1. milliman.com
FALL 2010
What do changes to Medicare Advantage mean for employers?
Updating the Active vs. Passive Debate
Diversification Rules for ESOPs and 401(k) Plans with Employer Securities
Medicare Advantage (MA) plans are set to become dramatically
less advantageous in the coming years. Health reform is putting
the squeeze on them, substantially reducing their advantages
relative to other health coverage options. Currently, MA plans
are paid more (in many cases, significantly more) than what the
federal government pays for standard Medicare. The new health
reform law gradually reduces the subsidies these plans receive.
As a consequence, the richer benefits and/or reduced premiums
offered by MA plans will be substantially reduced. Premiums and
liabilities for post-retirement health benefits will
most likely increase considerably for employers
that offer retirees (defined in this article as
Medicare-eligible retirees and their Medicare-
eligible dependents) the chance to enroll in an
MA plan.
What are Medicare Advantage
(MA) plans?
MA plans, which are approved by Medicare
and offered and administered primarily
by private insurance companies, cover
either Medicare Part C (medical services)
or Medicare Part C and Medicare Part D
(prescription drugs). For the purposes of this
article, both types of plans will be referred
to simply as MA plans. They are offered to
Medicare-eligible individuals (i.e., those who
are 65 or over, or disabled) and typically cover
benefits over and above those provided by
standard Medicare. Employers offer MA plans to their retirees
to provide extra benefits and lower copayments than standard
Medicare, at little or no additional cost. Up until now, the federal
government’s generous payments to MA plans have made it
possible for retirees, employers, and private insurers to benefit
from MA plan coverage. This changes under health reform.
Payments to MA Plans
Medicare first began contracting with private insurers to provide
Medicare replacement-type plans (MA plans are the latest iteration)
in 1985. MA plans are paid based on:
• Benchmarks published by the Centers for Medicare & Medicaid
Services (CMS), which vary by county as well as member
demographics and health characteristics, and
• The plan’s bid — an estimate of what
it will cost the plan to cover standard
Medicare benefits plus administrative
expenses and profit.
Benchmarks in most areas are set at
substantially higher rates than what Medicare
would expect to pay for the plans’ members
under standard Medicare. Nationally, on
average, MA benchmarks are roughly 111%
of the cost of standard Medicare in 2010. Not
all of this excess is passed on to MA plans,
however, because a portion of the difference
between the bid and the benchmark must
be returned to Medicare. In 2010 and 2011,
25% of the difference must be returned. Still,
payments are currently high enough to allow
MA plans to offer their members benefits that
are significantly richer than standard Medicare.
Ratcheting down the benchmarks
The most significant change affecting MA plans is that between now
and 2017 the MA benchmarks will be ratcheted down substantially.
In addition, the percentage of the difference between the bid and the
benchmark that must be returned to Medicare is increased from 25%
to between 30% and 50%. Together, these changes will substantially
What do changes to Medicare Advantage mean for employers?
Earl L. Whitney, FSA, and Matthew P. Chamblee, FSA
2. 2 :: FALL 2010
reduce the funds that MA plans will have available to provide richer
benefits to their members.
Several reductions in MA plan subsidies have already occurred or
will begin soon:
• 2010 benchmarks are artificially low (relative to the intent of
prior law), because they were not increased to reflect the impact
of provider payment increases (e.g., the “doctor fix”) that were
written into law after the benchmarks were set.
• 2011 benchmarks are being held at 2010 levels, so MA plans will
miss a year of medical cost increases in their 2011 payments.
• In 2012, a new methodology for calculating benchmarks takes effect.
The new formula will be phased in over two to six years (depending on
the magnitude of the ultimate change in each county’s benchmark).
Table 1 shows the new formula’s estimated impact on average MA
benchmarks for various locations (chosen for their large number of
MA members and regional variation). Assuming current enrollment
in MA plans remains unchanged, the U.S. average benchmark
is projected to drop from 111% to 101% of standard Medicare
over the next seven years. As an extreme case, the Puerto Rico
benchmark is projected to drop from 167% to 115% of standard
Medicare over the same time period.
