Pension plans that invest a majority of their assets in employer stock predate the establishment of the Employee Retirement and Income Security Act (ERISA) of 1974. However, it was this Act that codified the Employee Stock Ownership Plan (ESOP) in the law. While all pension plans are permitted to invest a portion of their portfolios in employer stock, ESOPs are required to invest a majority of their assets in qualified employer securities. Their other distinguishing feature is that ESOPs may be leveraged, utilizing the credit of the sponsoring company or actually borrowing from the sponsoring company to purchase the sponsor's stock. Taken together, these two features make ESOPs an attractive instrument of corporate finance.

There is a natural tension that arises from the dual purpose - corporate finance vs. retirement - which ESOPs are expected to serve. Companies adopt ESOPs for a variety of reasons: to provide retirement benefits to employees, to serve as an exit vehicle for shareholders, to obtain tax advantages, to serve as a corporate financing mechanism, to avoid hostile takeovers, and to avert shutdown, among others. Irrespective of the reason for adoption, all qualified pension plans are required to be operated for the exclusive benefit of the participants. Because ESOPs invest a majority of their assets in a single employer's stock, they present a greater risk to participants than do other types of defined contribution plans, which invest in well diversified portfolios. This is particularly important when the ESOP serves as the only or primary plan offered by the company. From a public policy perspective, it is therefore important to ascertain whether the financial returns of ESOP participants are commensurate with, and compensate participants for, the additional risk that they bear.

In our study, we analyzed the risk-adjusted financial returns to participants in ESOPs as compared with returns to participants in defined contribution plans that invest in well diversified portfolios, which we refer to as "diversified" plans. On average, the ESOPs in our database invested 78.5% of the plan's assets in employer stock, while the diversified plans invested less than one half of one percent in employer stock. The asset mix of our diversified plans portfolio is typical of single employer defined contribution plans generally.

Because ESOPs invest a majority of their assets in a single employer's stock, they present a greater risk to participants than do other types of defined contribution plans, which invest in well diversified portfolios.

Two features distinguish our research from prior work in the area. First, we utilized data on several thousand ESOPs and over ten thousand comparison plans. Our results are therefore quite reliable in comparison to those of prior studies, which typically relied on data for fewer than one hundred ESOPs and comparison companies. Second, we report evidence on the performance of ESOPs in closely held companies, which has never been done before. Because the stock of closely held companies is not valued on public markets, investments in these stocks could exhibit very different behavior from investments in publicly traded stocks. More than three-quarters of U.S. ESOPs are in closely held companies. Therefore, the return on ESOP investments in closely held companies is a subject of great importance.

The simple average return for ESOPs in each year of our study is compared to the average return for diversified plans in Figure 1. (The ESOP data in Figure 1 includes all ESOPs in existence in the corresponding year for which we could measure the annual return.) Also shown is the S&P 500 return, which is one of several frequently used benchmarks of stock market performance.

ESOP returns were typically, but not always, higher than returns of both diversified plans and the S&P. ESOP returns were negative in two years, while the diversified plans never had a negative return. This visual pattern indicates that ESOPs had returns that were higher but more volatile from year to year than were the returns of diversified plans, and that were more highly correlated with the S&P 500 index.

It is difficult to draw any conclusions about ESOPs versus non-ESOPs on the basis of simple comparisons like this. There are many reasons why the graph could show the indicated relationship: ESOPs, for example, are larger on average than diversified plans. This could account for some differences in returns. And, of course, ESOPs invest in the stock of closely held companies, which diversified plans do not. This could have a very dramatic effect on the comparison. Our research was aimed at controlling for these and other variations, so as to make a fair comparison between the returns of ESOPs with those of diversified retirement plans.

For technical reasons, we used "market adjusted residual" (MAR) returns to measure the annual performance of ESOPs and diversified plans. MAR returns measure the difference between the total return of the plan and the return achieved by the market in general. So, for example, if a particular plan achieved an 8% return in a given year and the market turned in 5%, the MAR for this plan in this year would be 3%.

We averaged the MARs of all the ESOPs in each year of our study (1981-1990, a period of ten years), arriving at one number for each year. This number represented the average MAR for all of the ESOPs in that year. We did the same for the diversified plans. Then, for each of these two groups, we calculated what we called a "synthetic geometric mean return" (SGMR), which is the average over time of the ten annual average MAR returns. There were two SGMR's, one for ESOPs and one for diversified plans. In addition to calculating the SGMR's, we also calculated the standard deviation of the annual average MAR returns (SDAAR). The SGMR was our primary measure of return, and the SDAAR was our primary measure of risk.

The SGMR for ESOPs was 5.1 %, compared to 3.5 % for diversified plans, implying that the return achieved by ESOPs was about 1.6% higher per year than that achieved by diversified plans. Since the portfolios of ESOPs are each concentrated in a single stock, we expect them to be risky investments. The SDAAR of ESOPs was 7.1%, more than one and one-half times higher then that of diversified plans, which was 4.2%. The question this raises is, is the higher average return for ESOPs high enough to offset their increased risk?

Because ESOPs invest primarily in employer stock, their financial returns are acutely sensitive to the performance of the sponsoring company, and are, in turn, affected by factors that determine security returns. We would therefore expect the return of ESOPs to be dependent on the trading status, size, and industry of the plan sponsor.

