New developments have been unfolding regarding the use of forfeitures in retirement plans. Over the past several months, a handful of pending proposed class action lawsuits have been filed challenging how companies use 401(k) forfeitures. The participant plaintiffs in these suits claim their employers breached their fiduciary duties under the Employee Retirement Income Security Act (ERISA) by reducing their expenses on employer contributions rather than using them to lower plan fees for participants. The suits allege the employer put their interests over those of their employees.

401(k) plan forfeitures occur when an employee leaves a company before the employer contributions are fully vested, which is a common provision that applies to employer matching or profit sharing contribution types. In early 2023, the Internal Revenue Service (IRS) reaffirmed its position on forfeitures with proposed regulations, permitting 401(k) plan forfeitures to be used for any of three permitted purposes: to pay plan expenses, to reduce employer contributions, or to make an additional allocation to participants. Forfeitures are initially held in a separate forfeiture account, but the IRS requires forfeitures to be applied towards these purposes and removed from the forfeiture account by the end of the plan year following the year in which they were forfeited. In its most recent guidance, the IRS reminded plan sponsors that plan language must authorize the use of forfeitures for these purposes before they can be applied.

Hayes Pawlenko LLP, a law firm out of Pasadena, California, is leading the charge on the new wave of 401(k) forfeiture cases involving several large plans including, but not limited to: Qualcomm, HP, Honeywell, Clorox, Mattel, Intuit, and Thermo Fisher Scientific. These lawsuits allege plan sponsors violated ERISA by using “forfeited” 401(k) money to pay for company contributions to workers’ accounts rather than offsetting some of the administrative costs that all participants pay. In many of the pending cases, the plan documents explicitly permit the companies to use forfeited funds to reduce their contributions to employee accounts. As a result, the companies have filed motions to dismiss the claims, arguing that the plan participants cannot sustain their breach of fiduciary duty lawsuits when their use of the forfeited funds is specifically permissible under the plan provisions. The companies also point out that the IRS and both existing and proposed Department of Treasury regulations fully support companies’ usage of forfeited 401(k) funds in this manner.

Claims regarding the use of forfeitures is a brand-new area of scrutiny within retirement plans and can be costly for plan sponsors in legal fees. To protect your plan and avoid potential allegations there are a few ways to address the issue:

• Understand your plan document – It’s important to know how your plan document addresses the use of forfeitures. Some documents state that the treatment of forfeitures is a settlor function, which may be made by an employer in the interest of the company. The distinction here is important because trustees and committee members have a fiduciary obligation to act in the best interest of participants, but as an employer wearing the “settlor” hat, there is no duty to act in the best interests of participants, just like the employer is under no duty to act in the participant’s best interest when it amends the plan to reduce benefits or terminate the plan.
• Review discretionary language – If your document allows for choice, or discretion, within the adoption agreement, you may be exposed to liability due to uncertainty. Language such as “or” suggests choice in allocating forfeitures funds and a best practice may be to set a specific hierarchy order of use and make sure to follow that hierarchy as part of the procedure. Another option is to remove discretion altogether.
• Make sure forfeitures are being used – A bigger issue with the IRS is making sure forfeitures are used timely, otherwise it is an operational failure. Forfeitures generally must be used by the end of the year following the plan year in which they occurred.
• Document, document, document – As with everything in 401(k) land, establishing a repeatable process and documenting the process is the best way to avoid unnecessary scrutiny. If your document is ambiguous regarding how forfeitures are used, consider removing the discretionary element and make sure you execute your process in a consistent manner.

The use of forfeitures continues to develop as motions to dismiss are ruled on and new precedents are established. Aldrich Wealth will continue monitoring this issue and will assist in developing prudent processes and best practice adoption, which may help protect plan sponsors against litigation.