In estimating the values in Table 1, we have assumed that provider
payment levels will be accurately reflected in the benchmarks of
each projection year after 2011. As mentioned earlier, this is not the
case for 2010 and 2011 benchmarks. If Congress does not pass a
physician fix for 2012 by early 2011, this may also be the case for
2012 benchmarks. If this pattern continues, the benchmarks will be
significantly lower than those shown in Table 1 - about 7% lower in
2012, grading to about 11% lower in 2017.
To make up for a portion of the reductions in benchmarks, the new
law phases in bonuses to MA plans with high-quality scores. When
fully phased in, bonuses can be up to 5% in most counties, and up
to 10% in a small set of special “qualified counties.” However, for
each county, the total benchmark, including quality bonuses, cannot
exceed what the benchmark would have been under prior law.
Prescription drug coverage is also changing
Over the next few years, Medicare Part D will cover more
prescription drug costs, shrinking the so called “donut hole.” When
fully phased in, Part D beneficiaries will be responsible for only 25%
of drug costs in the donut hole (about the percentage they pay up to
the donut-hole threshold). For certain employer group MA plans that
cover Medicare Parts C and D, called Employer Group Waiver Plans
(EGWPs), this may result in an increase in federal subsidies, but any
increase will be small relative to the reduction in MA benchmarks.
Looming disadvantage in MA plans
The bottom line for employer MA plan sponsors is that both premiums
for retiree medical coverage and liabilities for post-retirement health
benefits may increase significantly. Moreover, the impact on employer
costs may be highly leveraged, as shown in Table 2.
In that example, a 10% reduction in Medicare payments translates
to an 80% increase in retiree health benefit costs. This would be in
addition to the ever-rising cost of medical care.
As discussed above, if Congress continues to pass last-minute
provider payment increases, they too will pose a risk to MA plans.
To the extent that these increases are included in plans’ costs but
not reflected in the benchmarks, plans will be underpaid for the
coverage they are expected to provide. In this case, the 101% of
standard Medicare benchmark projected for 2017 could dip below
100%, making it difficult for many MA plans to survive.
Even at levels above 100% of standard Medicare, benchmarks may
be insufficient for many MA plans to remain viable. For instance:
• Private fee-for-service (PFFS) plans will require benchmarks
above 100% of Medicare to pay for their administrative
expenses, making it difficult to see how such plans would be
viable if benchmarks are reduced below approximately 110% of
Table 1: Projected MA Benchmarks as a percentage of standard Medicare payments, 2010-2017, under the new health reform law.
Average for entire U.S. and for selected States/Territories (excludes the impact of quality performance bonuses)
State/Territory 2010 2011 2012 2013 2014 2015 2016 2017
U.S. 111% 106% 113% 109% 106% 104% 102% 101%
California 109% 104% 111% 107% 104% 101% 99% 98%
Florida 100% 96% 103% 100% 98% 97% 96% 96%
New York 116% 110% 118% 114% 110% 107% 105% 103%
Puerto Rico 167% 159% 166% 155% 145% 135% 125% 115%
Texas 112% 107% 114% 110% 106% 103% 99% 96%
3. FALL 2010 :: 3
standard Medicare. A PFFS plan
that pays providers more than
Medicare (a common practice
today) would need even higher
benchmarks to be viable.
• Preferred provider organizations
(PPOs) may be able to achieve
efficiencies by selecting
more cost-effective providers
and through limited medical
management (i.e., coordination of
patient care). These efficiencies
would need to be sufficient to
offset administrative costs as benchmarks approach 100% of
standard Medicare, a tall order for many PPOs.
