Take Stock of Your ESOP Distribution Policy

It’s plain and simple: if your company’s Employee Stock Ownership Plan (ESOP) lacks a distribution policy, there may be no defined rules for when and how participants are paid from the plan. A distribution policy is a key component of an ESOP and should include timing, method, and form of payment.

Committee of Stakeholders

Developing an ESOP distribution policy begins by gathering a committee of company stakeholders – representatives from the executive team, human resources, shareholders and trustees. This policy group should focus on developing a well-written ESOP distribution policy that considers the employee benefit, ownership and corporate objectives, and their relative importance. An ESOP distribution policy:

  • Provides details for distribution to participants
  • Ensures adherence to legal requirements outlined in the plan document and the Internal Revenue Code (IRC)
  • Ensures the method of payment is nondiscriminatory and nondiscretionary
  • Simplifies administration of the plan
  • Aligns distributions from the plan with the company’s financial objectives
  • Supports the company’s philosophies and ESOP culture 

Ultimately, the committee will set rules related to when and how ESOP participants will be paid from the plan.

Take Stock of Your ESOP Distribution Policy

Timing of Payment

As the committee weighs the timing of ESOP benefits, one of the guiding factors should be based on the company’s overall goals and objectives. Deferring payments until the required deadline:

  • Allows for a longer planning horizon
  • Slows the reallocation of shares and repurchase obligation
  • Reduces the incentive participants may have to quit in order to gain access to their ESOP benefit

The committee may choose to provide immediate payment of ESOP benefits to participants who have terminated employment. Immediate payment allows the organization to:

  • Remove stock from accounts of terminated participants
  • Allocate shares to newer employees sooner, which addresses “have/have not” concerns typical in more mature ESOPs
  • Ease administration of the plan

Whether the committee opts to defer ESOP benefit payments or make them immediately upon the participant’s termination, it’s important to follow IRC regulations (IRC §409(o)) for ESOPs which set specific rules for distributions due to death, disability or normal retirement, as well as termination for any other reason.

In the event of death, disability or normal retirement, participants are entitled to ESOP benefits no later than one year after the end of the plan year in which the event occurs. A participant who retires in 2020, is entitled to payment of their ESOP benefit before December 31, 2021.

For participants who terminate employment for any other reason, benefits must be provided no later than six years after the end of the plan year in which the event occurs. A participant who terminates employment in 2020, is entitled to their ESOP benefit before December 31, 2026.

There are additional ESOP distribution rules (IRC §401(a)(14)) that must also be applied, including:

  • Age 65 or the plan’s normal retirement age (if earlier)
  • 10th anniversary of the date the participant entered the ESOP

In some instances, a participant’s request to delay an ESOP payment may be permissible. For example, an employee may wish to delay receiving their payment under the IRC’s required minimum distribution rules (i.e. attainment of age 72), instead of age 65. Rules addressing these delays should also be addressed during the formulation of the distribution policy.

Method of Payment

The ESOP distribution policy establishes the method of payment for the benefit: lump-sum, installments or alternative options based on the participant’s account balance. In accordance with IRC §409(o), installment payments should be:

  • Substantially equal payments
  • Made at least once per year
  • Fully paid within a five-year period (large balances can be paid over an additional five years)

The policy may also provide an option to make lump-sum payments for balances that are below a certain threshold (e.g. $10,000 or $20,000) and installments for balances above the threshold.

The committee should consider the company’s objectives as it chooses the ESOP payment method.

Installment Payments:

  • Help spread the overall distribution funding requirements over a longer horizon
  • Contribute to smoother plan benefit levels

Lump-Sum Payments:

  • Limit terminated participants from receiving future S-distributions/C-dividends
  • Help concentrate the shares held in the plan to primarily active employees

Form of Payment

The ESOP distribution policy should also define the form of payment – cash, stock or a combination. IRC 409(h) provides specific distribution rules for ESOPs, including participant rights to demand distribution in the form of employer securities and (if not readily tradable) have the employer repurchase the shares at a fair valuation.

Mandatory cash distributions are permissible in certain instances:

  • S Corporation ESOPs
  • When an employer’s charter or bylaws restrict substantially all ownership to the ESOP or current employees
  • Bank ESOPs

Just as the timing and method of the ESOP payment align with the company’s objectives, the form of payment should also be set with the organization’s goals in mind. When payments are made in stock:

  • Shares are distributed and redeemed by the company (Payment is either a lump-sum payment or installments backed by a promissory note, which must be adequately secured by the company)
  • Participants may be eligible for capital gains treatment on the difference between the market value and their cost basis (net unrealized appreciation (NUA))

If cash is the chosen form of payment, the distribution funding will typically consist of employer contributions to the ESOP or through S-distributions/C-dividends.

