A couple days ago, we started talking about some of the different ways you can dabble in your own company’s stock. Actually, it wasn’t “we” doing the talking; it was just me, but you did a very good job listening. In fact, as a reward for being such good listeners, today you get to listen to me talk in excruciating detail about the most common way that people like you can invest in the success (or disastrous, wallet-annihilating failure) of your company–Employee Stock Ownership Plans (ESOPs).

How ESOPs Work (Or At Least the Parts You’ll Care About)

The internal workings of an ESOP can be relatively complicated and, while I’ll spare you the grittiest details, it is worth mentioning that they even have their own governing laws covered by the Employee Retirement Income Security Act (ERISA). A lot more goes on in the background of ESOPs than many of the employees who participate in them realize. To start, while one of the primary purposes of ESOPs is to provide an incentive for employees to work hard for the success of their company, they actually yield huge benefits to the company and its primary owners. The company’s biggest benefit comes into play when the trust it establishes in connection with an ESOP borrows money that is used to buy stock for the ESOP. When the company goes to pay that money back, it can claim a hefty tax deduction. The company can also directly contribute shares of its stock to an ESOP, and those contributions are also tax deductible. A company’s biggest shareholders also heavily benefit from ESOPs because ESOPs serve as a market for the shareholders to sell their stock.

What you should care about when it comes to ESOPs is how you get a hold on your share (or at least the cash value) of an ESOP. When a company establishes an ESOP, it also sets up individual accounts for each of its employees who are qualified to participate–generally any full-time employee over the age of 21. The company then contributes to your account however it sees fit–most often through matching a portion of employees’ contributions to a 401(k) or through some other formula that takes relative pay or length of employment into account. In many companies, you don’t immediately have a right to the shares put into your account; rather, you gain more rights to your shares the longer you remain with the company. That’s what is referred to by the term vesting. ERISA rules dictate that employees be 100% vested in their ESOP accounts within five to seven years–possibly sooner, depending on how your ESOP is put together.

Eventually you’ll leave your company, either for another job or to retire (or maybe they’ll find your computer’s “hidden” porn folder and give you the boot). When you do leave, your company must buy your ESOP shares from you for whatever they’re worth. If you’re not at retirement age, you’ll probably want to roll that money over into an IRA. Otherwise, you might find yourself hit with capital gains and excise taxes.

ESOPs and 401(k)s

Many companies (including the one that employs me) make contributions to its workers’ 401(k) retirement plans with ESOP shares. Since these contributions typically come in the form of matches to an employee’s contributions to other 401(k) funds, it’s rare that an employee will put his or her own money into an ESOP. Instead, the ESOP will sit alongside your S&P Index Funds and Stable Value Funds and the like.

The important thing to realize about ESOPs, especially if they’re a part of your retirement portfolio, is that participating in one is akin to owning stock in your company. If a company does well, the value of your ESOP will rise. If a company does not so well, the value might go down. If a company goes bankrupt, your ESOP money goes bye-bye. So just like you wouldn’t invest all or most of your money in a single stock, you don’t want your ESOP to take up a disproportionately large chunk of your retirement plan.

That said, there are many employees out there with 33% of their 401(k)s made up of ESOP contributions–essentially, a third of their retirement money is riding on the success of their own companies. Now maybe these people are big fans of their companies and have complete faith in their continuing success, but I’m willing to bet that an awful lot of people simply take an hour to set up their 401(k) contributions and assume they’ll have lots of money waiting for them in 40 years.

The problem with taking a set-it-and-forget-it approach to 401(k)s when your company’s matching comes in the form of ESOP contributions is that, left untouched, you’ll have two-thirds of your retirement account in assorted funds (they are assorted, right?) made up of your personal contributions and one-third in an ESOP (since a lot of people get 50 cents put into an ESOP for every dollar they contribute to other parts of their 401(k)). If you’re in this situation and your company pulls an Enron, you could lose a third or more of your retirement savings.