• Health maintenance organizations (HMOs) are most likely to remain
viable as benchmarks drop. Medical management in many plans is
sufficient to offset administrative expenses. However, even these plans
will suffer as benchmarks approach 100% of standard Medicare.
Although MA plans with higher quality and effective medical
management programs may survive, almost all plans will lose many of
the advantages they have enjoyed in the past. Some plans will leave
the MA market, resulting in reduced competition and disruption for
their members. Other plans, not recognizing the negative financial
impact of the new laws in the short term, will experience significant
losses and need to raise premiums. In all cases, members and
employers will see the biggest change: receiving fewer benefits for
the same price or paying more for the same benefits.
Other health reform provisions affecting MA plans will:
• Eliminate employer deductions for federal retiree drug subsidies
(RDS). Currently, employers can deduct the entire cost of
prescription drug coverage for retirees even though Medicare pays
for part of it. The new law eliminates the deduction for the portion
of an employer’s retiree drug costs that are paid by the RDS. This
will increase employer net cost effective January 1, 2013.
• Add fees or taxes on certain healthcare providers, thereby increasing
the cost of care and, by extension, premiums and health liabilities.
• Introduce new minimum loss ratios. Beginning in 2014, MA
plans can retain no more than 15% of total revenue for non-
benefit items, on both prospective and retrospective bases. (This
is similar to individual insurance requirements in many states and
should have little impact on employer group plans.)
• Mandate benefits for all plans. Beginning in 2011,
copayments for certain services are limited by law. Also,
beginning in 2012, MA plans may no longer offer to pay the
Medicare Part B premium as a benefit.
• Establish a new type of MA plan – the Accountable Care
Organization (ACO). ACOs eliminate the insurer as an
intermediary by allowing Medicare to contract directly with
a provider group. The intent of this appears to be to reduce
overhead and apply more of the Medicare dollar directly to
health benefits.
For more details, see “The Impact of Health Reform on Medicare
Advantage and Prescription Drug Plan Programs: A Brief Summary”
on the Milliman Web site (http://insight.milliman.com; search for the
term “Medicare”).
Run the numbers now
Employer groups may be able to take advantage of the efficiencies
offered by MA plans that survive, though the relative advantage
that MA plans enjoy will be diminished. Some employers may find
that an MA plan is no longer justified relative to other options, such
as providing retirees with Medicare supplemental coverage (i.e.,
covering only Medicare deductibles and copayments, as well as
additional benefits).
Planning ahead is essential. Employers that offer an MA plan
need a firm grasp on what is coming and a clear assessment of
their situation within that context. Only then should they make the
strategic decisions required to navigate the turbulent times ahead.
The good news is that the impact of the law on retiree medical
premiums and liabilities can be estimated. By combining
projections of retiree medical expenses and county-specific MA
benchmarks through 2017, employers will gain a clearer picture of
whether an MA plan continues to be a viable option for them.
Earl Whitney (left) and Matthew
Chamblee (right) are healthcare
actuaries in Milliman’s Tampa office.
This article was peer reviewed by
Stuart Rachlin, who is also a healthcare
actuary with Milliman in Tampa.
Table 2: Example of the leveraged cost to employers with MA plans under health reform
(assumes 0% medical expense trend)
2010 2017 % Change
Total Cost of Medical Care Provided $900 $900 0%
Portion of Cost Borne by Medicare $800 $720 (-10%)
Balance Required in Premium from Employer $100 $180 80%
4. 4 :: FALL 2010
A critical initial investment decision for institutional investors,
such as retirement plan investment committees, is whether to
elect an active or passive investment management strategy. This
decision has to be made for each asset class and sub-asset
class in an investment portfolio. The question is this: Is it better
to invest in an index fund that mirrors the market as a whole,
that has a relatively low investment fee, and that will do as
well as the market does? Or is it better to invest in an actively
managed fund that charges higher management fees but that
may outperform the market so much that the added gain more
than compensates for the higher fee?
