Employee stock ownership plans: A Q&A with Alex Mumblat

Attracting and retaining talent continues to be a challenge in today’s workforce. Employers are constantly coming up with new ways to keep employees happy with their company. Employee stock ownership plans (ESOPs) can fill in the compensation gaps for employees.

Alex Mumblat, Managing Director at CSG Partners, believes ESOPs can appeal to prospective talent and help companies  retain current staff.

What is employee ownership, and what are the key benefits?

Employee ownership is a broad concept that can take many forms, ranging from grants of company shares or profit interests to highly structured management incentives. One common thread among these different instruments is in their intention to offer employees an opportunity to directly benefit from their company’s financial success.

The most common form of employee ownership in the US is the employee stock ownership plan (ESOP), a highly tax-advantaged retirement plan in which employees own shares through a company-formed trust. ESOPs are often used as business transition tools by closely-held companies. In these instances, a company will sell a portion or all its outstanding shares, at fair market value, to an employee trust.

Employee ownership is also commonly used to help attract and retain employees. Plans provide long-term wealth building opportunities and support high-involvement work cultures that directly incentivize employee owners.

How is an ESOP different from other qualified employee benefit plans?

Qualified retirement plans are employer-sponsored plans that meet the requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act (ERISA). These plans are eligible for certain tax benefits, such as tax deductions for contributions and tax deferral of investment gains.

The two primary categories of qualified retirement plans in the US are defined benefit and defined contribution plans. ESOPs and 401(k)s fall in the defined contribution plan category, where employers, employees, or both parties contribute a set amount to fund individual retirement accounts.

What makes an ESOP unique is that these plans invest solely in a sponsor company’s stock (using employer contributions). In doing so, a plan helps align the interests of all parties involved (companies, shareholders, and employee owners) and creates a major incentive for value creation.

Upon an employee’s departure from an ESOP-owned business, the company is expected to “make a market” and repurchase their shares. The exact timing of these repurchases depends on a company’s specific ESOP plan design. While repurchase pay-outs for younger employees can be deferred, retirees typically receive their full benefits in relatively short order.

What are the potential downsides of employee ownership?

One potential risk is that an ESOP only invests in a plan sponsor’s stock. That may represent added exposure for plan participants if their company’s performance declines. Therefore, it’s important for employee owners to continue their participation in other available retirement options that offer additional diversification, such as a 401(k). Under certain conditions, plan participants may be permitted to diversify their ESOP accounts – initially up to 25% of account value, and ultimately as much as 50%, into different publicly traded securities.

There also are various misconceptions about ESOPs. These include: “rank-and-file employees will run the company” (an employee-owned company is run by its management team with oversight by its board of directors), as well as “employees will gain access to sensitive company information” (participants receive annual plan statements, similar to other retirement accounts, but additional open-book management procedures are not required).

How will a company’s benefits program change once an ESOP is formed?

In most cases, there aren’t material changes. Most of our corporate clients who sponsor 401(k) plans prior to adopting an ESOP retain these plans post-transaction. Occasionally, companies will suspend or reduce matching contributions, while allowing their employees to continue making deferrals.

IRC Section 415 restricts the amount of annual contributions an employee can receive from all defined contribution plans. This amount is capped at $69,000 for 2024, so it primarily applies to highly paid employees. Those affected by this cap must decide how to allocate their benefits (such as maximizing ESOP share allocations at the expense 401(k) deferrals, or vice versa).

Related: Equity compensation: How to get employees to use it, like it and understand it

What is an HR/benefits team’s role in implementing and managing a successful ESOP?

A company’s HR team is often involved in the ESOP formation process. They can play a meaningful rule in calibrating plan design vis-à-vis a company’s broader benefits offerings. Initial plan communications – including formal transaction announcements and the dissemination of summary plan descriptions (SPD) – are usually coordinated by these same professionals.

Post-closing, the HR team’s role is two-fold. There is a technical side that includes interfacing with the ESOP’s third-party administrator (TPA). A TPA must receive correct census data in a timely manner in order to prepare annual plan participant statements.

Secondarily, HR professionals can help foster the cultural elements of an ESOP. That includes providing employee education, promoting plan benefits, and fielding questions about various plan features. Team members should also monitor the plan’s adoption and related performance metrics. These may include employee awareness, comprehension, and the plan’s efficacy as motivational and retention tool. Plans can be modified from time to time, and a tuned-in HR team can significantly enhance that process.