The 401(k) Forfeiture Kerfuffle and What it Means for 401(k) Plan Sponsors
photo credit: istock
On February 21, 2024, yet another lawsuit was filed against a 401(k) plan sponsor over alleged misuse of forfeited retirement plan savings of terminated participants. This is the seventh lawsuit filed by the Pasadena-based law firm of Hayes Pawlenko LLP in federal district courts throughout California. This latest claim against Tetra Tech is virtually identical to claims filed against Clorox, Honeywell, Thermo Fisher Scientific, Qualcomm, Intuit and HP.
What’s the Forfeiture Fuss About?
When a participant terminates employment without being fully vested in their qualified retirement plan account, the non-vested portion of the account is “forfeited.” The lawsuits allege that the plan sponsors violated ERISA by using forfeitures to reduce employer contributions instead of using those forfeitures to pay plan expenses (that were otherwise paid from participant accounts). As alleged in these complaints: “[d]efendants chose to use these Plan assets for the exclusive purpose of reducing its own future contributions to the Plan, thereby saving the Company millions of dollars at the expense of the Plan which received decreased Company contributions and its participants and beneficiaries who were forced to incur avoidable expense deductions to their individual accounts.”[i]
The IRS Clarifies Forfeiture Use
Why this dustup? Did these sponsors run afoul of the law? Many legal experts think not—and at least four defendants have already filed motions to dismiss these suits. Forfeitures are a common element of most retirement plans, and the IRS had permitted them to be used in the following ways, to:
- Reduce employer contributions,
- Pay plan expenses,
- Restore previously forfeited accounts, and to
- Allocate to other participants in plan.
In February 2023, the IRS issued proposed regulations that essentially formalized what had been understood as the informal IRS guidance for DC plan forfeitures. This informal guideline and its new, related regulation, would reaffirm employer discretion to use plan forfeitures to reduce employer contributions. They’ve operated within understood practices and according to the regulation just adopted.
But What About the DOL’s Own Lawsuit?
True enough, back in 2017, the DOL filed a lawsuit regarding use of forfeitures against Kentucky-based Sypris Solutions. The DOL claimed that from 2012 through 2015, the Sypris 401(k) plan documents required forfeiture funds to pay plan expenses—but plan sponsor, Sypris Solutions, used the forfeiture funds to reduce employer contributions to the plans. As a result, the plan sponsor benefited by reducing its contributions to the plans, but plan participants who saw their plan account balances reduced by payments of plan expenses from plan assets and not from forfeitures.
In September 2023, the presiding judge ordered the plan sponsor to restore $575,000 to the plan participants who were harmed by the defendants’ use of the forfeiture funds. But note this distinction: In the DOL-Sypris Solutions case, the judge determined the plan sponsor had failed to follow the plan’s own governing documents regarding the use of forfeiture funds for several of its 401(k) plans. It’s important to note the failure was not the use of the funds (forfeitures can be used to pay plan expenses), but, instead, the failure of the sponsor to follow its own plan governance.
And There’s One More Item to Settle the Storm
The DOL regulation adds another guideline of note: Section 1.401-7. It states “forfeitures in defined contribution plans must be used or allocated under the terms of the plan no later than 12 months following the close of the plan year in which the forfeitures occurred.”[ii] (In the past, and due to a lack of clear guidance, some plans had retained a forfeitures balance for two years or longer.)
Together, these regulations suggest the need for a thorough plan document review to avoid a failure. As an example from the DOL regulation itself:[iii]
Although nothing in the proposed regulations would preclude a plan document from specifying only one use for forfeitures, the plan may fail operationally if forfeitures in a given year exceed the amount that may be used for that one purpose. For example, if (1) a plan provides that forfeitures may be used solely to offset plan administrative expenses, (2) plan participants incur $25,000 of forfeitures in a plan year, and (3) the plan incurs only $10,000 in plan administrative expenses before the end of the 12-month period following the end of that plan year, there will be $15,000 of forfeitures that remain unused after the deadline established in these proposed regulations. Thus, the plan would incur an operational qualification failure because forfeitures remain unused at the end of the 12-month period following the end of that plan year. The plan could avoid this failure if it were amended to permit forfeitures to be used for more than one purpose.
How to Avoid a Forfeiture Use Dustup
It’s no surprise that several defendants have filed motions to dismiss these cases. As of this writing, we have no updates on any case decisions. Regardless of their outcomes, the lawsuits and others like it, together with the new regulation, should prompt plan sponsors to take these actions now:
- Review your plan language,
- Make certain plan documents clearly detail permitted use of forfeitures, and
- Document all transactions using forfeitures, noting that different sources of forfeitures must be individually allocated and documented.
It’s always prudent to review your plan documents and it’s a fiduciary responsibility to follow them. Contact Highland Consulting to discuss how your plan and its governing documents compare to defendants’ plans in these cases. For the law firm pursuing these cases, it seems more than possible that the forfeiture kerfuffles they’ve initiated will become ker-failures on their records. For the plans sponsors involved, we hope so.
[i] https://www.americanbar.org/groups/labor_law/publications/ebc_news_archive/2023-fall/mastering-retirement-plan-forfeitures/#:~:text=As%20alleged%20in%20the%20Clorox,and%20its%20participants%20and%20beneficiaries
[ii] https://www.federalregister.gov/documents/2023/02/27/2023-03778/use-of-forfeitures-in-qualified-retirement-plans#:~:text=Under%20this%20rule%2C%20forfeitures%20incurred,of%20that%20first%20plan%20year.
[iii] Ibid
Highland Consulting Associates, Inc. was founded in 1993 with the conviction that companies and individuals could be better served with integrity, impartiality, and stewardship. Today, Highland is 100% owned by a team of owner-associates galvanized around this promise: As your Investor Advocates®, we are Client First. Every Opportunity. Every Interaction.
Highland Consulting Associates, Inc. is a registered investment adviser. Information presented is for educational purposes only and is not intended to make an offer of solicitation for the sale or purchase of specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Highland Consulting Associates, Inc. was founded in 1993 with the conviction that companies and individuals could be better served with integrity, impartiality, and stewardship. Today, Highland is 100% owned by a team of owner-associates galvanized around this promise: As your Investor Advocates®, we are Client First. Every Opportunity. Every Interaction.
Highland Consulting Associates, Inc. is a registered investment adviser. Information presented is for educational purposes only and is not intended to make an offer of solicitation for the sale or purchase of specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
