The retirement savings crisis – go here for smart and unbiased analysis – is one of the greatest problems the U.S. economy faces. And there has been little done to fix the problem in recent years. Employee Stock Ownership Plans are an unusual bright spot in this picture.
Regular readers of this column are accustomed to stories of great successes at ESOP companies: the 42-year old grocery clerk with more than $1 million in her retirement account; the truck driver similarly well set; the association management giant whose ESOP has outperformed the S&P 500; and most recently the electric power equipment maker whose ESOP also beat the S&P 500, rewarding its employees who work harder because they’re owners.
A fair question I often get goes like this: yeah, Mary, that’s nice but aren’t you cherry-picking the best case studies? Are ESOPs in general really a good deal?
For the more than 25 years I have advised entrepreneur/founder/owners in ESOP transactions and on exit strategies generally, I have confidently answered, yes, ESOPs are a good deal, pointing to wide surveys or academic research and to my own experience.
And now, there is another compelling piece of analysis by the smart people at EY’s Quantitative Economics and Statistics Practice (QUEST) showing that S-Corporation ESOPs vastly outperform the S&P 500. QUEST, in analyzing S ESOP filings covering the years 2002 to 2012, found the employee owned companies delivered their worker-owners an 11.5% compound annual growth rate vs. 7.1% for the S&P 500 on a total return basis.
That’s a 62% advantage to the S ESOPs. The S ESOP return is based on combined distributions and growth in asset values, just as the S&P 500 total return includes stock price appreciation and dividend payments. To read the QUEST analysis, go here.
S ESOPs, by the way, are simply S-Corporations, which are pass through entities and a widely used form of corporate ownership, owned by employees. Congress in 1998 created the S ESOP to further encourage employee ownership. In the format, the corporation’s tax liabilities pass through to owners. S ESOP owners pay their share of the taxes when they retire or otherwise cash in their stock. The arrangement allows S ESOPs to operate without paying federal income taxes out of current operations, so they’re able to invest more in expansion, hiring, acquisitions and other productive activities. It’s a huge plus for our economy. And many C-Corporation ESOPs have converted to S ESOP status in recent years.
To ESOP watchers, the out-performance is no surprise. Prior studies have shown ESOPs less likely to go bankrupt than similar companies with different ownership structures. And ESOPs have been shown to expand employment more effectively.
Crushing the broader stock market isn’t a surprise to us, either. ESOP employees are owners and they tend to work harder, more collaboratively, and to share productive ideas more freely. The Schweitzer Engineering Laboratories case study illustrates this point.
The EY analysis, if anything, understates the advantages of an S ESOP. Why? Except in rare instances, employees don’t pay for their ESOP stock; it’s awarded as an employee benefit, no differently than a 401(k) match, say. The cost is zero, as opposed to buying into an S&P 500 fund.
Another skeptical question I often get goes like this: yeah, those are great returns for the ESOP workers, Mary, but isn’t concentrating one’s retirement savings in an employer’s stock a dangerous concentration of assets?
I answer that it’s a concentration, but not a dangerous one, when we compare S ESOP companies to the broader economy. As I mentioned, ESOP companies fail less often. But they also provide secondary retirement plans – 401(k)s and pensions – in greater numbers than companies overall provide a primary plan. That’s right, the QUEST analysis shows that 65% of S ESOPs offer some second retirement plan (on top of the ESOP), while only 45% of all U.S. companies offer any plan at all.
Which brings me to a third question I frequently field: that’s all great for the employees, but doesn’t that hurt the founder who sells to his workers? Quite the opposite, I believe. The superior operating performance and tax treatment of employee-owned companies means that ESOPs can bid competitively alongside private equity funds, with founders realizing a fair price.
And on an after-tax basis, founders can often do better selling to an ESOP; that’s because a C-Corporation owner selling to an ESOP can defer, potentially forever, capital gains taxes, which can eat up as much as 23.5% of proceeds, by reinvesting proceeds into qualifying securities like stocks and some bonds.
S ESOPs: good for founder/entrepreneurs looking for an exit strategy, good for the economic health of the U.S., and great for employee-owners as a retirement savings vehicle.
Mary Josephs, former head of ESOP advisory at Bank of America, is founder and CEO of Verit Advisors, investment bankers specializing in ESOPs. You can reach her at CEO@verit.com.
