An employee stock ownership plan is typically a balance forward retirement benefit plan with an annual accounting period. Participants receive ESOP account statements once a year.
That’s one significant difference between most ESOPs and some other direct contribution qualified plans, such as 401(k) or similar retirement plans. While some of these plans still use balance forward accounting, the period is often less than a full year, and statements may be issued on a quarterly or semiannual basis.
More frequent account reporting is possible in these plans’ cases because of the equities that plan assets are invested in. Many 401(k) and similar plans allow participants to track their account value on a daily basis — or even more often, as many investors can’t keep themselves from doing when markets become volatile.
An ESOP, on the other hand, is required by law to be primarily invested in employer securities. In most cases, the company’s shares are not publicly traded and therefore, their value is determined once a year through the ESOP’s annual valuation process. While market volatility can have an impact on the broader business landscape, and therefore also the ESOP company’s value, the relationship between markets and the ESOP account value may be a little less direct.
How does balance forward accounting affect participants’ ESOP accounts, and potentially their distributions? Let’s take a look.
How Balance Forward Accounting Works & Why It Makes Sense for Most ESOPs
Annual valuation simplifies the accounting of participants’ ESOP balances, making balance forward accounting a justifiable standard to use.
So, what does balance forward mean? Balance forward accounting is a method that looks backward over a specified accounting period (e.g., a quarter, six months, or a year). It calculates an account’s value based on all contributions, withdrawals, forfeitures, investment income, and transfers that took place over the accounting period.
ESOPs are required by law to provide participants with an annual account statement detailing each participant’s account balances in stock and cash. Every year, based on valuation history and other factors, the ESOP must attribute the stock and cash totals to individual participants — and individual participants’ account balances have to add up to equal the total plan assets.
Keep in mind, for example, that ESOP allocations can be forfeited by participants if they leave the company before becoming vested. Those forfeitures benefit the plan — and therefore the remaining participants all benefit from that forfeiture.
A similar issue can arise if shares fall in value and a distribution is based on the previous annual valuation. In that case, however, the participant who received the distribution would be on the winning side, and remaining plan participants would effectively “split the difference” of the loss of value among their accounts.
Balance Forward’s Meaning Becomes Tangible at Distribution
The effect of balance forward accounting is most likely to be perceived in the course of a participant’s ESOP distribution. That’s because significant time may pass between these key events:
- Annual valuations
- ESOP account statements
- Participants’ distributions (whether for diversification or after employment separation)
Whether (or rather, when) this issue arises for an ESOP depends on factors including:
- Annual valuation date
- Participants’ dates of eligibility for diversification, and whether and when they make a diversification election
- Participants’ chosen retirement date, or date of separation or death
- The ESOP’s distribution policies
Events like the COVID-19 pandemic had some ESOP companies second-guessing their 2019 valuations, especially in cases where participants were allowed to take hardship loans or withdrawals from their ESOP accounts. Some ESOP plan documents describe extraordinary circumstances that allow a plan administrator to call for a special, interim valuation.
Interim valuations are similar to customary annual valuations in terms of their documentation requirements, and the need for an independent valuation professional. What may be more difficult, under extremely uncertain circumstances, is knowing when it’s the right time to have an interim valuation performed.
Ensuring You Can Meet ESOP Obligations Calls for Expert Guidance
Ultimately, these decisions need to be made with the fiduciary best interests of all plan participants in mind. Careful consideration and legal guidance should be taken, along with communication to help plan participants understand reasons for any distribution policy amendments or other plan changes.
You can learn more about how to ensure long-term ESOP sustainability and the importance of forecasting, reporting, and funding your stock repurchases from plan participants. Just click below to download our free tip sheet.
