Today, employees are more likely than ever to seek new employment opportunities and change jobs. These employees may leave a company before becoming fully vested in their qualified retirement plan benefits – which may result in forfeiture of their unvested benefits. What is a retirement plan sponsor supposed to do with the forfeited amount? More importantly, what is the plan sponsor allowed to do with these forfeited amounts? This is an important question, as the use of forfeitures can raise compliance questions under both ERISA and the Internal Revenue Code requirements for qualified retirement plans.
For defined contribution retirement plans, such as 401(k) plans, the IRS has typically allowed plan sponsors to apply forfeitures to offset administrative expenses or reduce employer contributions. In proposed regulations, issued in February 2023, the IRS reiterates this position, indicating that defined contribution plan forfeitures may be used to offset plan administrative expenses or reduce employer contributions, or may be reallocated to participants pursuant to a nondiscriminatory formula.
The proposed regulations include a 12-month deadline to use forfeitures. Specifically, forfeitures must be used within twelve months after the end of the plan year in which the forfeiture occurred. However, under a transition rule, the proposed regulations would apply only for plan years beginning on or after January 1, 2024, and forfeitures incurred prior to January 1, 2024, would be treated as having been incurred in the 2024 plan year. The proposed regulations also require the plan document to address the use of forfeitures.
In the ERISA context, forfeitures are generally considered to be plan assets. ERISA includes restrictions on the use of plan assets, requiring them to be used solely to benefit plan participants or pay reasonable expenses of plan administration. Recently, plaintiffs have filed lawsuits against several companies related to their use of forfeitures. These suits include novel theories that a company’s use of forfeitures to reduce employer contributions results in a breach of ERISA’s fiduciary duties. According to some plaintiffs, when an employer uses forfeitures in this way, the benefit flows to the employer, not to the Plan or the participants, which allegedly violates the duty of loyalty under ERISA. Other suits claim that when employers offset their employer contributions, this stunts the Plan’s financial growth, thereby violating the plan sponsor’s general duty to maximize asset growth. The Department of Labor has not yet weighed in on whether this use of forfeitures would be permissible under ERISA.
Given the developing law on this topic, it is important for plan sponsors to review their documents and practices. Among other things, to prepare to comply with the proposed regulations, a plan sponsor should review the plan document to ensure it addresses the permissible uses of forfeitures, the time frame for allocating forfeitures, and the authority to make decisions related to the use of forfeitures. Plan sponsors should also review existing forfeiture account balances and monitor litigation in this area.
