How Do ESOPs Work and How Well Do They Perform for Employees

An ESOP is a unique type of retirement plan that can benefit a wide range of employers, but what about the people they employ? Are ESOPs good retirement plans for employees?

What is an ESOP?

ESOP stands for Employee Stock Ownership Plan (not to be confused with Employee Stock Option Plan). As the name suggests, the plan rewards employees with an ownership stake in the business by setting aside shares of company stock for them to claim when they reach retirement age.

How do ESOPs work?

During an employee’s tenure with the company, their employer typically  allocates shares of company stock to their retirement portfolio through company contributions.  Typically, these assets are held in a trust, earmarked for the future benefits of its employees. As the business becomes more successful and its stock values grow, so does the value of the employee’s retirement plan. When it’s their time to retire, employees typically have the option to (1) claim and hold onto those shares of stock, (2) sell those shares back to the company at market prices and retire with the cash value, or (3) a combination of both.

Why are ESOPs good retirement plans for employees?

ESOPs are often beneficial to employers, but they can also be beneficial to employees. 

ESOPs are funded by the employer.

In most ESOPs, employees do not contribute to their own plan. This means that their retirement accounts will grow without having to divert a portion of their salary, as is often the case with more traditional retirement plans.

ESOPs are eligible for tax-free rollovers.

If an employee is vested in an ESOP but leaves the company before retirement age, they aren’t necessarily stuck with those company shares; they can roll over the value of their ESOP into another retirement plan, like their new employer’s 401(k) or an external IRA. When done correctly, this rollover won’t be taxable.

What are some disadvantages of ESOPs?

One of the most obvious caveats to an ESOP is that the employees’ retirement portfolios are not well diversified.

ESOP retirement plans are not required to offer outside investments to their employees until they reach certain milestones. Once participants (1) reach age 55 and (2) have participated in the plan for at least 10 years, they can elect to diversify up to 25% of their retirement portfolios with external investments, like stocks from publicly traded companies, bonds, and mutual funds. 

Employees also need to be strategic with their exit plans. To get the highest payout, they need to plan their departure for a time when company performance (and therefore stock value) is high. This can make retirement planning more complicated.

How well do ESOPs perform for employees?

The statistics are clear: ESOPs tend to improve company performance and therefore often have better retirement outcomes for employees. These results are even more apparent during periods of economic unrest. 

• Forbes recently reported that during the 2020/2021 pandemic, ESOP companies outperformed non-ESOP companies, both in operational performance and in outcomes from mergers and acquisitions. 
• Results from a study published by the National Center for Employee Ownership (NCEO) in December 2021 show that ESOP companies appeared to provide greater financial security for their employees during the current pandemic compared to companies with only 401(k)s.
• According to a book written by two experts in labor studies, in the two recessions that preceded the COVID-19-induced economic downturn, employee ownership was typically correlated with increased worker commitment, lower employee turnover, and higher pay.

Employees looking to get the most out of their ESOP retirement plans should ask themselves a few things.

When employees participate in an ESOP, they are effectively saying that they want to be part owners of the business. If they have a sense of ownership, they are more likely to adopt the company’s goals as their own, and productivity is likely to improve as a result.

ESOP participants typically see best results when they stay tenured with a company for many years, letting the value of their shares grow as they work toward improving the company’s performance.

ESOPs can be great options for workers who have no way to fund their own retirement. Those that do have excess funds can still participate in other retirement plans by contributing to a 401(k), 403(b), an IRA, or something similar.

If your business has been considering an ESOP but aren’t quite sure if it’s a great fit, reach out to us today. Our team can assist you to see if an ESOP would be beneficial to both you and your employees.