Several lawsuits have been filed recently challenging 401(k) plan sponsors’ use of forfeitures to reduce employer contributions. (See, for example, McManus v. The Clorox Company, Case 4:23-cv-05325-YGR, N. D. Cal., filed 10/18/2023) This is a practice that has been permitted by the IRS since before ERISA was enacted, going back to Revenue Ruling 71-313 and existing and proposed Reg. 1.401-7. Plaintiffs in these suits have attempted to recast the decision how to apply forfeitures as a fiduciary determination, and claim that it is a prohibited transaction not to apply the forfeitures for the benefit of participants.
Is this a new phase in ERISA litigation or a wrong turn by plaintiffs’ counsel? While it is always risky to predict how courts will rule on issues, motions to dismiss filed by defendants Clorox and Fisher Scientific target the holes in plaintiffs’ cases. Further, it is not clear that participants would benefit even if plaintiffs were to prevail.
Here are some of the reasons using forfeitures to reduce employer contributions should not be restricted:
IRS Reaffimed Its Position in 2023. The IRS position on forfeitures, as most recently set out in 2023, permits 401(k) plan forfeitures to be used for any of three permitted purposes: to pay plan expenses, to reduce employer contributions, or to make an additional allocation to participants. Forfeitures are initially kept in a separate forfeiture account, but the IRS requires forfeitures to be applied towards these purposes and removed from the forfeiture account by the end of the plan year following the year in which they arose. In its most recent guidance, the IRS reminded plan sponsors that plan language must authorize the use of forfeitures for these purposes before they can be applied.
DOL Lawsuit Against Sypris Misinterpreted. The Department of Labor has not previously expressed any general concerns about forfeitures, except in a case where it successfully sued Sypris Solutions for applying forfeitures to reduce employer contributions in violation of a plan provision requiring that they be applied first towards plan expenses. (Pizzella v. Anthony Allen et al, case 3:17-cv-00784-BJB-CHL, W. D. Kentucky, September 28, 2023) That lawsuit is not inconsistent with the position of the IRS because under Title 1 of ERISA fiduciaries must administer plans in accordance with their terms, a requirement similar to the documentation requirement mentioned by the IRS in its 2023 guidance on qualification requirements. Although the DOL case was not a challenge to the IRS position, counsel in these new lawsuits probably interpreted it as a green light to sue any plan fiduciaries who used forfeitures to reduce employer contributions regardless of the specific plan language.
Is this really an ERISA violation? There are many reasons to consider this litigation trying to make decisions on how to apply forfeitures a fiduciary activity a wrong turn, and here are some of them.
1. DOL never objected to this longstanding IRS position. Although the determination of when a prohibited transaction occurs is a DOL responsibility, the Clorox brief points out that the DOL has indicated that it will not take positions contrary to the IRS on plan qualification issues such as this one and has not previously questioned the IRS position.
2. This isn’t a fiduciary decision at all. Every action a plan sponsor or committee takes with respect to a plan is not a fiduciary activity. Long-standing ERISA authority says that decisions on plan design, how to fund a plan and the level of contributions are settlor decisions and not fiduciary in nature. The law does not require plan sponsors to maximize their contributions. No one would argue that ERISA requires a plan sponsor deciding to make a discretionary contribution to always contribute the maximum contribution permitted by the plan document or that a plan sponsor must always make the maximum contribution permitted by law. Applying forfeitures to reduce contributions is simply an indirect way of setting the level of employer contributions, a settlor function. And in Rev. Rul. 71-313, the IRS clearly permitted forfeitures to be offset against contributions required by a profit sharing plan document and not just against discretionary contributions.
3. Forfeitures are derived from excess employer contributions. Forfeitures result because employee turnover cannot be taken into account in determining contributions to defined contribution plans as it is in defined benefit plan funding. If a participant forfeits any portion of a benefit on termination of employment and is rehired within a window period, the forfeiture can be required to be restored at employer expense if the forfeiture account is not sufficient. Since the forfeitures were derived from what are essentially excess employer contributions, and may be required to be restored, allowing their use to reduce future employer contributions is perfectly consistent and logical.
4. What about a plan where the employer pays all fees directly? These aren’t common nowadays but they exist. Does a plan sponsor that pays all plan fees itself have to allocate all forfeitures to participants as its only option? This would be a disincentive for any employers to pay plan fees directly.
5. What happens if a plan is terminating? In addition to the qualification requirement that forfeitures in an ongoing plan must be used up by the end of the plan year following the plan year in which they arose, there is a requirement that a terminating plan must allocate all assets, including forfeitures in the suspense account, at the time of termination. What if plan expenses would not use up the forfeitures? Would applying the balance to reduce final employer contributions in that situation be an ERISA violation under plaintiffs’ untested theory? If so, in that situation participants would receive additional contributions in excess of those required by the plan document.
6. Sponsors can just reduce their employer contributions as a response. As previously indicated, existing law is clear that plan design, including setting the level of employer contributions, is not fiduciary in nature. If plan sponsors can’t apply forfeitures towards employer contributions, they can just reduce their contributions accordingly. That won’t benefit participants at all, and would make this whole exercise counterproductive.
What Can Plan Sponsors Do to Protect Themselves?
These cases may end up revolving on whether the plan language clearly permitted the use of forfeitures to reduce contributions. All plan sponsors should review their plan language to make sure their use of forfeitures is permitted by the plan text. It is preferable to list all three permissible uses in the plan text. Some ERISA counsel are also recommending that ongoing plan sponsor discretion regarding use of forfeitures be eliminated by establishing a written order in which forfeitures must be used in the plan documents. (In the case of pre-approved plans, individual plan sponsors may not be able to do this unilaterally.) However, this removal of discretion hampers employer flexibility and may well be premature as we await court decisions on the viability of these claims.