Retirement plans are usually comprised of a number of different vehicles all working together to build your nest egg for when you finally finish working for good. An ESOP retirement plan might not be something you think of when discussing retirement investment options, but they should be if they’re offered to you.
So, is getting involved in an Employee Stock Ownership Plan ESOP part of a good retirement plan?
Generally speaking, yes, an ESOP is a smart decision when looking at retirement investments, but it shouldn’t be your only one. There are both risks and rewards involved with placing your retirement assets into a single security like one company’s stock, so as long as it’s not your sole retirement plan they can be hugely beneficial.
To understand why we must look at the ESOP pros and cons to weigh up either side of the argument.
With an understanding of how ESOPs work, why companies offer them, and what they can mean for your specific retirement plan, you’ll know whether or not this is a smart choice to make.
What Is an ESOP and How Does It Work?
An employee stock ownership plan is something that a company offers to its employees that allows them to gain employee ownership in the company.
Within these plans, employees are given stocks in the company as a form of remuneration, or they can be purchased, which gives them employee ownership in the company depending on how much they own.
These plans are set up like trust funds for employees and work in a few different ways.
The company funds an employee stock ownership plan ESOP by putting shares in, putting cash in to buy shares, or borrowing money to buy more shares.
When an employee leaves the company, their vested shares are then purchased back from them and the stock is shared with or sold to other employees.
The money that’s made from these can be paid in either one lump sum or smaller regular payments, but it depends on the details of the specific plan.
The shares will be sold at their current price and not the purchased price, so usually this amount has grown, but if an employee is fired from the company there could be a stipulation that they’re only returned their original investment amount.
Why Do Companies Form ESOPs?
Although an ESOP can benefit an employee, especially when it comes to a retirement plan, there are some good reasons for the company to start them as well.
Because an ESOP is giving employees a vested interest in the company, it’s believed that they help to align the interests of both employees and other shareholders, ensuring that everyone is focused on the growth and health of the company.
These shares might be offered as part of a salary package and by giving employees a share in the company, they usually encourage everyone to do what’s best for the company.
By making sure the shareholders are also trusted employees, it makes it easier to create a succession plan and gives employees a unique chance to take ownership in a company that’s usually closely guarded.
A Rutgers study into ESOPs and their effects on a company found that companies who utilized these plans saw a 2.3 to 2.4 percent increase in growth after distributing the shares.
This was credited to an improvement in employee performances because now those employees were effectively part owners in the company.
Although the study was from 2000, this same logic is applied today and a huge reason why companies choose to offer ESOPs to their staff.
Is an ESOP a Qualified Retirement Plan?
According to the IRA, Employee Stock Ownership Plans are considered a defined contribution plan and used by many companies in the US.
They were given this qualification as a retirement plan in 1974 and have since then grown to become a popular choice for a retirement investment or saving option.
A qualified retirement plan is one that meets the specific requirements of the IRS and it means that people involved in them will be able to get certain tax benefits.
These plans offer tax breaks and can decrease the rate of income tax you pay by lowering your taxable income.
For the sake of the company, having a qualified retirement plan like an ESOPs helps them to attract better employees and also keep them for the long term.
In this specific type of qualified retirement plan, the employee is also the part owner of a company thanks to their gift of stocks, which means they’re able to work there as well as gain ownership interest.
This unique type of retirement plan is often utilized in conjunction with other defined contribution plans offered by a company, like a standard 401 k account.
Are ESOPs Good Retirement Plans?
An ESOP can be a good retirement plan when used correctly, but of course, there are both sides to consider.
Depending on your age, the amount of stock you’re given, what other retirement plans you have in place, and your investment goals for retirement, they could be either a good or bad decision.
Studies from 1997 into the effectiveness of this type of retirement plan found that employees who take part in an ESOP usually have three times the funds when they’re ready to retire than those who work for companies without an ESOP.
Furthermore, the same study found that those working for a company that offered ESOPs as part of a retirement plan made between 5 to 12 percent more in wages.
It could be worthwhile taking this into consideration if you’re looking for new employment and want something that’s going to significantly benefit your retirement nest egg.
Usually, companies that offer ESOPs as retirement plans also have at least one other type of retirement plan to offer their employees.
It’s never recommended to place all of your retirement planning into an ESOP but rather use it as a supplemental investment option.
This way, you’ll have a more diverse investment portfolio and a way to combine your financial interests with your job performance.
What Are S-ESOPs and Are They Useful for Retirement?
Subchapter S-corporations are companies where profits go to company owners but there’s no tax to be paid at the entity level.
When an S-corp offers employers part of an employee stock ownership plan, it’s usually referred to as an S-ESOP, meaning that they also effectively become owners of these companies themselves.
An S-ESOP has been proven in recent years to be one of the best possible options when saving for retirement and if given the opportunity to be employed by a company that offers them, it can pay off significantly.
A look at the performance of S-ESOPs during the 2002 to 2012 decade showed that they outperformed the S&P 500 by 62 percent, which was a massive margin.
Over this time, S-ESOPs paid out $30 billion to their employees and plan participants and each year they had an average return of 11.5 percent.
When looking at this as a potential investment option, and especially one for long term gain like retirement, this seems like a far better choice for your money and if it’s a possibility, it’s definitely one that should be taken seriously.
