Using Account Segregation in an ESOP

This article was featured in the National Center for Employee Ownership (NCEO)’s January 2024 Newsletter. It is based on a presentation by  Dan Markowitz, Boulay Partner and NCEO board member.

Many ESOP companies prefer that when employees terminate employment, their shares are repurchased within the ESOP trust and reinvested in another investment account. The transfer of the shares to another investment account reduces the risk of any further appreciation or depreciation of the account, recycles shares to current employees, and prefunds the future repurchase obligations.

Companies could, of course, just pay people out, but that may encourage participants to leave just to get what is in their account. The decision to contribute cash to the ESOP for segregation is an annual Board of Directors decision.

Segregation uses available cash in the ESOP to exchange shares of company stock into an alternative investment account within the plan at the trustee’s discretion, not the participant’s. The trust may already have cash, or the company can contribute cash as needed. Some employees have questioned this decision in companies where the stock value has been rising, but a particular form of investment is not a protected benefit for former participants.

The segregated accounts need to be prudently invested. That is a judgment call for the trustee and should be subject to an investment policy statement. A very conservative approach, such as leaving it in short-term money market funds, may be justified, but most advisors urge a conservatively structured diversified portfolio.

The IRS approves of segregation, provided that the ESOP plan document authorizes it and there is a definitive formula for determining how many shares are segregated, how the price at which the segregation will be determined, and to whom the shares are to be allocated. The rules must be nondiscriminatory—more highly paid people cannot benefit disproportionately. The company also can’t pick and choose who they segregate for any other reason. It is also essential to communicate the segregation policy to plan participants. That should be done clearly and regularly to avoid participants becoming cynical about the ESOP if they leave and feel cheated because the share price had been rising.

Almost all new ESOPs are including segregation in their initial plan document. That does not mean they will choose to do it, but they do have the option. Additionally, mature ESOPs are adding segregation to their plan document.

Putting Segregation in Place

The cash requirements to implement segregation can be significant. Of course, if your stock price is rising faster than your cost of money, you will reduce cash needs over time, but not all companies have the cash flow or reserves to use segregation.

Segregation does not have to be an all-or-nothing approach. While you can segregate everyone who terminates, you could also have a staged approach in which you pay out based by the earliest termination date, the type of termination (just those at retirement age, how long employees have been in the plan, or other criteria) as long as it is in a non-discriminatory manner.

The plan can have the trustee decide on prudent investments or allow for a distribution during the next distribution cycle to the extent the participant has been segregated, which reduces the fiduciary risk.

Another decision is when to distribute segregated accounts. Holding the accounts for some period of time may discourage participants from taking their cash, although research on why people leave jobs suggests this probably is not a big factor. Retaining cash in the plan is an administrative burden when an account is fully funded, so paying out sooner has become the norm.

In deciding whether to segregate, boards of directors need to think about the philosophy of the plan, whether or not segregating will contribute to a “have/have not” problem where newer employees have relatively few shares, the company’s cash needs, the direction of the share price, and cash needed for other strategic initiatives.

Case Study

An ESOP company had a significant reduction in force 2008–2009, leading to significant turnover. As a result, many participants went to work for a competitor. By December 31, 2015, 50% of the stock was allocated among terminated participants. The company had a five-year wait/five-year installment distribution rule. The stock price grew from 2010 to 2015 in excess of 20% a year. Former participants now held $13 million in stock. The company contribution was 15% of eligible compensation, but that was just covering what was needed for distributions.

In 2016, the company made its distributions in stock, but the annual company contribution to the plan was made as well to start accumulating cash for segregating terminated participant accounts and normal distributions over the next two years. The segregation recycled shares back to active participants who were driving the growth of the organization.

Starting in 2017, the company saw continued growth and only had to use part of its annual contribution for segregation. Eventually, 90% of the stock was held by current employees. Morale improved, and the company saved over $10 million in the short term by segregating at the lower stock price vs. waiting for when the participant was eligible for a distribution.

Conclusion

Segregation is just one strategy to manage the repurchase obligation. Rebalancing, early diversification, and releveraging the ESOP are other options and can be used in conjunction with segregation. These are complex calculations, so doing this in conjunction with a repurchase obligation/ESOP sustainability study is essential.

Boulay’s ESOP Advisory team assists with segregation, repurchase obligation and other complex ESOP matters. To learn more about our ESOP services, connect with us today.