Unlike the typical defined contribution plan, which can hold an array of investment types, the assets held by an ESOP primarily consist of the sponsoring company’s stock. For an ESOP to be a viable retirement plan, however, there must be a way for participants to convert their shares of stock into cash or cash equivalents. This isn’t an issue for the 3% of ESOPs with publicly traded stock1. For the remaining 97% of ESOPs, Internal Revenue Code Section 409(h)(1)(B) requires the sponsoring company to buy stock back—at a fair market value—from participants who receive distributions from the plan. This is known as the “put option” requirement. Additionally, because ESOPs do not provide a diversified investment portfolio, participants must be given the right to sell back a portion of their account holdings beginning at age 55 with 10 years of participation in the ESOP2.
For an ESOP to be a viable retirement plan, however, there must be a way for participants to convert their shares of stock into cash or cash equivalents.
These requirements give rise to the employer’s “repurchase obligation” under the ESOP. The ESOP may repurchase the shares and redistribute them to plan participants (recirculate the shares), or the company may purchase the shares and return them to the treasury (redeem the shares), which reduces the number of shares owned by the ESOP. Regardless of the repurchase method used, the company is ultimately responsible for raising the cash needed to meet the repurchase obligation. The “how soon” and “how much” depends on the provisions of the plan document, the value of the stock in question, and employee demographics.
Enter the Repurchase Liability Study
The answer to how soon and how much can be found in a repurchase obligation study. A repurchase obligation study is a long-term projection of (1) the repurchase liabilities that an ESOP company can expect to incur when the shares in a participant’s account are distributed and (2) the cash the company will need to meet this obligation.
Because a repurchase obligation study is an actuarial projection of future events, it involves a great many assumptions and requires good underlying data. The study will look at plan provisions, such as vesting, the timing and form of distributions, terms of the ESOP loan, employee demographics, and, if it is an existing plan, participant account balances in the ESOP. These assumptions include:
- Tax status of the employer (i.e., C or S Corporation)
- Expected changes in participant demographic data due to death, disability, retirement, vested terminations, and stock diversification requirements
- Expected future contribution levels
- Expected release of shares to participants
- Expected changes in the covered group such as turnover, growth, and pay increases
- Expected growth in company stock value
- Expected dividends
- Expected growth in other investments
In a perfect world, a company considering an ESOP would undertake a repurchase obligation analysis as part of their plan design process. As a best practice, a repurchase liability study should be undertaken every two to four years in order to stay on top of even small variances between actual and assumed experience.
As a best practice, a repurchase liability study should be undertaken every two to four years in order to stay on top of even small variances between actual and assumed experience.
When an ESOP company is not publicly traded, federal law requires the company to buy back employer shares held in the ESOP accounts of its employees. The repurchase obligation can have a significant drain on cash, and failure to plan for the obligation can be burdensome, if not catastrophic. Companies that undergo a repurchase liability study on a regular basis are able to plan and budget for this obligation well in advance; companies that don’t adopt this best practice may be in for an unpleasant (and very expensive) surprise.
1. [About 330 ESOPs — 3% — are in publicly traded companies. Accessed March 9, 2017]↩
2. [Certain publicly traded ESOPs may have additional diversification requirements.]↩Findley Perspective, Retirement Plans