What’s an employee stock ownership plan? What you learn can help you earn money

The origin of generational wealth across the country’s affluent families is often closely linked to concentrated ownership of capital assets. Whether it’s founding a fast-growing business, working for a startup that gets acquired or goes public, or being granted equity ownership through company stock plans, many successful individuals create their wealth by holding a significant stake in the company in which they work and own.

One of the lesser known but effective ways to accumulate significant wealth is through participating in an employee stock ownership plan (ESOP), which is a type of qualified defined contribution plan that can help fund employees’ retirement. Several of the nation’s most successful ESOPs are in Kansas City, making it a hot topic in the metro area.

Former CEO and Chairman of Burns & McDonnell Greg Graves published “Create Amazing” in 2021, detailing the benefits and considerations of the ESOP model. It is considered required reading for those looking for a deeper understanding of this unique plan’s advantages for closely held business owners and their employees.

The book simply defines an ESOP as a retirement plan that provides all employees with retirement savings through investments in their employer’s stock, at no cost to the employee. Under this arrangement, there are two primary beneficiaries: the original founders or owners, and the new employee-owners.

For founders or majority owners, ESOPs provide a tax advantaged solution to a succession planning dilemma. Rather than selling to an outside party or allowing a small group of internal executives to purchase a company, establishing an ESOP allows all employees to own a portion of the company.

Generally, this approach preserves the company culture and often boosts morale by rewarding employees for their dedication and loyalty. When employees have a stake in the company’s profits, they are more empowered, motivated and engaged in their firm’s success.

Employee owners translate their daily contributions beyond annual salary or wages and instead relate their efforts to long-term company growth. They directly attribute their ability to meet personal, long-term financial goals by enjoying the powerful compounding benefit of the ESOP.

It’s a powerful motivator when employee-owners see the path to financial independence through their daily work contributions. Graves calls it the “whoa moment” — that instant when employees look at personal annual ESOP statements and see impressive numbers. Employees are then able to link their daily work mindset to long-term company performance and personal wealth.

For longtime employee-owners at successful ESOPs, seven-figure retirement balances are the norm and even eight-figure balances are not uncommon.

There are countless national studies by the National Center for Employee Ownership, as well as local anecdotal evidence, that paint a compelling picture of an ESOP’s ability to generate above average long-term growth and create financial independence for employee owners.

There is, however, a note of caution: Important consideration should be given to the concentration risk associated with an ESOP. For many long-time owner-employees, a sizable portion of their net worth is directly tied to the success of their company. Understanding this risk and identifying opportunities to mitigate it through diversification is prudent.

To the extent you can isolate this unique risk factor, we suggest several specific financial planning concepts for employee-owners:

▪ Maintain discipline in other areas of your personal financial life. Specifically, understand your current and future spending needs, limit or pay down “bad” debt when possible, and create other buckets of money outside of the ESOP.

▪ Understand the diversification provisions within the plan. ESOPs must provide participants the right to diversify up to 25% of company stock for five years after they reach the age of 55 (provided they have been in the plan for 10 years) and 50% of the shares, in the sixth year after turning 55. These are the mandated diversification rules, but the ESOP’s provisions often provide alternatives to selling company stock through in-service distributions or dividend payments invested to non-company stock.

▪ Review the rules around accessing your retirement funds to avoid early distribution penalties should you decide to retire prior to reaching age 59.5. These include the “Rule of 55” for those retiring after the year in which they turn 55 and “72(t) Distributions” for those retiring before age 55. The provisions for accessing your retirement funds can be tricky and if mishandled can lead to significant penalties.

Successful ESOPs increase business longevity and resilience, boost growth and enhance productivity. They’re a powerful wealth creation tool for employees who benefit economically through the sustainable financial success of their company.

K. Patrick Amey is a CERTIFIED FINANCIAL PLANNER professional and a member of Financial Planning Association of Greater Kansas City. He is an adviser and wealth and investment manager with FAS (Financial Advisory Services, Inc.) in Leawood.