Leading Companies Online Magazine
The Challenges of ESOP Administration
By Anthony I. Mathews, Beyster Institute Staff
 
In the last two installments of this column, we went over the administration of your ESOP with a broad brush. We have tried to fill in the details of administration of your ESOP and how it affects you whether you are doing it yourself or hiring one of the many professional administrators to help you do it. No matter what, in either case, you are at the center of the activity. So, I thought we’d go back now to some of the specific areas we covered, and take on a brief discussion of the most challenging areas of ESOP administration. The first of these is the area of benefit distribution policies and procedures.
To begin with, it seems pretty clear by now that there is no perfect answer to the question of what anybody’s specific distribution policy or procedure ought to be. Every policy I’ve ever worked with is, in the end, a not entirely satisfactory resolution of several conflicting intentions.
ESOP companies take their responsibility to develop and deliver value to the shareholders very seriously. In its most practical form, this objective is reflected in the payout of value to an individual participant. For the group, it is reflected in the many decisions that go into the process of building and preserving that value, which will later be reflected in a payout to an individual.
In implementing this basic intent, a number of conflicting decisions are pretty obvious. Most ESOP sponsors want to do what they can (legally and ethically) to preserve the cash flow of the company. After all, all benefits are funded ultimately from that cash flow. Close behind all of that, they also want to establish a payout policy that will not encourage participants to terminate early in order to collect their benefits or to waste the value that is ultimately paid out to them (whether through bad investing or just the significant tax level that often comes into play where distributions from qualified plans are made earlier than “retirement”.
These goals may well extend to include being sure that the value that is being created is generally accruing for the benefit of those who are making it happen – the current employees (and, on the other side of the same coin, that the risk of an investment in a closely held stock is removed from those who no longer have a real connection to the company other than their interest in the plan).
It is just not possible to design a policy that does all those things perfectly, but ESOP companies never tire of anguishing over details of policies that try.
So how do you make a distribution policy? Well, you start with a frank and thorough investigation of your goals. Which of the above goals sits highest on your priority list? Are there other factors that are going into influence your thinking? (If there are, I’d be very interested to hear about them, by the way.)
As with so many of the decisions we have to make on these matters, the beginning, at least, of the answers to all those questions is in your plan document. What does it say you will do? And what is the exact language that the plan uses to do so? There’s a big difference between “may” and “will”, and there’s an equally big difference between “will X as of Y” and “Will begin to X no later than Y”. I know you get the picture. The exact language is a critical starting point.
Again, do not mistake what the document authorizes the Board or the Administrative Committee or you to do and what it requires you to do. There is a big difference here between what you may do and what you must do. And you need to keep the difference in mind at all times. In the event that you realize after reviewing your document that you are required to do something incompatible with what you want to do overall, it’s time to get together with your counsel and sort that out. Plans can always be amended, and even distribution policies that are hardwired into your plan can probably be changed if it really makes sense to do so. But you can’t do it without your counsel’s help.
Once you have sorted out what flexibility you have to develop a policy, it becomes a matter of testing the results of various decisions against the outcomes you desire.
Delay in distributions will preserve cash flow in the short term, but, if the stock is increasing in value faster than the cost of money at that time, or if you are one of the growing number of S-Corporations that are making annual distributions of earnings, the ultimate real cost of leaving participants invested in employer stock for an extended period after they terminate service may be significantly greater than just paying people out right away.
At the same time, paying out terminated participants very rapidly after termination creates its own problems. While rapid payout will certainly see that the benefits of ongoing growth in value accrue mainly to the accounts of active employees, having that as your policy may, at the same time, inadvertently cause some people to quit sooner than they might otherwise have decided to do so.
All of the decisions related to distribution practices seem to put the sponsor in similar binds. Notably:
“Share distributions vs. direct cash distributions” frequently compromises the best outcome for retirees with large balances against the company’s ability (or desire) to commit its available cash flow.
“Lump sum distributions vs. installments” often balances the most desirable outcome for terminated participants against the company’s cash flow. (But don’t jump to a quick conclusion. You can’t tell who’s better off which way without a lot more information.)
It is beyond the scope of this article to go into detail on all the many specific decisions that need to be made, but the policy itself needs to start from an understanding of your real priorities and the realistic ability of the company to make the commitments necessary to act them out.
We’ll take the time in this corner from time to time to go over specific areas of administrative concern to ESOP companies. If you have a burning issue you’d like to see addressed here, or you’d like more information on something we’ve already brought up, please email us your questions and you will see them answered here.
©2006. The Beyster Institute and its authors and their entities. All rights reserved.
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