Over the last couple of years, a surge in class-action lawsuits has raised questions about the proper use of plan forfeitures. Forfeitures occur when participants in 401(k) or similar defined-contribution plans leave the company before employer contributions have fully vested. Many plans use forfeited funds to offset future employer contributions, but the recent lawsuits allege that this practice violates the Employee Retirement Income Security Act of 1974 (ERISA).

Although the outcome of the class-action cases is uncertain, plan sponsors, administrators and other fiduciaries should keep an eye on them. They should also review their plan documents and consider amending their plans to reduce their risk.

Background

Under ERISA, participants’ contributions to defined-contribution plans must vest immediately. Employer contributions, however, may be subject to a vesting schedule, provided they vest within six years. A common vesting schedule might provide that employer matching contributions are 20% vested after two years of service, increasing 20% per year thereafter until they are fully vested by year six. Forfeitures occur when participants leave before their matching contributions have fully vested. So, for example, participants who leave after three years of service would forfeit 60% of their employer contributions.

Forfeited contributions cannot be returned to the employer. Rather, according to long-standing IRS guidance, plans may use forfeitures to:

1. Reduce employer contributions under the plan;
2. Pay plan administrative expenses; and/or
3. Provide additional benefits to participants.

In 2023, the IRS issued proposed regulations that confirmed these permitted uses of forfeited contributions. They also clarified that plans must use forfeitures no later than 12 months after the close of the plan year in which the forfeitures occur. The proposed regulations have not yet been finalized, but they reflect the IRS’s position on the subject.

Theory Behind the Lawsuits

The recent class actions allege that using forfeitures to offset employer contributions violates ERISA. Essentially, the plaintiffs’ theory is that applying these funds to future contributions — rather than using them to pay expenses that otherwise would be charged to participants’ accounts — places the employer’s financial interests above those of the participants. Doing so, they say, constitutes a breach of fiduciary duty, which requires fiduciaries to act solely in the participants’ interests, and also violates certain other ERISA provisions.

These cases are still in their early stages, so the outcome is uncertain. Some courts have dismissed the plaintiffs’ claims, while others have allowed the litigation to proceed. Arguably, plans should be able to rely on well-settled regulatory guidance without running afoul of ERISA. However, in light of the U.S. Supreme Court’s 2024 decision in Loper Bright Enterprises v. Raimondo — which held that federal courts should not defer to regulatory agencies’ interpretation of federal statutes — it is not clear whether existing guidance will be followed.

Steps Plans Should Take

Defined contribution plan sponsors and administrators should monitor the ongoing litigation regarding permissible uses of plan forfeitures. In the meantime, there are steps plans can take to minimize their risk. The first step is to review plan documents to ensure that the use of forfeitures is consistent with the plan’s requirements. Demonstrating that the handling of forfeitures complies with the plan’s forfeiture provisions can go a long way toward defending against a breach of fiduciary duty claim.

Next, if the plan gives fiduciaries discretion over the use of forfeitures, consider amending the plan to specify how forfeitures must be used. For example, the plan might state that forfeitures “shall” be used to reduce employer contributions. Or that forfeitures shall be applied first to pay plan expenses, with any leftover funds used to offset employer contributions. By taking discretion out of the equation, it is more difficult for plaintiffs to allege a breach of fiduciary duty.

For more information, contact Stephanie Zaleski-Braatz at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services. Sign up here to receive our blogs, newsletters and Client Alerts.