Some studies have asserted that the answer is simple: lower fees,
over time, lead to better investment returns. However, the analysis
we at Evaluation Associates (EAI) did for this article suggests just
the opposite: active management, on average over the last 15 years,
produced superior results. (Results from more than 800 actively
managed institutional investment funds were considered.) Even in
sub-asset classes where passive investment was effective, today’s
market conditions may well favor active investment managers with
discretion to take active bets on individual securities. (Two caveats:
In any study that compares performance universes, survivorship
bias [i.e., poorer performing funds dropping out of the universe] may
influence the results. Our fee analysis represents the average of fees
charged; individual manager fees vary.)
Fees based on account size are not critical
The initial question taken up in this study was whether larger
accounts paying smaller fees should lead investors to pursue passive
strategies at lower asset levels and active strategies when investing
larger sums. Three institutional account sizes were considered:
$25 million, $50 million, and $100 million. The data revealed
that relatively little fee differentiation occurs among $25 million,
$50 million, and $100 million account sizes. For accounts larger
than $100 million, investors tend to negotiate directly with asset
managers; therefore, average fee data is not readily available.
15-year annualized excess returns
with active management
Over the 15-year time period ending December 31, 2009, the
median manager (50th percentile) added value in every sub-asset
class studied, with the exception of core U.S. fixed income.
However, this study focuses most closely on the results generated
by the 75th percentile of active managers. That is, 75% of active
managers in the respective universes generated results that were
as good or better.
As shown in Exhibit 1, over the 15-year period, most active managers
were able to add value even at the 75th percentile of their respective
EAI universes. The U.S. large cap core, large cap value, mid cap value,
and core fixed income markets were the exceptions.
Updating the Active vs. Passive Debate
Analysis Suggests Active Investment Management Benefits Patient Investors
James Huntley, Equity Research Associate
Key Findings
• Fees did not vary significantly between $25 million accounts
and $100 million accounts, and so had no bearing on the
active vs. passive question.
• Over the last 15 years, the median active manager (50th
percentile) outperformed passive strategies in every sub-asset
class, except for in the core U.S. fixed income securities market.
• Over the same period, even underperforming active
managers (75th percentile) outperformed in every sub-
asset class except U.S. large cap core equities, U.S.
large cap value equities, U.S. mid cap value equities,
and U.S. core fixed income securities, where the passive
investment outperformed.
Active vs. Passive Investment Strategies
The active vs. passive decision has long been debated, fueled
by opposing views. The efficient market theory states that it is
impossible to “beat the market” because stock market efficiency
causes existing share prices to incorporate and reflect all
relevant information, and in instances when it does not, active
management fees eliminate any value added. The opposing side
argues in favor of the inefficient market hypothesis, which states
that prices react to information slowly enough to allow some
investors to outperform the markets.
Active management involves taking active bets on securities:
investing in or overweighting, relative to a benchmark, securities
that an investment manager believes will increase in value and
underweighting, or not investing in, securities that an investment
manager believes will not increase in value as much. Active
management assumes that taking these active bets will result
in outperformance of a passive index on a net-of-fee basis over
time. It is generally understood that periods of underperformance
versus the respective index will occur; however, proponents of
active management note that over the long term, excess returns
are achievable.
Passive investment management involves purchasing an index,
through full replication or a sampling methodology, thereby
mirroring the movement of an entire market. Active bets are not
placed (i.e., views on which stocks will appreciate or depreciate
in value); rather, due to the low cost of such investments and
perceived efficiency of the markets, it is believed that passive
index exposure will lead to superior investment returns.
5. FALL 2010 :: 5
10-year annualized excess returns
At the median manager level, only U.S. core fixed income managers
were unable to generate excess returns over the last 10 years. At
the 75th percentile, active management did not fare nearly as well. It
failed to generate excess returns in eight of the 17 sub-asset classes:
non-U.S. small cap, U.S. mid cap growth, emerging markets equities,
U.S. mid cap core, U.S. core fixed income, U.S. large cap core, U.S.