Also Read: 7 Best Dividend Funds To Invest For Retirement
When Should You Start Investing in ESOPS?
The key to any good investment is knowing the right time to invest, but when we’re talking about retirement plans in general then the earlier you can get started the better.
With ESOPs specifically most employers will have a stipulation in place that the minimum age to enter these plans is 21, and usually, you need to be a full-time employee.
Compared to something like a 401 k that only covers those employees who choose to be a part of the plan, ESOPS cover all employees that meet the minimum required length of service and hours of work.
The earnings you make from a 401 k from matching bonuses and contributions depends on how much they’re able to put aside, so for younger and lower income earners, this means they’re not able to make as much as those on higher salaries.
With most ESOPs, all employees will be getting the same percentage of money regardless of their income.
The earlier you start with one of these plans, the more you’ll be able to earn, and if you plan on staying with a company for the long term, it can be significantly beneficial.
Even if an ESOP is the only retirement plan a young person has in place for some time, it’s still better than not being covered by anything at all.
It’s important to note that some companies will have restrictions in place about when you’re eligible for an ESOP plan.
Usually, a minimum of 12 months of service is required, but in the case of companies that have immediate vesting, this number can increase to up to 24 months.
Regardless of age, you’ll have to serve this period before you can start to benefit plan from this specific retirement plan.
How Much Stock Do You Get in an ESOP?
The amount of company stock that one gets as part of an ESOP plan can differ dramatically.
As a form of remuneration, it can depend on things like your salary, how long you’ve worked for the company, and the overall value of the company when it comes to the company stock market.
When you turn 21 or become eligible to join the plan after service, allocations are made using the same formula that all employees fall under.
This could be in conjunction with your salary or how long you’ve served the company, with those in more senior positions usually having rights to gain access to their personal shares.
This process is known as vesting, and rules state that all employees must be 100 percent vested within six years of joining the plan.
Some companies offer similar stock ownership plans in the form of direct purchase programs, phantom stock, stock appreciation rights, and access to restricted stock.
The most common is a direct purchase program that lets employees buy shares in the company at a reduced price using their own after-tax money, but there’s usually a limit on how much they can invest.
The 7 Benefits of ESOPS
There are many benefits of ESOPs for both employers and the companies that hire them, but for the purpose of looking at these as retirement plans, we’re only interested in what the employee can gain.
These are some of the benefits that an ESOP can offer when you’re considering investments for your future.
- A number of tax benefits are offered with these plans that can make them a lucrative remuneration offer. Any distribution you get from these plans is taxed like other plans including 401 k, and you’re able to withdraw from them early if you want to pay the penalties. If you sell your shares in the plan, you can get capital gains treatment for the sale, and taxes can even be delayed by rolling them over to another account like a traditional IRA.
- Dividends that are paid to employees from these plans can be taken in cash or used to invest in more company shares, and no withdrawal penalties will be paid but they will be taxed as regular income.
- ESOP plans have good liquidity and they are usually easy to sell your shares if needed.
- This type of retirement plan offers a chance to build your wealth by saving money and investing it in stocks, especially when used as a long term solution.
- Employees will get voting rights as they become shareholders which gives them an extra say in the company they work for and also helps to determine the very market that they work in.
- Compared to other investment vehicles, there are no fees involved in an ESOP so everything that you have invested will be there to grow.
- Being part of an ESOP means you can ‘set and forget’ this retirement plan. Once it’s been established, there’s little you need to do and you can simply let your shares increase in value over the years.
The 5 Disadvantages of ESOPS
Although there are a lot of benefits to these retirement plans, there are also downsides.
When considering using an ESOP as part of your retirement plan, you’ll want to be aware of the potential disadvantages they come with.
- Having a large portion of money in an ESOP alone is restrictive and lack diversification. By relying on just this type of plan, you can put too much weigh in the one option in your portfolio. It’s better to have at least one other type of retirement plan in place, like a 401 k or IRA.
- Compared to buying stock on the market, the share price of ESOP stock is usually lower. Therefore, when you go to sell your stock eventually, you won’t get as much for it than if it were publicly traded.
- There’s a limit to the type of companies that offer these retirement plans and they might not always be an option. Only C or S corporations can use them which limits people to finding these specific employers if they want to be involved.
- When new shares are added to the plan to account for new employees, this can dilute the price of the existing shares.
- It can be hard for a company to cover the cash flow needed if a number of people start taking withdrawals from their ESOPs at the same time. Therefore, it can be risky when you are ready to take your money out.
Related Questions
Employee stock ownership plans are a good retirement option when offered, but there are a lot of rules and regulations that have to be considered.
We’ve answered some popular questions about ESOPs so you can determine whether they’re a smart investment vehicle for you.
How Do You Cash Out ESOPs Money?
You will be able to cash out the money earned from your ESOPs when you leave that company, but there may be penalties.
A 10 percent penalty will be charged by the IRS if you are younger than retirement age and you will have to pay regular income tax.
To avoid this, you might be able to transfer the money into a traditional IRA if you don’t need the money right away.
Can You Borrow Money From Your ESOP?
Some retirement funds, like 401k accounts, allow you to borrow money from them and then pay it back, but an ESOP doesn’t allow this.
Almost no employer will let you borrow money from your ESOPs, and if you withdraw from it early you’ll be forced to pay penalties and taxes.
