Better Manage Your ESOP Repurchase Liability: Consider a Defined Benefit Pension Plan

By John N. Vitucci, CPA, Partner

Many Employee Stock Ownership Plan (ESOP) corporations are presented with the challenge of maintaining an ESOP over the long term. As the ESOP company becomes more successful, the repurchase liability to cash out retiring or terminated workers increases. Proper financial planning, therefore, becomes critical to manage your repurchase liability – particularly when preparing your business for succession planning. One solution to help better manage ESOP repurchase liability is to establish a pension plan. Here are some decisioning steps to help you determine if a pension plan is right for your ESOP corporation:

• Know what factors will influence your ESOP funding requirements.
• Consider the impacts of adding a pension plan.
• Weigh the benefits, protections and risks of an ESOP pension plan.
• Understand proper plan design.

Know What Factors Will Influence Your ESOP Funding Requirements

There are two key factors that you should consider when planning for the cash funding requirements of your ESOP repurchase liability:

• High ESOP Account Balances: The success of the company and the high value of the ESOP account can both be a retention tool or, conversely, an incentive for early retirement.
• Employee Demographics and Retirements: It’s important to keep your employee demographic data current and have analytics in place to help predict the likelihood of upcoming retirements.

Consider the Impacts of Adding a Pension Plan

It may be counter-intuitive, but with proper planning and design, a pension plan can effectively help manage the repurchase liability through its impact on the financial statements and ESOP valuation. Comparing an ESOP corporation with a pension plan versus an ESOP without one illustrates the impact.

Weigh the Benefits, Protections and Risks of an ESOP Pension Plan

Let’s first start with the benefits to an ESOP corporation when adopting a pension plan, along with some protections a pension plan can offer:

• Repurchase Liability Reduction: Lower and better management of the ESOP repurchase liability obligation will be created, while shifting benefits to participants in a pension plan.
• Participant Retirement Diversification: The potential for a more diversified retirement benefit will exist, with less reliance on the performance of your company stock.
• Wealth Creation: There could be greater value and wealth creation for participants in a pension plan, otherwise potentially limited by Internal Revenue Code Section 409(p) for ESOPs.
• Lifetime Benefit: There would be lifetime guaranteed income with spousal protections provided to participants through a qualified pension plan.
• Replacement Income: There will likely be less volatility in the pension retirement benefits, creating an adequate and consistent retirement replacement ratio.
• Distribution Options: Greater flexibility regarding participant distributions and withdrawals will exist.
• Improved Cash Flow: Your business will have improved cash flow since payments from a pension plan can be paid as a life annuity.
• Bankruptcy Protections: A pension plan can provide Pension Benefit Guaranty Corporation (PBGC) bankruptcy protections for participants.
  • Different from ESOP benefits, the pension benefits are by law guaranteed retirement benefits that are insured by the PBGC. In the event the ESOP corporation enters bankruptcy, the pension benefits are protected.

You’ll also need to weigh the key potential risks associated with the establishment of a pension plan and how it correlates with your current ESOP:

• Impact to Enterprise Value: Pension plan design, funding and plan investments will have an impact on the organization’s enterprise value.
• Siloed View: To avoid the misalignment when managing a pension trust as a separate silo, we suggest a holistic approach in which the pension plan is viewed as part of the organization’s overall capital structure, and pension management practices are aligned with the enterprise risk management system.
• Lack of Oversight Rigor: To avoid this risk, adopt a holistic approach to pension plan management and performance measurement that strives for the same degree of rigor that organizations use when managing their overall business.
• Volatility: To limit the risk of mismanaging pension plan volatility, pension strategies should be developed with an eye toward managing the ESOP repurchase liability and pension benefit obligation. If handled correctly, this will make managing ESOP repurchase liabilities much easier.

Proper Pension Plan Design

A pension plan can be adopted for all active participants, selected individuals and new hires, provided certain discrimination rules are satisfied. Below are key points to consider when designing your plan:

• Set Monthly Income: A pension plan can provide a set monthly income (also known as a pension or annuity) at retirement through a formula based on age, years of service and average annual compensation. This monthly income is then paid to the retiree as a monthly pension over the course of their retirement. Pension benefits can be based on past service or accrue going forward over time.
• IRS Code 409(p): Disqualified persons can participate in a pension without violating Internal Revenue Code section 409(p) anti-abuse rules. In addition, pension plan benefits are not considered synthetic equity for purposes of the 409(p) anti-abuse rules.
• Maxium Benefit: A pension benefit at retirement cannot exceed the lesser of 100% of the participant’s compensation over the three years of highest compensation or $275,000 (2024, indexed). At age 65, the value of this benefit can be approximately $3.5 million in lump-sum form.

Contact Us

The Employee Benefits Practice of PKF O’Connor Davies can assist you and your company with pension plan design and implementation, ESOP transactions, feasibility analysis, succession planning, tax, accounting, employee benefit transformation services and executive compensations analysis. For more information, contact your PKF O’Connor Davies client service team or:

Timothy J. Desmond, CPA
Partner
tdesmond@pkfod.com | 551.249.1728

John N. Vitucci, CPA
Partner
jvitucci@pkfod.com | 917.841.8718

Ashley Pellegrino
Senior Associate
apellegrino@pkfod.com | 212.286.2600