Forfeiture lawsuits have been in the news a lot lately. It may have you second-guessing what to discuss or do for clients and built-up forfeitures in their retirement plans. However, there are two critical aspects you should cover with your clients about forfeitures in 2024.

First, consider whether clients can utilize relief provided by the IRS in 2024 for any forfeitures not timely used in prior years. Second, determine if clients’ forfeiture use is susceptible to a potential lawsuit. Helping clients comply with the law and avoid lawsuits makes you a valued resource.

Forfeiture Use in Retirement Plans

In early 2023, the IRS released proposed regulations on general forfeiture rules. Most of the guidance provided has been industry standard for decades. For example, the proposed regs advised that a defined contribution (i.e., 401(k) profit sharing plan or ESOP) plan document should have provisions detailing how and when forfeitures will be used or allocated.

The IRS also clarified that forfeitures in a DC plan may be used for any of the following:

1. paying plan administrative expenses,
2. reducing employer contributions, or
3. increasing benefits in other participants’ accounts.

Many plans and their documents already comply with these guidelines.

However, there is one forfeiture aspect that tends to be missed: the timely use of forfeitures. The IRS wants forfeitures to be used no later than 12 months after the close of the plan year in which the forfeitures are incurred. Unfortunately, some plans have built up forfeiture balances that have not been properly used for a long time.

Transition Rule for 2024

The IRS considers it to be an operational failure if forfeitures remain unused beyond the 12-month deadline. Thankfully, the proposed regs provide transitional relief for old forfeiture balances. For any forfeitures incurred during any plan year that begins before January 1, 2024, the IRS will treat those forfeitures as having been incurred in the first plan year that begins on or after January 1, 2024.

For example, you take over a plan in 2024 with a calendar year end from another TPA. You notice there is a balance that transfers over that is simply labeled “forfeitures” in the system. It is a large sum and the plan sponsor was unaware of this “forfeiture” account. Under the proposed reg’s transition rule, you can consider the full amount in the “forfeiture” account to be forfeitures incurring in the 2024 plan year.

As such, the plan sponsor has until December 31, 2025, to fully use those forfeitures. If the forfeiture amount is really large, you may want to start using forfeitures for fees or contributions in 2024 to ensure the entire forfeiture balance is used by the end of 2025.

Defined Benefit Plan Forfeitures

We mainly focus on forfeitures in DC plans, but they also occur in defined benefit (i.e., pension) plans. For DB plans, the proposed regs state that reasonable actuarial assumptions should be used to determine the effect of expected forfeitures on the present value of plan liabilities under the plan’s funding method.

Differences between actual forfeitures and expected forfeitures will increase or decrease the plan’s minimum funding requirement for future years pursuant to the plan’s funding method. Therefore, DB plans do not have to worry about whether forfeitures are timely used to pay expenses or increase the benefit accrual.

The Rise of Forfeiture Lawsuits

Lawsuits filed in 2024 allege that plan fiduciaries are improperly using forfeitures. Both sides claim victories based on the early results. Consequently, there is no clear direction yet on how these lawsuits will affect plan administration. However, you can assist clients now by discussing the following strategies for preventing or avoiding a forfeiture lawsuit.

Paying Plan Expenses With Forfeitures

The current lawsuits generally make the same claim. Participants believe fiduciaries – if given the discretion – have an obligation to pay plan expenses with forfeitures before they can be used to reduce an employer’s contribution obligation (e.g., matching or profit-sharing contribution). Participants argue that forfeitures are plan assets and must comply with the exclusive benefit rule.

If the plan provides discretion to the fiduciary, the argument is that forfeitures must be used to pay plan expenses which would otherwise be deducted from participants’ accounts. If any forfeitures remain after paying all plan expenses, then they may be used for the employer’s benefit in reducing a contribution obligation. Therefore, a plan fiduciary doesn’t have to worry about a potential forfeiture lawsuit if forfeitures are being used to first pay plan expenses.

If a plan has deducted expenses from participants’ account while using forfeitures to reduce a contribution obligation, the plan sponsor may want to consider one of the following strategies to prevent a future lawsuit:

1. Remove any discretion in the plan document for the fiduciary to use forfeitures to pay plan expenses (see section below).
2. Switch operations to use forfeitures to pay plan expenses first then any remaining amount can be used to reduce a contribution obligation.
3. Change policy to have the employers pay for plan expenses instead of those expenses being deducted from participants’ accounts.

Specifying the Use in the Plan Document

The foundation for forfeiture lawsuits relates to discretion provided to the fiduciary in the plan document. A few restatement cycles ago, most pre-approved plan documents changed their forfeiture section to allow full flexibility in how forfeitures were used. Specifically, the fiduciary had the discretion to use any of the three permissible methods – pay plan expenses, reduce employer contributions, or increase benefits – and could switch the method year to year if desired.

The document change was made to ease plan administration. Prior to the change, the plan sponsor had to specify in the document which one of the three methods would be used. For example, the document would state “forfeitures would be used to offset employer contributions first and if any forfeitures remain, pay plan expenses, then increase participant benefits.” Consequently, the plan sponsor needed to timely amend the document in order to make any modification to that specific language.

If your clients are concerned about a forfeiture lawsuit, you may recommend they return to the old method. In other words, the plan sponsor should specify that forfeitures will be first used to reduce the employer’s contribution obligations. In doing so, the plan sponsor takes any discretion away from the fiduciary and eliminates any alleged fiduciary breach.

Don’t Forfeit Forfeiture Relief

Forfeiture use can be a forgotten piece of plan administration – especially if forfeitures don’t occur each plan year. Make sure to use the transitional relief provided by the IRS to clean up any old forfeiture balances in 2024 and 2025. Although the regulations providing the relief are not finalized, the IRS allows plan sponsors to rely on them for periods preceding the applicability date.

In addition, if your clients are looking to avoid forfeiture lawsuits, they should consider how they are currently using forfeitures in their plans. They may consider an operational or document change to prevent any future lawsuit. As more of the current lawsuits conclude, we should have a clearer picture on how much, if any, the lawsuits affect future use of plan forfeitures.

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About the Author

Brian Furgala, Esq., CPC, QPA is Senior Director, Retirement Services Strategy for PenChecks, a leader in outsourced retirement plan distribution processing and Automatic Rollover/Missing Participant IRAs and related services. His broad experience as an ERISA attorney and senior executive for several leading retirement plan service providers gives him a unique perspective on the industry.

The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust®, its subsidiaries or affiliates.

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