By Pete Shuler, Partner at Crowe LLP, and Jim Bado, Consultant at Workplace Development
When owners choose ESOP plan provisions, they often select the federal minimum rules (i.e., the most restrictive provisions under the law). These rules appear to reduce the company’s required cash outlays while it is repaying the debt used to acquire the shares. They are also selected because owners may be unaware of other options.
Let’s not undervalue the importance of maximizing cash flow and repaying debt. Without a viable company, there is no employee ownership. However, plan design decisions are sometimes made with little consideration of how the choices will look to employees and affect their perceptions of the ESOP’s value. Design choices can have unforeseen consequences, especially for companies that want to make the most of employee ownership.
This Plan Design to Build Your Ownership Culture series will examine common plan provisions. Our goal: providing you with ideas/options about how the ESOP’s rules can be modified to make your plan a more effective tool to recruit and retain employees and to foster an ownership culture. As we share ideas, we will also look at the cash-flow implications of these changes because, more often than not, the changes have minimal impact on the company’s cash flow.
Today’s topic: plan entry rules.
Federal minimum standards for entry dates (i.e., the norm)
The entry rules to your ESOP influence how employees experience ownership at your company. How quickly, or slowly, someone becomes a participant has a direct link to how much (or little) he or she values employee ownership. If you want to build an ownership culture at your company, taking another look at these provisions is a good place to start.
The most common ESOP entry rules are also the most restrictive under the law:
- Age 21
- 12 months of service, working 1,000 hours or more during that time
- Enter the plan the following January 1 or July 1
With these provisions, all new employees will wait a minimum of two years before seeing a participant statement. Even worse, it is possible for a new hire to wait more than three years before seeing his or her first statement. Assume a person is hired on July 3, 2022. Their 12-month waiting period will end on July 3, 2023. If they worked 1,000 hours during the 12 months and are over 21, they would enter the plan on the next semi-annual entry date: January 1, 2024. Statements for the 2024 plan year may not be finalized until summer 2025, meaning that individual isn’t seeing their first statement for a full three years after their start date at the company.
Despite that, these entry rules have become somewhat of an industry standard. Why? Some companies have high turnover rates among new hires; it is easier to keep those employees out of the ESOP until they demonstrate that they will stick around. Others cite the internal and external administrative and tracking costs associated with high turnover and only want to invest their time and energy into employees willing to be with the company for the long term. Many firms, as mentioned, adopt the federal minimum standards and don’t realize they can do anything differently.
While the cost reasons make sense on the surface, here are a few questions worth asking:
- Are we really saving work and resources by keeping employees out?
- How much are we actually saving?
- Do the savings outweigh the benefits of new employees becoming participants more quickly?
- How do new employees perceive the long waiting period? What will current employees” reaction be if we change it?
There can also be a philosophical position connected to this decision. Some companies feel that even if it doesn’t cost much time or money, they don’t want new hires who are probably going to leave to receive anything in the ESOP. Ownership should be targeted to employees who prove they will stay. If employee ownership is truly valuable, we shouldn’t just “give it” to anyone. This argument is somewhat of a red herring. Because, in almost all ESOPs, employees who leave early will receive nothing or very little from the ESOP. Most plans require that employees be active on the last day of the plan year and work at least 1,000 hours to receive an allocation. Plus, they have vesting schedules connected to an employee’s years of service.
If your plan has the federal minimum entry provisions, put yourself in the shoes of a new hire for a moment. You are joining a company that promotes the value of employee ownership. In fact, the ESOP might have been the reason you decided to work for the company. National statistics demonstrate that ¾ of Americans would rather work for an employee-owned company. Then you learn it may take three years before you see any tangible benefits of the ESOP. Does that sound exciting to you? Three years is an awfully long time to wait, especially for younger employees just beginning their careers. This delay can build frustration and even perpetuate the idea of a false promise of ownership.
Entry Date rules/changes to address the long waiting period
Fortunately, there are many ways to deal with the challenge of delayed participation. These will require a plan amendment, so consider that before jumping into making any changes.
