Plan Sponsors Face Legal Challenges Over 401(k) Plan Forfeiture Use

The Employee Retirement Income Security Act of 1974, known as ERISA, was enacted in part to protect plan assets and to subject plan fiduciaries — those who exercise discretionary control or responsibility over the plan — to certain legal responsibilities and obligations. Typically, employers who offer benefit plans (or their chosen delegate) are deemed to be fiduciaries.

Under ERISA, fiduciaries have a legal obligation to act solely in the best interests of the plan and its participants. ERISA sets forth other obligations and responsibilities of fiduciaries, including:

• Carrying out their duties prudently.
• Following the terms of plan document(s), to the extent the plan terms are consistent with ERISA and the Internal Revenue Code.
• Paying only reasonable plan expenses and
• Avoiding conflicts of interest.

The duty to act prudently requires fiduciaries to remain informed about current retirement plan practices and legal requirements; diversify plan assets, assess the performance of service providers and seek professional guidance when needed.

In a handful of recent lawsuits, plan sponsors have been sued related to their use of a plan’s forfeiture account to reduce future employer contributions in 401(k) plans. Approximately two dozen of these lawsuits are now pending.  

Forfeitures typically occur when an employee leaves a company before becoming fully vested in employer contributions in the 401(k) plan. The funds forfeited by the departing employee are then moved to the plan’s forfeiture account. According to the IRS, which reaffirmed its position in 2023, 401(k) plan forfeitures can be used for any of three permitted purposes: to pay plan administrative expenses, to reduce employer contributions or to make an additional allocation to participants.

In the recent suits, plaintiffs allege employers have breached their fiduciary duty to act solely in the best interests of the plan and its participants by choosing to use forfeited funds to reduce future employer contributions to the plan instead of reducing the administrative expenses that are often borne by participants.

These lawsuits and the underlying allegations pose two questions:

• When the terms of the plan document provide that the plan sponsor may use forfeitures either to offset future employer contributions or to pay plan administrative expenses otherwise borne by participants, is the plan sponsor acting as a fiduciary when it chooses between the two options?
• If acting as a fiduciary, does the sponsor breach its duties if it uses the forfeitures to reduce employer contributions rather than to pay administrative expenses?

In light of these legal developments, it is important for plan sponsors to review plan language to ensure their use of forfeitures follows the terms of the plan.

Although the future of these lawsuits is uncertain, employers may want to consider protecting themselves by amending their plan document to provide a predetermined, specific order in which forfeiture funds shall be used.

Please contact Regan M. Canfill or any member of the Phelps Employee Benefits/Executive Compensation team if you have questions or need advice or guidance.