Other Considerations

While the ESOP distribution policy committee will focus primarily on the timing, method and form of payment, the group should also address these topics which may impact plan distributions:

  • Account segregation
  • Qualified Domestic Relation Orders (QDROs)
  • Events after termination
  • Forceout distributions
  • Diversification

Questions about ESOP Policy Distribution? Contact the Findley consultant you normally work with or Aaron Geibel in the form below.

Published June 3, 2020

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More Pension Lump Sum Cashout De-risking Activity Expected in 2019

Pension plan sponsors looking for significant cash savings and de-risking opportunities have another favorable environment to pull the participants’ lump sum cashout lever this year. But that lever includes several options and considerations. In 2019, the interest rate environment is favorable which gives pension plan sponsors an opportunity to provide lump sum payments to participants while improving the funded status of the plan. So why wait to offer this cashout opportunity when you have this significant benefit staring you right in the face?

Lump Sum Cashout Opportunity in 2019

Lump Sum Cashouts Defined

A Lump Sum Cashout program occurs when a defined benefit pension plan amends its plan to allow terminated vested participants to take a lump sum payment of their benefit and be cashed out of the plan entirely. The program is typically offered as a one-time window but can also be made a permanent feature of the plan with potentially significant financial impact. Plans generally may offer this type of program only if their IRS funded percentage is at least 80% both before and after the program is implemented.

Many pension plans have offered, or at least considered, Lump Sum Cashout programs over the last several years to minimize their financial risk. Plan sponsors that have implemented these programs have been rewarded with significant cash savings as well as risk reduction

Advantages of Implementing Lump Sum Cashout Today

1. Favorable Lump Sum Interest Rate Environment

In 2019, the lump sum interest rate environment is favorable for most employers thanks to a significant interest rate increase during 2018 when lump sum interest rates are locked in for 2019 calendar year plans. These higher rates will result in smaller lump sum payments when compared to 2018 (15-20% decrease).

2. Improved Funded Status

Another advantage of the current interest rate environment is that lump sums will be less than most other liability measurements related to the plan. In other words, interest rates used for 2019 calendar year plans to determine accounting liabilities are lower than lump sum rates. Therefore employers will be paying benefits to participants using a value less than the balance sheet entries being carried for those benefits. These lower lump sum payments will then help employers improve the funded status of the plan in addition to de-risking or reducing the future risk. This interest rate arbitrage is not expected to exist in 2020 since defined benefit lump sum interest rates have continued to decrease since the beginning of 2019.

3. PBGC Premium Savings

The most significant benefit of offering a Lump Sum Cashout Program is the Pension Benefit Guaranty Corporation (PBGC) premium savings. The PBGC continues to increase the annual premiums that pension plans are required to pay to protect the benefits of their participants in the pension plan. The per participant portion of the premium (flat rate) is now up to an $80 payment per participant in 2019. This is more than a 200% increase since 2012. The variable rate portion of the premium is up to $43 per $1,000 underfunded which is an increase of almost 500% since 2012.

Flat Rate (per participant) + Variable Rate = PBGC Premium

These rates are expected to continue to grow with inflation each year. Therefore it is ideal for pension plan sponsors to reduce their participant count sooner rather than later so they can save on these future premiums. In total, some defined benefit plan sponsors could see annual PBGC premium savings of over $600 for each participant who takes a lump sum distribution.

Can You Offer a Lump Sum Cashout More than Once?

Employers that have previously offered a lump sum cashout to participants should be aware that this doesn’t exclude them from pursuing a de-risking program again. In general, as long as plan sponsors wait 3-4 years between similar programs, they can offer the same program to plan participants again. This gives participants who have terminated since the original program an opportunity to take their pension payment. A second round offering also gives participants from the first program a second chance to take a cashout while de-risking the plan for the plan sponsor.

Other Considerations When Planning for a Lump Sum Cashout

There are some concerns that plan sponsors will also want to consider such as:

  • Potential increases to contribution requirements;
  • One-time accounting charges that could be triggered;
  • Potential increase to annuity purchase pricing upon plan termination. Note that a permanent lump sum feature may increase pension plan termination annuity pricing and cause some insurers to decline to bid.

In summary, 2019 is an ideal year given the lump sum interest rates. The current interest rate arbitrage provides pension plan sponsors a low cost opportunity to de-risk the pension plan and save significantly on future PBGC premiums. As with any de-risking opportunity, there are several considerations that should also be discussed. The defined benefit plan’s actuary should be consulted so they can properly evaluate the impact of offering such a program.

Some plan sponsors use lump sum cashouts as part of their pension plan termination preparation strategy. This Findley white paper provides tips to map your route to pension plan termination readiness.

Questions? Contact the Findley consultant you normally work with, or contact Amy Gentile at amy.gentile@findley.com, 216.875.1933.

Published on June 7, 2019

© 2019 Findley. All Rights Reserved.

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