REITS, U.S. small cap value, and U.S. large cap value areas. Although
both non-U.S. small cap and emerging markets equity generated
impressive results at the 25th percentile, managers in these sub-asset
classes failed to generate excess returns at the 75th percentile, which
highlights the importance of manager selection.
Five-year annualized excess returns
This data for the last five years includes more short-term noise due
to major market inflection points (2008 and 2009); however, the
outperformance of non-U.S. small cap equity at the 75th percentile
should be noted. Conversely, emerging markets equity failed to generate
excess return not only at the 75th percentile, but also at the median (50th
percentile). The MSCI Emerging Markets Equity Index has been relatively
difficult to beat during this five-year period compared to its prior history.
The index ranked in the 50th percentile of the peer universe for the period
2005-2009 versus the 78th and 98th percentiles for the 2000-2004 and
1995-1999 periods, respectively. The improvement in the Index’s ranking
suggests that the exponential increase in capital flows to the emerging
markets over the time period, a significant portion of which went into
passive funds, played a large factor in stock performance, while company
and country fundamentals played a lesser role. Thus, it is reasonable to
say that active management was not rewarded to the same degree as it
was prior to 2005.
The importance of manager selection in the most efficient areas
of the U.S. market (large cap value equities, and core fixed
income) has implications for the active vs. passive decision. For
example, despite operating in a very efficient space, our analysis
of rolling three-year returns for the 30-year period ending
12/31/09 shows that the Barclays Capital Aggregate Index
ranked on average at the 46th percentile of the EAI Core Fixed
Income universe. When analyzed over the 15-year period ending
December 31, 2009, the index ranked at the 39th percentile
of the universe. The results for large cap value are similar.
Examining the frequency of the index’s performance within the
universe, we find the index is rarely in the top or bottom quartiles
and ranks in the second quartile (better than median) twice as
often as in the third quartile. While it has been a challenging
benchmark for managers to outperform, a large percentage of
the active management universe was successful.
Exhibit 1: Fifteen-year annualized excess returns for active investment managers (ending 12/31/09)
Methodology
In this study, long-only manager performance on a net-of-fee
basis across various sub-asset classes was studied in
an attempt to identify in which sub-asset classes active
management added value over time. The performance of active
investment managers was compared with their respective
market benchmarks, and both the active management fees
and the passive investment fees were subtracted from
their respective gross investment returns. Thus, the relative
investment results reflect what an investor earned after fees.
Performance over the last 15-, 10-, and five-year periods
was assessed. Seventeen underlying sub-asset classes
were analyzed. For each sub-asset class, the average
active management fee (net of passive management fee)
was subtracted from the EAI sub-asset class universe 25th
percentile, median (50th percentile), and 75th percentile returns
to determine whether value was added.
-100
0
100
200
300
400
500
600
USMidCapValueEquity
USLargeCapValueEquity
CoreFixedIncome
USLargeCapCoreEquity
USMidCapCoreEquity
CorePlusFixedIncome
USREITs
USSmallCapValueEquity
HighYieldFixedIncome
USMidCapGrowthEquity
USLargeCapGrowthEquity
GlobalFixedIncome
EmergingMarketsEquity
Non-USEquity
USSmallCapCoreEquity
USSmallCapGrowthEquity
Non-USSmallCapEquity
15 Year 75th Percentile
15 Year Median
15 Year 25th Percentile
-9
-6
-3
0
3
6
9
12
15
Jan 07 -
Dec 09
Jan 06 -
Dec 08
Jan 05 -
Dec 07
Jan 04 -
Dec 06
Jan 03 -
Dec 05
Jan 02 -
Dec 04
Jan 01 -
Dec 03
Jan 00 -
Dec 02
Jan 99 -
Dec 01
75th percentile
Median
25th percentile
6. 6 :: FALL 2010
Exhibit 2 shows that over rolling
three-year periods, even non-U.S.
small cap equity, the best-performing
sub-asset class in the 15-year
analysis, has experienced periods
in which the median manager has
underperformed the passive index.
