A common concern about ESOPs is their potentially higher level of risk for participants than a diversified 401(k) plan. As the argument runs, investments in a single company's stock carry more uncertainty than the same amount of investment in a diverse portfolio, and this risk is compounded when the company is also the investor's employer. Critics of ESOPs point to spectacular failures like Enron, where thousands of employees lost their retirement savings, ignoring that participants in 401(k) plans during steep market declines also often suffered dramatic losses.
Still, the argument for diversification seems theoretically sound, but in practice rarely plays out for several reasons. For one, ESOPs tend to be an additional benefit rather than a substitute for a more traditional 401(k) retirement plan. Companies with ESOPs are more likely to have an additional retirement plan than non-ESOP companies are to have any retirement plan at all (32% of private-sector workers do not have access to a retirement plan, according to data from the National Compensation Survey). As well, ESOPs have built-in diversification. Participants are entitled by law to diversify up to 50% of their ESOP assets upon reaching age 55 and 10 years of participation in the plan, and many mature ESOPs diversify their plan assets over time as the plan evolves.
Data from the Department of Labor on the rates of return for pension plan assets offer another reassuring piece of evidence for ESOPs. This data show that ESOPs have robust and consistent rates of return, and in fact have slightly outperformed 401(k) plans in terms of asset growth.
The DOL's data, which examines plans with 100 or more participants, shows that the average annual rate of return for ESOPs from 2007 through 2016 was 5.8%. By comparison, the rate of return for 401(k) plans was 5.0% over the same period. The DOL calculates yearly rates of return for retirement plans by dividing the change in assets due to investments by the amount of investible assets. The averages are expressed as the geometric mean of yearly returns. These data are consistent with earlier DOL analyses between 1990 and 2010, which showed both higher returns on ESOP assets and lower volatility than in 401(k) plans.
Table 1 shows the year-by-year performance for ESOPs and 401(k)s since 2007. ESOPs had higher rates of return than 401(k) plans in eight of those 10 years.
The volatility of ESOPs, expressed as the standard deviation in yearly returns, was also lower over this period: 10.8% for ESOPs compared to 11.9% for 401(k)s.
ESOPs' lower volatility may be due in part to the required annual independent appraisal for closely held ESOP companies, which typically projects earnings out over several years and calculates a risk-adjusted present value. This has the effect of smoothing out year-to-year swings, as multiple years of projections are incorporated into each year's valuation.
The Department of Labor data also shows that ESOPs were stricken less severely than 401(k)s by the Great Recession: In 2008, the crash year, the decline in ESOP asset value was shallower than in 401(k)s by three percentage points. Going back to the previous recession, in 2001, tells a similar story: ESOP assets dipped by 4.8% that year compared to a 6.4% decline for 401(k) plans. This comports with other research on employee ownership companies' hardiness in downturns: A 2017 study found that companies with employee stock ownership had only half as many layoffs as other companies during those two recessions.
As seen in the Employee Ownership Report.