ESOP Diversification

Key Takeaway

Since Employee Stock Ownership Plans (ESOPs) invest mostly in employer stock, there are many reasons why participants nearing retirement age consider reallocating a portion of their ESOP balance into other investment options.

Diversification. Since many personal investment philosophies involve diversification and most ESOPs are invested by the trustee into one company, ESOP diversification gives the participant the opportunity to take the helm of investing part of their ESOP balance. This feature allows the participant to divest a portion of the account balance out of employer stock and into a more conservative and/or diversified option.

Risk-based. It is not uncommon for people to invest more conservatively as they near retirement. Target Date Fund managers remove risk from portfolios as the funds near the targeted retirement date, i.e., a 2060 fund might start out at a 90% stock/10% bond mix and migrate to 50% stock/50% bond during its “glide path.” Since employer stock is generally viewed as having more risk (as well as higher long-term results) than even publicly traded small and micro-cap funds, electing to diversify out of employer stock removes some market risk from a portfolio.

Varying Sale Prices. If ESOP diversification is not elected, many ESOP distributions are made based on a single year’s stock valuation. A participant that receives an ESOP distribution when an employer stock price is at an all-time high is more fortunate than one receiving a distribution after an employer stock price decreases. Choosing to diversify a portion of your account balance during the multi-year window provides for some selling of employer stock at varying prices.

Busted Myth. Some participants believe diversifying employer stock indicates a loss of faith in the company. Once we strip the emotion from this myth, we realize ESOP diversification can be viewed as a positive for all involved: 1) The participant removes potential risk from the overall portfolio, and 2) allows either the employer to buy back the stock or other participants in the plan to invest. In most situations, diversification is seen as a healthy transaction for all involved.

How does a participant engage in ESOP diversification? It starts with eligibility; most ESOPs allow diversification once you have reached age 55 and completed 10 years of service or plan participation. Next, let your plan sponsor know you want to diversify shares and request the paperwork to make the election.

Action Items:

  1. 1

    If you are nearing age 55, inquire about the ESOP’s diversification conditions;

  2. 2

    If you are eligible, request the paperwork from your plan sponsor;

  3. 3

    Weigh the options/factors and make an election.