Despite short-term underperformance,
over time the 75th percentile non-U.S.
small cap manager has generated
considerable excess return. This is
a good illustration of why investors
need to be patient and maintain their
active management allocations over a
long-term market cycle.
Market Implications
and Our Recommendation
In a low-growth GDP environment,
competition will increase and high-quality companies will
outperform their lower-quality counterparts. In essence, the strong
will get stronger. The market is likely to reward fundamentals,
leading to greater variance among individual stock returns. Similarly,
in the core fixed income space, a large part of the index will face
headwinds if interest rates rise. Such an environment also bodes
well for active management.
Over the most recent five-year time period, active management
has been challenged in most sub-asset classes. But investors still
must grapple with the question of timing. Those that shift to passive
investment allocations at an inopportune time lock in what might have
been only temporary underperformance.
After careful examination, it would appear that over longer periods,
in most sub-asset classes, active management even at the 75th
percentile (net of fees) tends to outperform its appropriate index.
Therefore, investors must know where active management is
most likely to be rewarded and maintain active exposure to these
areas. Even in the most inefficient sub-asset classes, periods of
underperformance are to be expected.
James Huntley is an equity research associate
with Evaluation Associates, a Milliman company, in
Norwalk, Connecticut. This article was peer reviewed
by Ellen Petrino, an investment consultant, also with
Evaluation Associates.
Giving employees an equity stake in the company can be a boon,
because the fortunes of the company and its employees are more closely
intertwined. Employees have reason to work as effectively as possible for
the good of the enterprise. If the company flourishes, so will the value of
the company’s stock (and the value of employees’ share in the whole).
Some retirement plan designs facilitate company ownership.
An employer may make stock a 401(k) plan investment option,
contribute stock to 401(k) plan accounts, or implement an
employee stock ownership plan (ESOP).
However, employee ownership can pose substantial risk:
• If the company goes bankrupt, employees whose retirement
savings are in stock will lose everything — their jobs and
retirement savings. Employee shareholders suffer acutely when a
company’s stock price plummets; their retirement savings take a
huge hit.
• The company may open itself up to charges of fiduciary
irresponsibility for having stock as a retirement investment option
in the first place. The courts are awash in “stock-drop” cases
contending that the company should have known better than to let
employees own their beleaguered stock.
To protect employees and employers alike, 401(k) plans that include
employer stock as well as ESOPs must allow employees (that meet
specific conditions) to divest themselves of their company stock, thereby
diversifying their retirement assets.
Final PPA diversification rules for 401(k) plans
A fair number of 401(k) plans offer employer stock as an investment
option. This is more common with publicly traded companies than
private companies. If employer stock is an investment alternative or the
employer makes stock contributions to employee 401(k) accounts,
employees must be able to divest themselves of the stock and invest in
other options.
Diversification Rules for ESOPs and 401(k) Plans with Employer Securities
Kara Tedesco, Employee Benefits Consultant
U
U
U
U
US
U
US
-9
-6
-3
0
3
6
9
12
15
Jan 07 -
Dec 09
Jan 06 -
Dec 08
Jan 05 -
Dec 07
Jan 04 -
Dec 06
Jan 03 -
Dec 05
Jan 02 -
Dec 04
Jan 01 -
Dec 03
Jan 00 -
Dec 02
Jan 99 -
Dec 01
75th percentile
Median
25th percentile
Exhibit 2:
Three-year rolling excess returns for active investment managers of non-US small cap equity
7. FALL 2010 :: 7
Whether the employer contributes the securities or employees choose
to invest in them, the Pension Protection Act’s (PPA) final diversification
rules under IRC section 401(a)(35) apply. (They also apply to an
employer security that is not publicly traded, if the employer or members
of the employer’s controlled group of companies have issued a publicly
traded class of stock.)
