Minimize Risks for ESOP Participants
While company stock is a good source for saving toward retirement, it should not be your only source. Risks for ESOP participants include an over-concentration of wealth in company stock and company performance or economic cycles can dramatically impact your ESOP account value.
Diversify your wealth.
If the shares in your ESOP are doing well, you probably have a large concentrated stock position within the company. If everything goes well, you should enjoy substantial payouts from the ESOP share value when you are eligible for retirement. However, it is a good idea to be prepared if something happens with your company or its industry.
Take the travel industry as an example. During the Covid pandemic, the travel industry was hit quite hard. According to research conducted through the U.S. Travel Association, travel spending totaled a mere $679 billion in 2020. This was an unprecedented $500 billion annual decline from 2019, with international travel and business travel suffering the sharpest declines. If you have investments in travel related employer stock, it may be several years until values fully recover.
A company’s financial circumstances affect the value of its stock, thus lowering the value of employee’s ESOP accounts. Take the example of Hobbico in Champaign, IL. Hobbico was one of the largest employers in Champaign county, with 330 employees when it filed for bankruptcy in 2018. The company, formed in 1985, filed for Chapter 11 because it had added too much debt and ran into issues with suppliers. In 2017, employees learned that the value of the company's employee stock-ownership program declined by more than 80 percent, and the U.S. Department of Labor opened an investigation into deferred ESOP payments.
Every year businesses fail, but when a company is backed by an ESOP the losses are compounded throughout the community.
If you are solely invested in company stock, you risk losing all your retirement funds in the event your company fails or falls on hard times. You’ll not only be looking at the prospect of losing your job, but also losing money on the company stock. It’s an example of putting too many eggs in one basket.
Remember if a company with an ESOP is struggling financially and has to lay off workers, it may have to cash out workers’ shares in the ESOP. This could create more cash flow problems and more layoffs, creating a death spiral that could ultimately sink the company and the value of your ESOP account.
According to the Pension Rights Center, best practices for people with ESOPs are:
Transfer ESOP balances out of employer stock into other investments, particularly when the value of the employer’s stock is too large a portion of the total retirement plan investments, such as more than 10 or 20 percent.
If an ESOP is also part of a 401(k) plan, participants are entitled to diversification rights, which include the right to transfer out of publicly-traded employer stock after three years of service.
If the stock is privately traded or if the ESOP is not part of a 401(k) plan, participants only receive these diversification rights after reaching age 55 and participating in the ESOP for at least 10 years.
Consider receiving any payouts in the form of cash that is directly rolled over into an IRA or 401(k) plan to avoid incurring tax penalties and so that the money can be invested in diversified funds rather than in a single stock.
Work with your financial advisor to understand and take advantage of the diversification options available to protect your hard earned ESOP wealth. In addition to taking advantage of diversification options, consider the strategies below to grow your wealth and protect your financial well being.
Cushion the Blow: Emergency Savings & 401k Contributions
Set aside money in a savings account and a 401k in case you need to change jobs. This diversifies your investments and protects you from being wiped out in the event of a company bankruptcy. Invest in a diversified mix of stock and bond funds within your 401k instead of only investing in company stock.
If you save money in your 401k, some plans allow you to borrow money or take a hardship withdrawal. If you have an emergency such as a serious illness with unexpected medical bills or high tuition bills, a 401k can be a lifesaver. A 401k coupled with a savings account for emergency funds can allow you to sleep better at night. At a minimum, I recommend having six months of emergency savings in the bank in addition to your 401k.
If you’ve maximized your 401k contributions and have a healthy emergency fund established, you may want to look into other accounts to optimize your savings.
Are you comfortable with your progress towards retirement?
If you are uncertain or would like a second opinion regarding diversification of your company holdings, schedule a call with me today.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance and estate planning advice, Peak Wealth Planning is a fee only financial advisor based in Champaign, Illinois.