As described in our post earlier this year, the Department of the Treasury issued proposed regulations on the use of forfeitures by tax-qualified retirement plans. The changes, published in the Federal Register, provide clarity in a previously murky area for plan sponsors and create a one-time opportunity to bring plans into compliance that ends in 2025. See: Whose Money is it Anyway? IRS Proposes New Regulations Governing Plan Forfeitures
A recent development in the class action space adds new urgency for plan fiduciaries to look at forfeiture issues. At least four class action lawsuits have now been filed alleging that the plan fiduciaries engaged in self-dealing when they exercised their fiduciary discretion to allocate forfeitures to offset employer plan contributions (which benefits the employer) instead of to offset plan expenses (which benefits the participants). See, e.g., (McManus v. Clorox Co., N.D. Cal., No. 4:23-cv 05325 (10/18/23)[1]. These claims are being made despite the long-standing practice of plans, with IRS approval, of plan language allowing the use of discretion in allocating forfeitures to offset employer contributions. Of course, this may be a distinction without a difference. If the employer can show it would have reduced an otherwise discretionary employer contribution by the amount of the forfeitures used to pay plan expenses, it may be a “no harm, no foul” situation. But if the plan has a non-discretionary contribution formula, e.g., in a money purchase pension plan or where contributions are mandated by a collective bargaining agreement, and discretionary use of forfeitures, the plaintiffs could still argue that participants were harmed by the use of forfeitures to offset future contributions."
Understanding how to handle forfeitures properly is pivotal to ensuring compliance and avoiding potential legal pitfalls.
OVERVIEW
When an employee departs before achieving full vesting, they forfeit the portion of their retirement benefits that were unvested. But how should these amassed forfeitures be managed? Here’s what the IRS is proposing in its regulations:
For defined-benefit pension plans: forfeitures can't boost other participants' benefits but can be factored into the plan's minimum funding cost predictions.
For defined contribution plans: forfeitures, incurred within a plan year, must be allocated within 12 months after the close of that plan year for:
Covering plan admin expenses.
Lowering employer contributions or restoring past forfeited amounts.
Enhancing benefits in other participant accounts as per plan specifications.
If finalized, the proposed regulations will apply starting on January 1, 2024, but plan fiduciaries may rely on them in the meantime. The good news is that a new transition clause permits the plan to use up old forfeiture balances from prior years by 12/31/2025 by deeming old forfeitures to have been created on 1/1/2024. But because of the new class actions, it is important to take a careful look at your plan’s forfeiture procedures.
WHAT TO DO NOW
1. Examine Your Plan Document & Plan Design: The starting point for any forfeiture-related review is your plan document. It is imperative that you closely examine it concerning the treatment of forfeitures. Does it clearly outline how forfeitures should be managed? Are there ambiguous terms that may lead to discrepancies in interpretation? Is the order for using forfeitures hard-wired in or up to the plan administrator’s discretion? Plans in which employer contributions are made on a payroll-by-payroll basis rather than at the end of the year may not have much in the way of employer contributions to offset at year-end, which can lead to accumulations in the forfeiture account. Addressing these questions upfront can save a lot of trouble down the line. Employers need to review their plan documents in any event as we look to the new Secure 2.0 provisions taking effect in 2024 (e.g., some current plan designs will accommodate those changes better than others).
2. Properly Manage Your Forfeiture Account: A closer look at your forfeiture account can help you ascertain whether forfeitures are being utilized correctly. Here are a few essential things to keep in mind:
Timeliness: Forfeitures need to be used promptly (within 12 months after the plan year in which they are created) and in accordance with the plan document. If there's been a delay in this in the past, consider using the current transition period to handle existing forfeitures and then realign your processes.
Consistency with the Plan Document: Always ensure that the usage of forfeitures aligns with the guidelines and conditions stated in your plan document.
Plan Design Alterations: If there's room for discretion in handling forfeitures in your plan, it might be worth revisiting its design. Consider whether an amendment is needed to specify how forfeitures are to be used (so no fiduciary discretion is needed).
Keeping Expenses in Check: It's crucial to understand which expenses should—and should not—be run through the forfeiture account. For instance:
· “Settlor Expenses”: These expenses, by definition, should not be managed through the forfeiture account. For more information regarding what is a “settlor” expense and what is not, see Unpacking the Settlor - Fiduciary "Two Hat" Principle.
· Certain Fiduciary Items: Some fiduciary items might not be apt for the forfeiture account, depending on the facts and circumstances.
· Attorney Fees: It's rare for attorney fees to be appropriately charged to the forfeiture account. Always double-check before proceeding.
WHAT'S NEXT?
It will be important to watch and see how the courts handle these new allegations (at this point, which is all they are, allegations). We can expect various motions (e.g., motions to dismiss for failure to state a claim) and further rulings in these cases (and possibly more of these types of cases). In the meantime, now is a great time to review your forfeiture compliance both in light of the new regulations and the new class action cases.