Should employers who sponsor 401(k) and 403(b) retirement plans and plan fiduciaries be concerned about plan forfeitures that accumulate, for example, when employees exit before becoming fully vested? More importantly, how should they manage these funds? Allowing forfeiture accounts to build up might be the first mistake, but failing to use the funds appropriately can result in serious consequences.
ERISA retirement plan documents contain provisions covering forfeiture accounts, often drawn directly from IRS proposed regulations issued in February 2023 (which have not been finalized as of publication of this article). In practice, addressing these funds involves more than simply knowing that rules and guidance exist. Plan fiduciaries must also know how to apply these rules to their specific circumstances.
In the following article, we offer key details to help plans manage their forfeiture accounts — starting with an understanding of the rules.
Where Do ERISA, the IRS, and DOL Fit In?
Provisions in the Employee Retirement Income Security Act (ERISA) and rules established by the IRS relate to the management of plan forfeitures as follows:
- ERISA requires people or entities with fiduciary responsibility over plan assets, including forfeiture accounts, to act only in the interest of participants and beneficiaries.
- IRS rules generally provide three ways for plans to use forfeitures:
- To pay plan expenses,
- To reduce future employer contributions, or
- To increase benefits to participants by allocating the extra funds to participants.
For several years now, plan participants have filed lawsuits claiming that a breach of fiduciary duties under ERISA occurs when forfeiture funds are used to reduce employer contributions. Recently, the DOL has filed a brief in one lawsuit indicating support for such use of forfeitures.
Thoughtful oversight and management of plan forfeitures can help plan sponsors and employers avoid the potentially serious consequences of allowing funds to grow unused.
Risks Associated with Forfeiture Accounts
Plan documents typically specify the use of forfeitures and may require forfeiture balances to be used within a specific time period. Generally, forfeitures must be used by the end of the plan year in which they arise or no later than the end of the plan year following the plan year in which the forfeiture occurred. If those rules, including any plan provisions regarding the timing of using the forfeitures, are not followed and forfeiture balances are allowed to accumulate, this noncompliance can lead to tax qualification issues for the plan.
Additionally, participants and former participants may disagree with the method used by a plan to manage forfeiture accounts. In recent years, over 70 federal lawsuits have been filed related to the usage of forfeitures and whether the usage is considered a breach of fiduciary duty. These lawsuits typically relate to forfeitures used to reduce employer contributions, since that appears to use plan assets to directly benefit the employer. The failure to properly address overgrown forfeiture accounts can open the door to litigation and can lead to complete disqualification of the plan.
While there are risks associated with forfeiture funds, plans also can take steps to mitigate those risks.
Proactive Forfeiture Account Management
As plan fiduciaries determine how to manage their plan forfeitures, it is important to remember three best practices:
- Review plan provisions related to forfeitures, including the permitted uses for forfeitures and required timing
- Discuss forfeiture accounts on a regular basis and document approval for use of the funds
- Monitor account balances at least annually and ensure timely use of funds based on plan provisions to avoid unnecessary accumulation of funds
Forfeitures are a normal part of ERISA retirement plans. However, it is how plans manage these funds that makes the difference.
Do You Know How Your Plan’s Forfeiture Accounts Are Being Used?
Thorough, periodic review of plan forfeitures is a critical responsibility for plan fiduciaries. For assistance, please contact us. Our Employee Benefit Plan Audit team can help review your ERISA benefits plan and offer comprehensive advice.