Beneficiary Designation Drawbacks
May 31, 2023
When we are asked to review equity plans and related agreements governing equity awards and share purchase rights granted to participants in the United States and abroad, they often contain beneficiary designation provisions. While nice in theory, beneficiary designations are administratively burdensome and fraught with pitfalls, particularly outside the United States.
As we’ve recently been helping several companies work through the ins and outs of the treatment of awards upon the death of a participant, we thought it would be worthwhile to highlight the potential complications with permitting beneficiary designations and provide alternate recommendations when drafting equity documentation and policies.
Why Beneficiary Designations May Be Appealing (in Theory)
If a participant completes a beneficiary designation, the company has clear instructions on what to do with the deceased participant’s equity awards (e.g., restricted stock units, stock options, etc.) or employee share purchase plan payroll deductions and usually can complete the payout process fairly quickly.
Without a beneficiary designation, the plan benefits typically transfer to the participant’s heirs in line with the rest of the deceased participant’s estate. In the United States, this may mean that the awards will have to go through probate which, depending on the size of the participant’s estate, could be an expensive and time consuming process. However, there is no guarantee that permitting beneficiary designations for plan benefits will actually avoid probate, as many participants will hold other assets in a form that will require the estate to be probated for other reasons.
Why to Avoid Beneficiary Designations
One reason to avoid beneficiary designation is that they may be invalid. In which case, the company may pay the benefits to someone who is not legally entitled to them, thereby opening the company up to liability if a claim is brought by the rightful heir.
Numerous laws impact the validity of a beneficiary designation:
- Certain countries and jurisdictions have procedural or substantive requirements for a valid beneficiary designation. For example, some countries require that the execution of the beneficiary designation form be notarized and/or witnessed. Any designations that do not meet these requirements will be deemed invalid.
- Other countries have rules requiring that a percentage of the decedent's assets pass to the surviving spouse, children or other specified heirs. A beneficiary designation of anyone other than these specified heirs will be subject to challenge.
- Some US states have laws addressing the invalidity of a beneficiary designation upon divorce or a subsequent marriage. Further, if the participant resided in a community property state prior to death, the designation may not apply to the surviving spouse’s community interest in the plan benefits.
- Simultaneous death laws (which address what happens where the participant and beneficiary die at or around the same time) and killer and other similar statutes (which address what happens if the beneficiary plays a role in the death of the participant) may also impact the validity of the designation.
The administrative burden of collecting, tracking and updating beneficiary designations is cumbersome enough. Adding the due diligence needed to ensure the designations are valid under local law is more than most companies want or are willing to take on.
Designations Can Become Outdated
Life happens and beneficiary designation forms can become outdated. Employees may forget the beneficiary designation exists and neglect to make changes to reflect their current intentions when life events (marriages, births, divorces, deaths, etc.) occur.
This can result in the plan benefits being paid to unintended individuals. This problem could be mitigated by conducting regular campaigns encouraging participants to review and update their beneficiary designations. However, inevitably, not every participant will update their designations, regardless of the company’s best efforts.
Consider providing for payment to a participant’s estate. In every US state and nearly every country, there is a concept of a personal representative of the estate (e.g., executor, administrator). In almost all cases, it will be much easier for the company to interface with that individual and not worry about whether the beneficiary designation form on file is valid.
If the plan documentation provides that any payments will be made to the estate, the company will only need to verify the authority of the local personal representative and then can work with that individual for all matters. (In this regard, US estate tax is a significant consideration when a plan participant dies, especially for non-US participants for whom the threshold for an exemption from such tax is quite low. Dealing with the personal representative, rather than beneficiaries, in relation to the estate tax will also be more efficient.)
If your company has been permitting beneficiary designations and would like to revisit this approach, consider when would be the best time to make changes to plan documentation and/or policies and how to communicate this change to participants. Sit down with your internal business partners and develop an action plan that will address how and when the company will proceed with making the shift.
In conjunction with this, if the company will require payments to be made to a participant’s estate, evaluate whether other changes to award terms may be warranted. For example, navigating estate management can be time consuming. If your plan allows a relatively short window to exercise stock options before they expire, consider whether the option exercise period should be extended to ensure enough time for the estate to exercise the options.
If, however, your company feels strongly about allowing beneficiary designations in the limited cases where it may be desirable for tax or other reasons, you should ensure that the plan documentation is drafted broadly enough to permit such designations, while reserving the company’s discretion to permit or disallow such a designation.
The company should also conduct the appropriate due diligence and put safeguards in place to minimize the risks described above. Further, the company should (i) require participants to certify that they have consulted with an estate planning professional and that the designation is valid under applicable laws and (ii) have participants agree to update the beneficiary designation, as needed, and establish a regular process for reminding participants to do so.
If your company currently permits beneficiary designations, it may wish to reconsider this approach going forward. If, however, your company decides to allow beneficiary designations (ideally in limited cases), conducting the appropriate due diligence and taking the steps mentioned above should help to improve reliability of the designations so that the company can comfortably act upon them when needed.
Global Equity Services