ESOP Diversification

[Guest lkmcgivney]

We have over diversified five participants in an ESOP Plan. We were provided with the incorrect beginning balances which overstated the amount eligible for diversification.

What do you suggest that we do to correct this?

The stock is closely held and not a good market. But do we repurchase the stock that was overdiversifed at the price that we sold it at...

OR do we give the participants the option to leave the stock diversified and just subtract that amount from future eligible amounts....:confused:

[mbozek]

I dont understand what you mean by over diversfiied? Secondly IRC 401(a)(28) requires only diversification of a minimum % of the participants account -- there is no penalty for the diversification in excess of the minimum amount, e.g., 25% of the account, into assets other than employer stock. The participants are probably better off with more diversification since this is a privately held company.

[RLL]

Hi mbozek ---

You say that "The participants are probably better off with more diversification since this is a privately held company."

Doesn't that depend on the business/financial prospects of the company involved? What if the company also provides some other generous retirement plan for its employees?

Unless you know something about the particular company, there is no valid basis for your comment....other than, perhaps, an anti-ESOP bias.

It is not uncommon for some private equity investments to result in average annual returns in the range of 15%-30% per year. Such returns are very uncommon for diversified portfolios over a period of years.

[stephen]

RLL-

How would you suggest lkmcgivney correct the "over diversification amounts"?

[RLL]

If diversification was effected through benefit distributions from the ESOP, it may be difficult to correct....particularly if the distributions occurred in a prior year. But it may possible to give the affected participants the option to repay the "excess" distributions back to the ESOP.

If diversification was effected through investment choices within the ESOP or by transfer of assets to another plan, it should be relatively easy to give the affected participants an option to "un-diversify" the "excess" portion and reinvest it in employer stock under the ESOP.

[mbozek]

Rll: My comments on privately held ESOPs was based upon notes from other persons on the lack of disclosure available to ESOP participants in non publicly held companies. Secondly, as any investor knows diversification of investment is the best means of maximizing return by minimizing risk as Harry Markowitz discovered almost 50 years ago. According to recent news reports almost 60% of the assets in the Enron 401(k) plan were invested in Company stock which was publicly traded. The reason that publicly held companies cannot achieve 15-30% returns over a prolonged period is because the accounting rules for publicly held companies require eventual disclosure of the bad news. As Enron/Global Crossings just proved, a publicly held company cannot hide its losses forever--- they must be disclosed eventually with appropriate fianancial consequences. This is not true with privately held companies which are subject to different standards. In NJ there was a recent bankruptcy of a company that was touted for years as having great prospects by analyists but was misstating earnings until it filed for bankruptcy. For non professional investors the best investment strategy is diversification of assets among different classes of investments.

[RLL]

mbozek ---

I certainly won't deny the benefits of investment diversification. But it's not fair for you to say that "The participants are probably better off with more diversification since this is a privately held company" in a particular situation that you know nothing about.

It's been my experience with closely-held ESOP companies (over the past 29 years) that the ESOP participants have usually been much "better off" with investments in employer stock than they would have been with diversified investments under a non-ESOP retirement plan. Maybe I've been fortunate to work with the "cream of the crop," but I also know many other professionals whose experience with ESOP companies has been similar to mine.

[Kirk Maldonado]

Aren't employee's entitled to demand that their benefits be distributed in the form of stock to the extent that they had elected to over-diversify?

[RLL]

Hi Kirk ---

It appears that the "over-diversification" here resulted from a mistake in determining the amounts available for diversification, rather than from a plan provision that permitted diversification in excess of the amount required under IRC section 401(a)(28)(B). Accordingly, under these circumstances there would have been no right to elect a distribution in employer stock. In addition, if diversification is effected through investments under the ESOP, there is no present right to any distribution.

Also note that IRC section 401(a)(28)(B) provides for a diversification right of "at least 25%" (50% in the 6th year) of the employer stock allocated to the participant. Accordingly, allowing a diversification election in excess of 25% still results in the amounts being diversified "under" section 401(a)(28)(B), so the "excess" amount is not subject to the right to demand stock under section 409(h)(1)(A)...even if the exceptions of section 409(h)(2)(B) do not apply.

Now get back to work!