A Deep Dive into Segregation What, Why & How

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1 A Deep Dive into Segregation What, Why & How Barbara M. Clough, QPA, QKA Newport Group Rita P. Tucker Lewis Tree Service, Inc.

2 What is Segregation? First The technical name for Segregation (per the IRS) is Reshuffling Reshuffling is the mandatory transfer of employer securities into and out of plan accounts, not designed to result in an equal proportion of employer securities in each account. (Tech Advice 4)

3 What is Segregation? Typically, reshuffling invests the accounts of terminated participants in assets other than company stock so they don t continue to share in the appreciation or depreciation. Their accounts are segregated.

4 Why Segregation? Prevents terminated participants from sharing in stock growth Recycles shares to active participants sooner

5 Why Segregation? Helps with the Have/Have Nots Have/Have Not Problem: some folks have shares, and some folks do not have shares, and it s a problem. What causes it? Long term employees have had more time to accumulate shares More shares are allocated early in the life of the ESOP Dividends / S Distributions are allocated to accounts with shares

6 Why Segregation? Benefits Provides diversification for terminated participants Provides stock appreciation reward for those who contribute to the ongoing success of the business (i.e. Current employees) Potential Concerns What if insufficient cash is available to segregate? Potential discrimination issues If intermittent or incomplete Consider adopting rebalancing provision in coordination with Segregation becomes an expectation Funding is discretionary Possible negative reaction from participants Declining stock value

7 How does Segregation Work? Terminated participants receive other investments from active participants in exchange for stock. Active participants receive stock from the terminated participants in exchange for the other investments. Terminated participants no longer share in the investment experience of the company stock. Careful consideration must be given to the investment of the terminated account balances (fiduciary concerns).

8 How does Segregation Work? ABC Company ESOP ABC Stock Other Investments Total Trust Balances at the close of the allocation period: $ 400,000 $ 100,000 $ 500, % 20.0% Participant Balances (pre-reshuffle/segregation): Active Participant A $ 130,000 $ 35,000 $ 165, % 21.2% Active Participant B $ 250,000 $ 10,000 $ 260, % 3.8% Terminated Participant C $ 20,000 $ 55,000 $ 75, % 73.3% Participant Balances (post-reshuffle/segregation): Active Participant A $ 145,556 $ 19,444 $ 165, % 11.8% Active Participant B $ 254,444 $ 5,556 $ 260, % 2.1% Terminated Participant C $ - $ 75,000 $ 75, % 100.0%

9 IRS Technical Advice IRS issued response to Request for Technical Assistance dated April 3, 2009 (Technical Assistance Request #4 ~ TAM #4) Main issues: Can Trustee in it s discretion segregate? Yes Does this violate 401(a)(28) diversification? No Violate rights to investment in employer stock? No

10 Segregation Pros & Cons Pros: Delays and installment payments are preserved, but terminated participants do not share in growth or receive dividends Provides diversified investment for terminated participants Provides appreciation of stock and dividends to current employees Cons: Funding for segregation Cash requirement is equivalent to immediate lump-sum distributions Note: can segregate in installments or pro rata Increases turnover of shares, which can increase repurchase obligations

11 Design Considerations Segregation Process (how, who, when) Vested Balance vs. Total Balance What happens if participant rehired? Fiduciary Considerations regarding Investments

12 Design Considerations Large contribution requirements when implemented in mature ESOPs Effects on ESOP culture Company should consider and model distribution & diversification impacts Effect on Repurchase Obligation

13 Lewis Tree Segregation Policy Segregations are performed after a one year break in service from the company Vested balances are segregated and invested in a Balanced Fund Segregated balances are held for a 5 year period before participant can receive payment Participants are paid in lump sum after the 5 year wait Considerations as to why we segregate

14 Lessons Learned ESOP sponsors should avoid the temptation to utilize segregation as a tool to take advantage of swings in the company stock price. Consider this a benefits policy rather than a corporate finance tool Rebalancing and Reshuffling/Segregation are not mutually exclusive policies. In fact they work particularly well together when the plan has insufficient cash to fully fund segregation of all terminated account balances.

15 Lessons Learned Reshuffling (or Rebalancing) can affect the number of shares a participant can diversify Code Section 401(a)(28) provides diversification of stock balance once segregated participant may not have a stock balance What if the participant s balance was not fully segregated?

16 Thank You! Barbara M. Clough, QPA, QKA Newport Group (515) Rita P. Tucker Lewis Tree Service, Inc. (585)