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The Solution to Managing the Repurchase Liability Challenge: A Defined Benefit Plan

October 29, 2018Articles For Your Benefit

Undoubtedly, the sponsors of mature ESOPs face numerous challenges that only become apparent after the ESOP has been implemented and has been in operation several years. These challenges include implementation of a seamless leadership transition program as the founding shareholders reduce their role as active managers, as well as effective incentivizing of the workforce through education and well-planned participant communication efforts.

As the most senior workforce begins to retire, other challenges usually arise, many of which are related to the use of the ESOP as the primary retirement vehicle for the company that sponsors the arrangement. This includes the lack of diversification due to reliance on company stock as a retirement benefit, the need by many employees for guaranteed lifetime income and the relative lack of flexibility regarding distributions and withdrawals from ESOPs.

However, the most significant problem facing the “mature” ESOP company is managing its repurchase liability. Part of the problem is that the success of the company exacerbates repurchase liability approaches. As the ESOP company becomes more successful, the drain on cash flow to pay out  retiring and terminated participants can increase exponentially. Without proper financial planning, an ESOP company can be thrown into a financial crisis.

One of the most frustrating aspects of managing repurchase liability is that much of it is beyond the employer’s control. Indeed, the company has little control over employee demographics, the timing of retirements and diversification elections. These variables can play havoc with the most carefully drawn plan to fund ESOP repurchase liability.

Unfortunately, many of the typical solutions employed by ESOP plan sponsors often worsen the problem they seek to solve. This usually occurs because of the natural reaction of finance executives in attempting to smooth out the significantly fluctuating year-to-year liabilities by accumulating cash reserves. The problem with cash reserves is that such reserves are usually counted as a balance sheet asset, while the associated repurchase liability is not. This mismatch has the effect of artificially increasing the value of the company, and, as a result, the associated repurchase liability. Further, and as a practical matter, creation of a reserve is usually only a partial measure, as few companies have sufficient resources to create a reserve sufficient to fund the entire liability.

The Solution

At first blush, having an ESOP company adopt a defined benefit pension plan may seem counter­intuitive. After all, why add an obligation to fund a second plan to a company already challenged to fund liabilities associated with its primary retirement vehicle? The reality is quite different, however, because the costs associated with funding the defined benefit plan reduce the value of the company and the associated repurchase liability. Further, the employees do not lose value. Their benefit will be paid to them from the defined benefit plan upon retirement.

There are several other advantages in using a defined benefit plan to pre-fund repurchase liability. Defined benefit plans can be overfunded and any excess cash is not counted as an asset when determining company value. Thus, the company can create a reserve to fund repurchase liability without engaging in the counter-productive step of increasing the value it seeks to fund. Additionally, the company can use the excess cash directly to purchase stock from retiring participants. ERISA and the Internal Revenue Code both allow a defined benefit plan to invest up to 10 percent of its assets in employer securities. Otherwise, the excess can be quickly consumed by skipping or reducing a contribution to the plan, thereby freeing up cash for share redemptions.

There are other benefits to the use of a defined benefit plan in conjunction with an ESOP. By substituting a pension benefit for the value that would have otherwise have been paid through an ESOP, each employee will receive a fixed, predictable pension based upon his or her salary, age and service with the company. The employer’s cash flow can be improved by requiring benefits from the defined benefit plan to be paid as an annuity based upon the participant’s life. It is the employer’s choice as to whether to offer lump sum and installment payment options as forms of benefit.

The concept is best illustrated through the following example. Assume a 100 percent, ESOP-owned company is worth $2,000,000 before adoption of any defined benefit plan and that, upon retirement, Participant A will be entitled to five percent of the value of the company, or $100,000. Further, assume that the company adopts a defined benefit plan that will provide benefits costing $300,000. The obligation to fund those benefits is a liability of the company; all things being equal, that obligation will reduce the company’s value by $300,000 to $1,700,000. Accordingly, the value of Participant A’s ESOP account would decrease to $85,000. Assuming that our “average” participant is also entitled to a pension with a value of five percent of the total value of the defined benefit plan, his pension would be worth $15,000. Thus, his total benefit would not change; it would simply be divided between the ESOP and the pension plan.

In addition, the company could choose to put $500,000 into the pension plan, without increasing the value of the plan benefits. All things being equal, the additional $200,000 would be plan overfunding, which can serve as a reserve for the payment of repurchase liability. These additional funds cannot be withdrawn from the plan absent termination of the plan or unusual circumstances. Further, it would not be counted in determination of the value of the company, as would be the case if held as part of the company’s general corporate assets.

This structure also addresses one of the principle objections raised by the Department of Labor and others regarding the use of an ESOP as a retirement vehicle: lack of diversification. By dividing each employee’s retirement benefit between ESOP and defined benefit components, a degree of diversification can be achieved. More importantly, the Pension Benefit Guaranty Corporation insures a significant portion of the benefit payable to every defined benefit participant. This provides an additional layer of “downside” protection for employees in the event that the company encounters serious financial problems.

It is not uncommon for an ESOP company to maintain a 401(k) plan alongside or as part of its ESOP. Arguably, the 401(k) plan addresses the diversification issue as well. However, 401(k) benefits can vary greatly depending upon employee participation and do not provide the government insured, predictable fixed payout provided by a defined benefit plan. They also do not provide a mechanism to accumulate reserves to address repurchase liability concerns available with a defined benefit plan.

There is another advantage available to employers desiring to provide additional deferred benefits to key executives. In many cases, Internal Revenue Code Section 409(p) restricts or prohibits these additional perquisites. Because defined benefit plans are qualified plans within the meaning of Section 401(a) of the Internal Code, these plans are exempt from the restrictions imposed by 409(p). Thus, a defined benefit plan designed to favor key and long serviced individuals accomplishes these goals without implicating 409(p).

It is important to note that this article only scratches the surface of addressing the issues discussed above. Both repurchase liability funding and diversification of benefits can be fine-tuned through the combination of the ESOP with a defined benefit plan, 401(k) plan as well as other types of arrangements that are customized to address each company’s specific needs. The specific circumstances of each company, as well as the engagement of experienced advisors familiar with these issues, will help drive the manner in which a company will best address these concerns. However, this option is certainly worthy of consideration by any ESOP company seeking to manage its repurchase liability