The first thing to think about, especially if you hire younger employees, is whether to move the entry age from 21 to 18. That way, new hires will not wait three years just to join your ESOP. If you’re using the ESOP as a recruitment and retention tool, this will help you compete against 401k plans that usually offer entry after 30, 60 or 90 days.
The next thing to consider are the provisions for plan entry. How long do you want new employees to wait before they can enter the ESOP? Getting new hires into the plan sooner means, of course, that they will earn benefits and see a statement faster. The company will also incur more administrative costs. Here are some less restrictive options we’ve seen at companies over the last three decades:
- Employees enter the ESOP on their date of hire
- Employees enter the ESOP on first day of the month after their date of hire
- Employees enter the ESOP on first day of the quarter after their date of hire
- Employees enter the ESOP on the day they complete 90 days of service
- Employees enter the ESOP on the day they complete six months of service
These choices ensure that participants get a statement sooner and are worth examining if you want to create a more robust sense of ownership among all employees.
One way to mitigate the additional tracking and administrative costs related to employees entering the ESOP is utilizing a retroactive entry date. With retroactive entry, you can keep the one year, 1,000 hours requirement, but make the participant’s entry date January 1 of the year he or she meets the criteria. In other words, someone hired on July 3, 2022, would enter the plan on January 1, 2023, as long as they are still employed on July 3, 2023. With a retroactive entry date to the beginning of the plan year, no new employee would wait longer than a year to enter the ESOP.
We like retroactive entry because a new hire needs to be with the company for at least a year, like under the federal minimum requirements. They are still “earning their keep,” but enter the ESOP much quicker than the next following January 1 or July 1 approach. Plus, because they don’t officially enter the plan until they hit their one-year anniversary, there’s no need to track them before that.
Keep in mind that in most plans, even though they become a participant, a new employee wouldn’t be eligible to receive an allocation unless he or she was still active on December 31 (or whatever the last day of the plan year is for your company) and had worked at least 1,000 hours during the year. Given those provisions, one certainly wouldn’t be “giving away the store to the undeserving” by changing eligibility rules to accelerate ESOP participation.
Welcome employees in, but incentivize staying with vesting
Most ESOPs have a vesting schedule that enables employees to earn ownership of their account over a period of years. If people join your ESOP sooner, they will receive an allocation of shares, but if they leave prior to vesting, the company will not owe them the value of those shares. The most common vesting schedules are a six-year graduated schedule and three-year cliff vesting (0% vested year 1 and 2, 100% vested when you reach 1,000 hours year 3).
Under the six-year schedule, participants usually must work 1,000 hours per year for two years to become 20% vested. Their vesting increases by 20% each year thereafter; they are fully vested after six years of service. With a three-year cliff-vesting schedule, new employees are zero percent vested until they have earned three years of service. Once they do that, they become 100% vested.
So, if you change plan entry dates to get people into the ESOP earlier, the vesting schedule still provides the company with protection against paying out “short timers.” With the six-year schedule, an employee needs to accumulate two years of service before they become 20% vested. Under the three-year cliff vesting, they must have three years of service before vesting at all. At most ESOPs, if someone stays for two or three years, they are staying for the long term.
And that, alas, is the irony of delaying plan entry to protect the company from “doling” out benefits to the undeserving. It ends up harming people who stay with the company because they receive no benefits from employee ownership during their first year or two at your business. In other words, the plan is damaging the people that you want it to reward.
But what about the cash flow implications? Changing the participation provisions will have almost no impact on your company’s cash flow or ability to repay debt. Why? Because most “short timers” will not earn any vesting, so you will owe them nothing. If you adopt a retroactive entry date and maintain the 1,000 hours/one year requirement, no one who stays less than a year ever enters your ESOP.
If you want to use your ESOP as a recruitment, retention and ownership-culture building tool, consider changing your entry age and process to get new employees into your plan quicker. Because, at the end of the day, nothing gets people more interested and excited about employee ownership than being an actual employee owner.
To ask questions about plan design or help improve employee-owner retention and performance, contact Workplace Development at email@example.com or (330) 899-7100.