A recent rash of class action lawsuits in California claim that using forfeitures to reduce future employer contributions to tax-qualified retirement plans runs afoul of the Employee Retirement Income Security Act (ERISA). These cases have continued to advance despite their central claim seeming to contradict long-standing Internal Revenue Service (IRS) guidance for the permitted use of plan forfeitures.  (Retirement plans are governed by both ERISA and the Internal Revenue Code (Code).)  Considering these developments, how can an employer best use the forfeiture dollars without risking exposure to litigation?

Background

Certain employer contributions to tax-qualified retirement plans may be subject to vesting requirements. When an employee separates from service with the employer before these contributions fully vest, the unvested contributions will be forfeited back to the plan. Forfeitures attributable to a plan year generally must be used before the end of the following plan year.

The use of plan forfeitures is subject to limits imposed by the Code. For example, the Code prevents forfeited contributions from being returned to the employer – they must stay in the plan to be used to benefit plan participants. Prior IRS guidance, along with the proposed regulations issued by the IRS in February 2023, indicates that employers may use forfeitures to offset future employer contributions, to pay for plan administrative expenses, and/or to provide additional contributions to participants. We discussed the IRS’s proposed regulations here. Yet recent lawsuits claim that plan fiduciaries violate ERISA when they choose to use forfeitures to offset employer contributions rather than allocating such forfeitures to plan participants or paying reasonable plan expenses.

The litigants allege that when an employer uses forfeitures to offset future employer contributions, it benefits the employer rather than the participants and that the plan cannot grow as large as it would if it had the benefit of both the forfeitures and future employer contributions. The former is an alleged breach of the duty of loyalty, which requires that the plan administrator act solely in the interest of the plan’s participants and beneficiaries. The latter is an alleged breach of the plan sponsor’s fiduciary duty, which litigants argue obligates the fiduciary to maximize asset growth. Further, by not applying forfeitures to the plan’s administrative costs, those costs may instead be borne by the plan participants, which is also an alleged breach of the duty of loyalty.

How can companies mitigate their litigation risk?

  • Ensure plan documents allow the use of forfeitures in the manner intended by the plan fiduciary. For example, if the employer wishes to maintain flexibility, the plan document should clearly state that forfeitures may be used for any of the above purposes. A case arising from forfeitures being used in accordance with the terms of the plan document is easier for an employer to defend.
  • Establish a policy outside the plan if the plan document provides discretion over the use of forfeitures. Employers may find that their plan document, particularly a pre-approved document that cannot be revised, allows the use of forfeitures for all three purposes but then provides discretion to the employer regarding the hierarchy of how forfeitures are used. An employer may wish to establish a separate policy outside the plan that memorializes the intended hierarchy for forfeiture use.
  • Establish a well-documented fiduciary review process. The fiduciary duty of prudence is a test of process.A well-documented and reasonable decision-making process offers a strong defense against forfeiture claims and other types of claims that may be brought against plan fiduciaries. In the forfeiture context, it means demonstrating an adherence to the plan terms and any standing policy/procedure regarding the order and use of forfeitures. 

The Jackson Lewis Employee Benefits Practice Group members continue to monitor developments in forfeiture-related cases and are here to help employers with questions on best practices for using forfeitures. Please contact a Practice Group member or the Jackson Lewis attorney with whom you regularly work for assistance.