When a participant terminates employment without being fully vested in their qualified retirement plan account, the non-vested portion of the account may become a “forfeiture.” While forfeitures are a common element of most retirement plans, many plan sponsors remain unclear on how and when forfeitures may be used. This led the Internal Revenue Service (“IRS”) to issue proposed regulations earlier in 2023, clarifying guidance on these concepts. Additionally, despite longstanding practices by some plan sponsors to use plan forfeitures to offset employer contributions, fiduciaries have been accused of violating ERISA for doing so in four recent lawsuits. Plan sponsors should consider both this new IRS guidance and the allegations in these cases when examining practices for using plan forfeitures.
General Use of Forfeitures
Forfeitures are considered to be plan assets that must be used for the exclusive purpose of providing benefits to participants in the plan and defraying reasonable expenses of plan administration (see Internal Revenue Code (“Code”) Section 401(a)(2) and ERISA Section 403(c)(1)).
In defined contribution plans (e.g., a 401(k)), forfeitures may be used to pay plan expenses, reduce employer contributions (see Rev. Rul. 84-156), or maybe reallocated among other plan participants (see Rev. Rul. 81-10). The plan document should specify how forfeitures may be used.
In a defined benefit plan, forfeitures may not be applied to increase benefits an employee would otherwise receive under the plan before the termination of the plan. The IRS has expressly stated that defined benefit plans may use plan forfeitures to pay for administrative expenses (see Rev. Rul. 84-156).
IRS Proposed Regulations on Forfeitures
Under proposed regulations at Prop. Reg. 1.401-7 (“2023 Proposed Regulation”), the IRS has provided some guidance related to when forfeitures must be used and the purposes for which they may be used.
In defined contribution plans, the 2023 Proposed Regulations require that forfeitures must be used no later than twelve months after the close of the plan year in which the forfeiture is incurred. Forfeitures must also be used to (1) pay plan administrative expenses, (2) reduce employer contributions, or (3) increase benefits under plan terms.
For defined benefit plans, the 2023 Proposed Regulations clarify that forfeitures are not required to be used “as soon as possible” to reduce employer contributions (as is currently provided under Treasury Regulations) since that requirement is inconsistent with the minimum funding rules to which defined benefit plans are subject. The rule remains that forfeitures may not be used to increase participants’ benefits.
Fiduciary Breach Litigation
Lawsuits have recently been brought against Qualcomm, Intuit, Clorox, Thermo Fisher, and HP by the same California employment litigation firm, all alleging that the plan sponsors violated ERISA because the sponsors allegedly chose to use forfeitures to reduce employer contributions instead of using those forfeitures to pay plan expenses (that were otherwise paid from participant accounts). The suits allege a breach of the duties of loyalty and prudence under ERISA, and that the use of forfeitures resulted in a prohibited transaction. As alleged in the Clorox complaint: “[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.”
There are a number of reasons why these lawsuits may not be successful:
- As discussed above, there is a longstanding IRS precedent expressly permitting sponsors to use forfeitures to pay plan expenses, including to reduce employer expenses. Specific Department of Labor (“DOL”) guidance is absent on this point, however.
- While ERISA does require that plan assets be used for the “exclusive purpose” of providing benefits to participants, there is longstanding U.S. Supreme Court precedent that an incidental benefit provided to a sponsor (in this case, reducing employer contributions) would not in of itself give rise to a breach (see Lockheed Corp. v. Spink, 517 U.S. 882 (1996), Hughes Aircraft Company v. Jacobson, 525 U.S. 432 (1999)).
- The complaints admit that the plan documents expressly provided employer discretion over using forfeitures to reduce employer contributions or pay administrative expenses. If the documents had not provided this discretion, or if the plans’ terms had not been followed in some way, this would be a more straightforward claim for a fiduciary breach of the requirement to follow the terms of the plan document (see ERISA 404(a)(1)(D)).
Best Practices for Plan Fiduciaries
Pending the results of the fiduciary breach cases, plan sponsors might consider relying on longstanding guidance from the IRS and DOL to ensure compliance.
Sponsors should consider:
- Engaging employee benefits counsel to draft plan language that is consistent with practice for use of forfeitures. Some plan sponsors may wish to build in flexibility for use of forfeitures. Others may wish to have specific rules for ordering (i.e., forfeitures are first used to reduce administrative expenses and then used to reduce employer expenses).
- Adopting procedures for the use of forfeitures that outline the intended compliance approach, consistent with the 2023 Proposed Regulations.
- Reviewing service provider agreements and ensuring that forfeiture provisions are consistent with the adopted procedures.
- Working with plan recordkeepers on adopting an approach to timely use accumulated forfeitures under the 2023 Proposed Regulations.
It remains to be seen what will come of these recent lawsuits. Given that there is longstanding explicit guidance from the IRS permitting the use of forfeitures to pay for administrative expenses, and the commonality of that practice, it would be a sea change for a court to hold that such a practice constituted a prohibited transaction under ERISA. However, there have been sea changes in the ERISA world in the past, with fee and fund litigation cases. We will continue to monitor these and other similar cases.