In addition to the factors affecting stock value, the technique of arriving at values is also important. Publicly traded stock is valued through daily buying and selling on an open market. In contrast, the stock of closely held companies is valued by appraisers. Therefore, there is reason to believe that the returns of ESOPs sponsored by public companies might be governed by a different model than the returns for ESOPs sponsored by private companies, even after controlling for dissimilarities in average firm size between the two groups. In addition, there are a number of special tax provisions that are applicable only to private ESOPs, which would serve to further differentiate the expected pre-tax returns between these two groups of plan sponsors.

In contrast to ESOPs, diversified plan returns are not expected to reflect sponsor characteristics. Trading status, size and industry of the sponsoring company should have no direct effect on the returns achieved by their diversified plans. However, sponsor characteristics may have an indirect effect on the returns of diversified plans if they affect the plans' investment strategies or investment efficiencies. For example, smaller sponsors may be relatively risk-averse, thereby leading to slightly lower expected investment returns. Smaller sponsors may have higher overhead costs per dollar of invested assets, also lowering expected returns by a number of basis points. Closely held sponsors tend to be smaller than public sponsors, and therefore their returns may share in the small firm indirect effect. For these reasons, one might anticipate finding a small trading status effect and a small sponsor size effect for diversified plans, as well as a small industry effect to the extent that industry is correlated with firm size.

As shown in Table 1, the financial returns of ESOPs sponsored by public companies were higher than those of private companies, and ESOPs sponsored by larger companies exhibit systematically higher returns than those sponsored by smaller companies. The returns also vary widely depending on the industry of the plan sponsor. As anticipated, the returns of diversified plans were generally found to be independent of the characteristics of the plan sponsor. Average MARs lay between 3.43% and 3.55% for diversified plans in all industries except mining. The gap between the returns of small diversified plans and medium sized plans was 0.19% (3.53% versus 3.70%), with the return on large plans falling in the middle.

Having found that returns were generally higher for ESOPs than for diversified plans, we calculated various statistics to assess whether the superior performance of ESOPs still exists after controlling for their added risk.

Among plans sponsored by public companies, the beta values (which measure the relationship of portfolio returns to returns achieved by the market as a whole) were much higher for ESOPs than the diversified plans. This confirms that ESOP returns are more highly correlated with the stock market than are the returns of diversified plans. This correlation with the market is a source of "systematic" risk. The fact that the estimated alpha values are higher for ESOPs than for diversified plans means that the ESOP returns are more than sufficient to compensate for their systematic risk.

The next question was whether ESOPs exhibited higher risk unrelated to the market as a whole (unsystematic risk), and, if so, whether ESOP returns compensate for this additional source of risk.

We found that the residual variation in returns, after controlling for market-related variation, was much higher for ESOPs than for diversified plans. This was expected because ESOPs are concentrated in a single security, rather than spread over many stocks. In order to assess whether ESOP returns compensate for unsystematic risk, we estimated regression equations wherein the dependent variable was the plan's average return over the study period and the independent variables were the standard deviations of the same plan's returns and an ESOP dummy variable (taking the value "1" if the plan was an ESOP and "0" otherwise). The estimated coefficient on the ESOP dummy variable is a measure of the differential in excess returns between ESOPs and diversified plans, after controlling for total risk.

Of the 1,790 ESOPs in our dataset, 277 were terminated in the course of the study period. About 71% of these plans terminated due to changes in tax incentives (principally the end of the PAYSOP tax credit), and another 24% of ESOPs terminated due to merger or acquisition. Fewer than 5% of the ESOPs in our sample terminated due to bankruptcy of the sponsor.

In order to determine whether the terminated plans had investment performances that were significantly different from the non-terminated plans, we calculated residual returns for each terminated ESOP in each of the six years prior to termination, using non-terminated ESOPs as a benchmark. Only in the case of bankruptcy were returns consistently and highly inferior in the six years prior to termination of the plan. These results suggest that even though the overall rate of termination was much higher for ESOPs than for diversified plans, the terminated plans were not necessarily ended for poor performance.

We found that the return for ESOP investments in all types of companies is superior to the returns achieved by diversified plans. However, in general, these superior returns do not compensate for the additional risk which participants bear in these plans. The major exception to this are ESOPs sponsored by large publicly traded companies; our research shows the returns of plans in this category to be sufficient to compensate for the additional risk. Since more than 90 percent of all ESOP participants participate in plans sponsored by large public companies, we may conclude that, on a total risk adjusted basis, the financial returns available to a typical participant in ESOPs are comparable to returns available to participants in diversified plans.

This is not the case for participants in smaller plans, however, or for participants in plans of closely held companies. The risk-adjusted returns available to these participants is lower than that from alternative types of plans.

The first and foremost policy implication of these results is that ESOPs should not be viewed as primary retirement plans. If the objective is to plan for retirement, an ESOP is not the best vehicle for this purpose. Secondly, these assets have been pledged to support the retirement goals of participants, and should not be compromised by the added risk imposed by an ESOP. Industry practice is not to do this. An issue here is whether pension assets should be used to effect an employee buyout when the alternative involves downsizing or shutting down the plant. Our results do not address this question as the potential benefits from continued employment could outweigh the effects of an ESOP's inherent risk.

Finally, how about plans which are funded with company cash which would otherwise have gone to a qualified plan which was terminated or frozen in order to establish the ESOP? The answer to this question is similarly not supplied by our research. The benefits to employee-participants from such a transaction may not be fully captured in the ESOP returns themselves. Rather, there may be additional benefits such as employment stability, higher wages and/or higher contributions for retirement plans than would be available to participants if the ESOP transaction had not taken place.

The total economic welfare of plan participants is affected by many factors apart from the financial returns on plan assets.