Unfortunately for you, the rules for diversifying (in this case, moving your money from the ESOP to other funds in your retirement account) aren’t in your favor. With some exceptions, until you turn 55 and have been participating in the ESOP for at least 10 years, it is solely at your company’s discretion whether or not to permit you to diversify some or all of your ESOP. After that point, your company must give you the option of diversifying 25% of your ESOP balance or pay that 25% out to you. That figure goes up to 50% at age 60. But if you’re still a whippersnapper, you may have no choice but to let that ESOP stay a big chunk of your retirement portfolio.

In my case, my employer matches 50% of my 401(k) contributions with ESOP dollars. Before this year, we weren’t allowed to diversify our ESOPs until age 55, but my company changed that rule drastically this year to allow immediate diversification of ESOP contributions. Now if I had absolutely zero faith in my company’s future existence, I could theoretically log into my retirement account every week and move those ESOP contributions to other funds (though in practice, I can’t because we’re only allowed a limited number of changes to our plans each year). Instead, I try to keep the value of my ESOP around 10-15% of my total 401(k). I closely monitor my 401(k) and whenever my ESOP hits 15% of the total balance, I usually transfer enough to other funds to knock the ESOP’s worth down to 10%. I could diversify all of those ESOP contributions, but I’m pretty sure my company will still be around for a while.

“I Nominate My Goldfish For Chairman of the Board”

I’ve already briefly touched on the idea that ESOPs vary in several ways from direct stock ownership. If you go out and buy 100 shares of The Sexy Green Pants Company, you’ll be entitled to 100 votes when it comes time to make big decisions about the company like merging with The Saucy Red Pants Company or selling out to The Sensible Black Pants Company as well as other important corporate issues like electing the board of directors.

Participating in an ESOP does not empower you as much as purchasing the stock yourself. In publically traded companies, employees participating in ESOPs must have some sort of voting power on all the issues that a regular shareholder can vote on. In private companies, ESOP participants only need to have a say in those major, company-altering events like selling or closing the business. This sounds pretty good considering you’re probably not even spending your own money on company stock, right?

In reality, voting rights for ESOP participants aren’t truly voting rights. If you have the equivalent of 50 shares in your ESOP, you don’t get 50 votes. You don’t even get one vote! Instead, it’s the trustees of the ESOP who have the voting power granted by the shares in the ESOP. These trustees are free to do as they please and can even make decisions without consideration to anyone else. Most often, though, the trustee will vote the ESOP shares either according to the wishes of the committee that administers the ESOP or, if you’re lucky, to those of you lowly employees.

There are plenty of other rules governing ESOP voting, many of which allow companies to restrict an individual employee’s ability to have any real influence in big corporate decisions. So if you’re looking to wield some real power, you might want to look into more direct forms of stock ownership than an ESOP provides.

Summary of ESOPs

What, you thought I was going to talk for ten hours and not give you a CliffsNotes version? I’m a nice guy!

• ESOPs are investments in your company. Performance of your ESOP money is directly tied to the performance of your company. Employers expect that ESOP participants will work harder for the good of the company. You’ll do that, right? Of course you will!
• Your employer dictates when you are vested in your ESOP shares, though the law requires 100% vesting within seven years, sometimes sooner.
• 40l(k)s and ESOPs are a great combination. The pairing of ESOPs and 401(k) retirement accounts is becoming more and more common. In most cases, employers will match part or all of employee 401(k) contributions with ESOP shares…
• …but don’t let your retirement portfolio get too ESOPpy. If left undiversified, you could end up with one-third or more of your retirement money riding on the success of your company. If your company allows diversification of your ESOP funds before the government-mandated age of 55, it might be a good idea to spread some of your ESOP balance to other funds.
• ESOP voting powers are often limited. Because of the way ESOPs are structured, your ability to use ESOP shares in important company decisions can vary. Typically you won’t have anywhere near the same voting rights as normal shareholders.

Of course, ESOPs can come in all sorts of sizes and shapes and have special caveats that require you to milk the CEO’s baby goat three times a year. So if you have an ESOP at work and you’d like to learn even more about them, aim your web browsing device at these babies:

An Interactive Introduction to ESOPs
Wikipedia – Employee-owned corporations
SEC and ESOPs

In part three of this series, we’ll look at ESPPs and why a one-letter difference from ESOPs can mean a whole lot of difference for you and your money.