Under these rules:
• At least three diversified investment options, other than employer
securities, with materially different risk and return characteristics,
must be offered to participants.
• Participants must be able to divest their own after-tax or pretax
contributions of employer securities and reinvest in alternative
investment options at least quarterly.
• If the employer contributes company securities to participants,
those with three years of service or more, their alternate
payees, and beneficiaries of deceased participants
must be able to divest the employer securities
and reinvest in other
plan options at least
quarterly.
The 401(k) plan cannot:
• Place any restrictions
or conditions on a
participant’s employer securities investment that are not placed
on the plan’s other investment options (except those required by
securities law), nor
• Base direct or indirect benefits on the participant investing in
employer securities.
The plan sponsor must notify participants at least 30 days before
the first date they are eligible to exercise the right to divest.
This notice — for both employee-purchased stock and employer-
contributed stock — should explain diversification rights and the
importance of diversifying retirement assets.
These final PPA diversification rules are effective for plan years beginning
on or after January 1, 2011. Calendar-year 401(k) plans must be
amended to comply with these rules no later than December 31, 2010.
ESOPs in brief
ESOPs are required to invest primarily in employer securities
and are frequently set up by smaller, privately held companies
whose stock, by definition, does not trade publicly. However, the
securities may or may not be publicly traded.
Like 401(k) plans, ESOPs are also defined contribution plans and
therefore do not guarantee a specific retirement benefit. Instead,
they contribute securities to participant accounts. The final account
value depends on the number of securities and their value.
An ESOP can:
• Help employers raise new capital, refinance existing debt, or
acquire additional assets;
• Provide a market for shares that do not trade publicly;
• Improve current cash flow, because employer contributions may
be made in securities;
• Provide tax benefits, such as tax deductible dividends; and
• Allow the employer to purchase stock from shareholders leaving
the company, as soon as permitted, at fair market value; or the
employer can hold onto the cash and allow former employees to
delay distributions.
If certain requirements are met, participants who receive lump-sum
distributions in employer securities may defer capital gains tax until
they sell their securities at termination or retirement.
ESOPs may be combined with other employee benefit plans, such as a
401(k). Or an employer may choose to maintain both plans separately
in its retirement program. An ESOP is not subject to the PPA final
diversification rules if the ESOP is a stand-alone plan and not subject
to IRC sections 401(k) or 401(m). However, the ESOP would be
subject to the rules if it included a 401(k) feature where the employer
contributes or allows participants to elect stock as an investment.
Divestiture rules for ESOPs
ESOPs have their own complex statutory diversification
requirements under IRC section 401(a)(28). ESOP divestiture
rules kick in more slowly, later, and less fully than the 401(k) plan
rules cited above. ESOPs must give employees who have reached
age 55 and have 10 years of plan participation a six-year window
in which they have the right to diversify up to a “designated
percentage” of the stock in their account. The designated
percentage is 25% for the first five years of the window period
and increases to 50% in the sixth year. This right is cumulative. In
other words, the amount eligible to diversify is adjusted annually by
amounts taken in prior diversifications.
For example: Assume the first diversification year was 2008, the
participant’s account holds 500 shares, and the participant elects
to diversify the full 25% (500 shares x 25% = 125 shares). The
participant’s account balance drops to 375 shares (the original 500
minus the diversified 125). In 2009 an additional 50 shares are
allocated to the participant’s account in accordance with the ESOP’s
allocation formula, resulting in a new balance of 425. Accordingly,
at the end of 2009 the participant had 425 shares plus the amount
previously diversified, 125, for a total of 550 shares. These 550
shares x 25% = 137.50. After subtracting the 125 shares previously
diversified, the participant has the right to diversify an additional 12.50
shares the second year. Once the participant enters the sixth year of
the diversification period, the same rules apply except that “50%” is
substituted for “25%.”
