk.

Once employees are 55 and have 10 years of service, they can diversify a portion of their investment outside of the ESOP—up to 25% for the first five years, and up to 50% in the sixth and final year. Many plan sponsors will also provide the option for participants to roll over the diversified ESOP funds into their 401(k) plan at age 55.

Evaluate your employee education: Do your employees understand their investment options? Do you have a resource to answer participant questions and provide ongoing plan education?

A delicate balance

ESOPs are funded through employer contributions, while 401(k)s are largely funded through employee contributions. When an ESOP is introduced, it’s common for the plan sponsor to decrease its 401(k) match in order to fund the ESOP. Without a strong match incentive, participant contributions may plateau or even decline. To encourage participants to continue to grow their 401(k) contributions, plan sponsors should consider other features such as automatic enrollment and automatic escalation, as well as ongoing employee education and gap analysis. Developing easy-access points for participants to join and increase contributions can help facilitate greater plan participation.

Consider: Are your employees saving enough for retirement? How will you need to adjust your 401(k) match to fund the ESOP? What are other ways you can encourage and facilitate more 401(k) participant contributions?

A little more conversation

For many participants, a 401(k) plan seems complicated enough without the added layer of another retirement plan. If you’re considering an ESOP, work with your adviser to streamline the communication process so that participants can view the two plans as a complete retirement package. Having a centralized communication hub will allow participants to accurately track their retirement goals, consider all assets and investments, and identify next steps to reach their goals.

A streamlined communication approach is not only critical for participants but for the recordkeeping side, as well. Having one recordkeeper for both plans is ideal, as it can save you time and prevent confusion. If this isn’t an option, make every effort to ensure both companies are in regular communication with one another and have a clear understanding of their roles.

Reflect: What is your current communication plan? How would you integrate the ESOP into your communication plan? Is working with the same recordkeeper for both plans an option?

An ESOP isn’t for everyone.  A company’s approach to compensation and benefits is a defining factor in its success. Take time to reflect on your vision for your business, explore your options, know the risks, and learn how different plans work together, to determine the most strategic approach.

Trevor S. Bare, a Fellow of the Society of Actuaries (FSA), is a consulting actuary at Conrad Siegel and specializes in retirement plan consulting and administrative services for defined contribution and defined benefit plans. Conrad Siegel is a mid-Atlantic employee benefits and investment advisory firm with offices in Harrisburg and Lancaster, Pennsylvania.

[1] “Actuaries Longevity Illustrator,” Society of Actuaries, www.longevityillustrator.org.