Finding the Answers in Your Plan Document
Sept. 26, 2016
By Heather R. McNabb, Peter J. Shuler, and Mark D. Swanson, J.D.
Plan administrators of any qualified retirement plan, including employee stock ownership plans (ESOPs), must operate the plan according to the plan document and the law. Although the answers to some of the most common questions can be found right in the plan document, it is never a bad idea for plan administrators to contact an ESOP attorney or third-party administrator when they are uncertain of the correct action to take or of the answer to a participant’s question. Following are some of the more common questions plan administrators should be ready to answer.
When Are Distributions Paid?
Perhaps the most common question ESOP participants ask – and the most difficult question for administrators to answer – is, “When will I get my money?” This question is addressed either in the distribution section of the plan document or in the distribution policy, a separate document that provides details on distribution timing and form in cases where the plan document offers only a general framework.
Most often, ESOP participants have to wait to take a distribution at least until the allocation is finalized for the year during which they terminate. For example, a participant who terminates in 2016 generally will have to wait to take a distribution at least until the 2016 allocation and valuation are completed.
In addition, ESOP participants who terminate for reasons other than death, disability, or retirement often will have a longer wait – sometimes up to six years. For example, a participant who terminates for a reason other than death, disability, or retirement in 2016 may have to wait until 2022 (after the 2021 allocation and valuation are completed) to take a distribution. Furthermore, the language in a plan document often states that participants are eligible for a distribution no later than the sixth plan year-end following termination. This language usually is intended to give the plan administrator flexibility, and the actual waiting period will be detailed in the distribution policy.
Once a participant is eligible for a distribution, the plan document or distribution policy will dictate whether the distribution is paid in one payment or in several installments. Except for very large balances, the installment period cannot exceed five years. Within that framework, the law allows many options. For example, the plan could specify that vested account balances of more than $20,000 will be paid in up to five installments, with a minimum installment of $10,000. All rules about distribution timing and method should be clarified in the written distribution policy, if not in the plan document, and should be communicated to employees through the summary plan description.
When Is Retirement?
Another common question is about the term “retirement.” A company and its employees might have ideas about what retirement means that differ from the ESOP’s definition. For example, a 62-year-old employee might say he is retiring, but if the ESOP defines retirement as termination after the age of 65, the employee is not considered retired for ESOP purposes. The distinction likely will affect vesting and distribution timing and may affect allocation eligibility for the year in which the employee terminates.
The plan document should define retirement, and only those who meet the definition will be considered retired. This definition also should be included in the summary plan description, so participants are not taken by surprise if they are not considered “retired” by the plan.
Who Are the Beneficiaries?
Plan administrators need to be able to determine the beneficiary of a deceased participant. Though it is important to attempt to persuade every participant to elect a beneficiary or beneficiaries, nearly every plan document contains instructions as to who is considered the beneficiary if none has been elected. Legally, the beneficiary will be the participant’s spouse, if there is a spouse, and, usually, any children will equally benefit if there is no spouse. If the deceased participant has no children, his or her parents are often next in line to serve as beneficiaries, followed by the participant’s estate.
Although language in the plan document is helpful when a participant dies without a beneficiary election, it does create work for the plan administrator who must identify and locate the appropriate relatives. As such, plan administrators should make sure participants fill out their beneficiary designation forms, and keep them updated for changes due to marriage, divorce, a new child, or the death of a beneficiary. As noted earlier, the participant’s beneficiary is the participant’s current spouse unless the participant designates another beneficiary and obtains valid spousal consent. If a participant completes a beneficiary designation form naming his or her then-current spouse as beneficiary and is later divorced from that spouse and remarries, at the time of the participant’s death, the former spouse still could be the beneficiary unless the participant revoked the original designation or the plan states that, in cases of divorce or legal separation, any beneficiary designation naming the former spouse is revoked.
Similarly, if a child is a beneficiary and that child is deceased but had children, questions can arise about whether the distribution that would have gone to the deceased child now goes to the other living children or to the deceased child’s children. Again, it’s important to review the plan provisions and remind participants to update their beneficiary designations for changes.
When Is Diversification Allowed, and How Much Can Be Diversified?
Many questions often arise about diversification with ESOPs. The diversification rules generally are consistent across ESOPs and are defined in the plan document. The most common questions about diversification are about when participants are eligible and the amount for which they are eligible. Participants typically are able to diversify once they have attained 10 years of participation in the plan and are at least age 55. The eligibility period starts the plan year that both of these requirements are met and usually ends six years later. It does not start when a participant first makes an election to diversify. If a participant does not elect diversification in the first four years of eligibility, then he or she will have only two years remaining to diversify.
The amount eligible for diversification generally is 25 percent of all shares ever allocated, less any shares previously diversified. It is not, as many believe, 25 percent of the shares in the participant’s account each year. The formula to calculate the amount eligible for diversification starts with the participant’s current total shares, then adds back any shares previously diversified or distributed to get to the total shares ever allocated. This total is then multiplied by 25 percent. Any shares previously diversified then are subtracted to calculate the amount currently eligible to diversify. (Note that the regulations are not clear if all shares ever distributed and diversified are subtracted or if only the shares diversified are. Conservative calculations subtract just the shares previously diversified.) As a result, if a participant elects to diversify 25 percent the first year he or she is eligible to do so, the shares eligible for diversification the next year will be 25 percent of any new shares allocated during that second plan year.
For the sixth and final year, the percentage is increased from 25 percent to 50 percent, which allows participants to diversify more shares if they so choose. Most plans only allow diversification of shares – the minimum legal requirement – but some allow diversification of cash too. Also, some plans permit a participant to diversify more shares than the regulations require or expand the diversification eligibility period to start before the age 55 and 10 years of participation criteria and to continue beyond the six-year election period.
When Is a Participant Eligible for the Plan, and When Is an Allocation Received?
Many ESOPs require employees to work for the company for one full year (during which they must work at least 1,000 hours). Once this requirement is met, eligible participants enter the plan on the next entry date – often the first day of the plan year and the first day of the seventh month.
Once a participant has entered the ESOP, he or she generally needs to work at least 1,000 hours and be employed on the last day of the plan year to receive that year’s allocation, although these requirements often are waived for those who leave due to death, disability, or retirement.
Many other options exist for plan entry and allocation eligibility requirements. Information about eligibility and allocations is available in the plan document and the summary plan description. It is important for plan administrators to be familiar with these requirements and to communicate them to employees. Doing so will help employees better understand and be more comfortable with the ESOP and will help plan administrators understand who should and should not be entering or benefiting from an allocation.
Have the Answers Ready
Plan administrators need to be educated about the ESOP’s provisions, as they are responsible for administering the ESOP. This knowledge will help them to educate participants and prevent misunderstandings and negative or skeptical attitudes about the plan.