Proactive, prudent, and nondiscriminatory management of an employee stock ownership plan (ESOP) is required to ensure plan health over the long term.
And while meeting ongoing repurchase obligations is a primary concern, it certainly isn’t the only ESOP sustainability factor to consider. Others include:
- Limiting the benefit of increased ESOP share value to current employees
- Controlling the overall level of benefit employees get from the ESOP
- Preventing a surplus of cash that can inflate share value
- Avoiding a have/have-not scenario among plan participants
- Keeping company shares in the plan
Account segregation, or reshuffling, and account rebalancing are two key tactics an ESOP may use to manage plan assets. While they sound similar, they serve distinct purposes. Both are subject to rules and limitations.
Here’s what you need to know about ESOP rebalancing, reshuffling, and recycling shares.
What is Reshuffling in an ESOP?
In a 2010 memorandum, the Internal Revenue Service (IRS) defines reshuffling as “the mandatory transfer of employer securities into or out of plan accounts, not designed to result in an equal proportion of employer securities in each account.”
Why would an ESOP want unequal proportions of cash and company stock in plan accounts? In short, when an employee terminates, they are no longer employee-owners. Yet they may experience a years-long period between the end of employment and full distribution of their ESOP benefit.
Reshuffling, also called account segregation or cash conversion, prevents former employees from participating in future gains as a result of share price increases — and it also protects them against potential future losses before their distribution is paid to them. Typically, the plan moves cash from active employees’ accounts to the terminated participant’s and moves the terminated participant’s shares into employee accounts.
As a result, the terminated participant’s account retains its value, but in cash instead of shares. Reshuffling is fairly common among plans that hold cash, and creates a way for the ESOP to recycle shares rather than redeem them. For a 100% ESOP-owned company, this preserves employee ownership.
Because ESOP distribution rules allow a plan to take several years to pay out a distribution after an employee terminates, account segregation can be a crucial part of managing the ESOP. At the same time, certain practices must be described in the plan document, and administrators have to execute them in a nondiscriminatory way.
In addition, reshuffling must not impose a significant detriment on a participant who does not consent to a distribution. So once a participant’s account has been segregated, the ESOP is still responsible for prudent investment of the cash on the participant’s behalf.
What Does it Mean to Rebalance an ESOP?
The same IRS memo defines rebalancing as “the mandatory transfer of employer securities into and out of participant plan accounts, usually on an annual basis, designed to result in all participant accounts having the same proportion of employer securities.”
The key word here is proportion. Rebalancing is an annual process for cash-holding ESOPs that ensures all plan participants have the same percentage breakdown of cash and company stock that the overall ESOP trust holds. Rebalancing does not increase or decrease the face value of an ESOP participant’s account balance.
For example, a mature ESOP may have allocated all of its shares over time to its employees, and begun contributing cash into accounts. Without rebalancing, the ESOP would have employee shareholders and employees who are plan participants yet not shareholders — a “have and have-not” scenario that could stunt the development of an ownership culture.
A rebalancing provision in the plan document can prescribe this annual rebalancing, so that cash in newer employees’ accounts can be “traded” for shares. So for example, if the ESOP trust has 75% of its assets in stock and 25% in cash, rebalancing ensures the same ratios among all nonsegregated plan participants.
For an ESOP to be able to perform rebalancing, it must hold cash. The plan document must also include an annual rebalancing provision. Not all ESOPs include rebalancing in the plan document; even if rebalancing isn’t necessary early on, including a provision can head off participant confusion around rebalancing later in the life of the ESOP.
Ensuring Nondiscrimination in Practice
Regulations require an ESOP to have an allocation formula that:
- Is included, in writing, in the plan document
- Includes a definite, predetermined formula for allocating contributions
- Directs the administrator as to the number of shares or amount of cash to transfer into/out of accounts
- Describes the event(s) that would effectuate the transfer (such as annual valuation)
Federal regulations also require that benefits, rights, and features of the ESOP must be available to plan participants in a way that does not discriminate in favor of highly compensated employees. It’s also important to note that, while rebalancing helps ensure equal proportions in participant accounts, it is not a solution to nondiscrimination issues that may arise due to plan design failures.
Best practices involve working closely with legal counsel and/or an experienced ESOP third-party administrator or consultant to ensure all plan documents comply with all applicable regulations. These kinds of experts should be able to perform and report on anti-abuse testing. They can also run the plan through sustainability forecasting to test the plan against various repurchase obligation scenarios, to help administrators and trustees make well-informed decisions about how to handle cash and ESOP shares moving forward.
Learn more about how distribution policies can affect a plan’s future repurchase obligations and other key aspects of plan sustainability with our free tip sheet. Just click the link below to get yours now.