Forfeitures, Revenue Sharing and ERISA Accounts: Here’s What You Need To Know

Forfeitures in Defined Contribution Plans

The term forfeiture comes from Internal Revenue Code Section 411, which addresses vesting requirements for qualified plans. Forfeitures are a common occurrence in defined contribution plans. Unfortunately, so is their improper administration. Participants are entitled to a non-forfeitable or vested portion of their employer-derived contributions in accordance with statutory vesting schedules. Non-vested employer-derived benefits may be forfeited. Partially vested employees who terminate employment are the most common source of forfeitures.

The cash-out provision is the most common method of forfeiture. A cash-out forfeiture occurs when a participant separates from a service and receives a distribution of their entire vested account balance. Another common method of forfeiture is due to the break in service rule. A forfeiture under the break in service rule occurs on the accounting date coincident with or following the fifth consecutive break in service. In general, a break in service is a plan year in which a participant works less than 500 hours. A plan may also forfeit the account balance of a participant that they are unable to locate, known as a lost participant. When a participant is lost, it must be defined in the plan document.

Forfeitures are considered plan assets under ERISA. Plan assets impose rules on forfeitures, and the most significant is ERISA’s fiduciary duty of loyalty. The duty of loyalty requires plan assets to be used to defray reasonable expenses of administering the plan or to provide benefits to participants. Therefore, most plan sponsors will use forfeitures to reduce reasonable plan expenses or to increase or reduce employer contributions such as profit sharing or employer match.

In addition to providing a method to allocate or use forfeitures, the IRS has a time frame in which they must be used or allocated. In general, the IRS will not permit forfeitures to remain unallocated past the end of the plan year in which they arise. However, the IRS has approved plan documents allowing allocation of forfeitures by the end of the plan year following the year in which they arose. Thus, a plan may permit a one-year carryover of forfeitures. Without this language, forfeitures must be allocated by the end of the plan year in which they arose.

Plan Investment Options

Individual account plan record keepers typically provide investment alternatives from which a plan fiduciary may select plan investments. The investment alternatives generally consist of both affiliated and unaffiliated funds, some of which provide revenue sharing to the record keeper in the form of 12b-1 fees, shareholder and administrative service fees, and other payments. Since these payments are a form of compensation that the record keeper receives for services to the plan, the plan fiduciary must evaluate how reasonable the revenue sharing payments are with other forms of compensation the record keeper receives.

In recent years, many record keepers and plan fiduciaries have negotiated a variety of arrangements to enable plans to share in the benefits of revenue sharing payments. While the specifics of these arrangements vary, they have generally been structured in one of two ways. First, certain arrangements deposit some or all of the revenue sharing payments into a plan account, which may then be used to pay for plan expenses or reallocated to participant accounts. The second option requires the record keeper to maintain records of the revenue sharing payments received as a result of plan investments, and it allows the plan fiduciary to direct the record keeper to pay third parties for administrative services provided to the plan.

Pursuant to the above, plan fiduciaries should:

• Periodically review and evaluate the plan’s arrangement with its record keeper.
• To an extent, some or all the record keeper’s compensation is paid through a revenue sharing arrangement. Evaluate whether the plan has or should have an Employer Retirement Income Security Act of 1974 (ERISA) budget arrangement to recapture some or all the payments for the benefit of the plan.
• Confirm that the plan document language regarding the payment of expenses is consistent with the provisions of the service agreement and plan’s operation.
• Make certain that any amounts not spent on paying reasonable plan administrative expenses are allocated to participant accounts by the end of the year.

ERISA Budget Accounts

In general, an ERISA budget account should be used for the period to which it applies. Plan sponsors should use the account to pay reasonable plan expenses on an annual basis with any funds remaining at year end allocated to participants. Alternatively, a plan sponsor can also determine that a 12-month period, other than the plan year, is more appropriate.

For assistance with revenue sharing, ERISA accounts or other investment questions, please contact your local Sikich advisor.

By Michael Johnson, Director, Retirement Plan Services