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Many employer-sponsored defined contributions plans, including 401(k) profit sharing plans and money purchase pension plans include a vesting schedule – a period over which a plan participant earns a nonforfeitable right to the employer’s contributions, such as matching and profit sharing contributions. If a participant leaves employment with the plan sponsor before the contributions are fully vested, they may forfeit all or a portion of these contributions. The forfeitures are moved to a forfeiture account and then, depending on the terms of the Plan, used to (i) restore forfeitures for participants who return to work for the employer, (ii) pay plan expenses, (iii) off-set future employer contributions, or (iv) some combination of these.

Recently, there has been an increase in lawsuits filed against retirement plan fiduciaries, alleging breaches of fiduciary duty related to how forfeitures are used in retirement plans. Specifically, these lawsuits allege that an employer's use of plan assets to offset its contributions is self-dealing, which violates ERISA's prohibited transaction and anti-inurement rules, as well ERISA's fiduciary requirements. The claims also focus on provisions that give the Plan Administrator discretion to use forfeitures to pay plan expenses, to reduce future employer contributions, or to allocate the forfeitures to participant accounts. The novel legal theory in these suits is that fiduciaries are misusing their discretion in applying forfeitures to benefit the employer.

Many plan documents allow the Plan Administrator discretion in deciding how to use forfeitures rather than directing how the forfeitures are used. Typically, when a Plan Administrator is acting with discretion, they are acting in a fiduciary capacity. In contrast, when there is no discretion, the Plan Administrator generally acts in a ministerial capacity. The crux of the alleged claims is that when the Plan Administrator uses forfeitures to offset future employer contributions, it may not be acting in the best interests of plan participants—thus violating the exclusive benefit rule – the fiduciary duty to act solely in the interest of the participants with the exclusive purpose of providing benefits to them.

Federal district courts have varied in their rulings on whether an employer’s use of forfeitures to offset its contributions violates ERISA. The majority of district courts to date have held that such use does not constitute a violation. There are also differing results coming out of the district courts on alleged violations of the exclusive benefit rule. In cases where the plan document gives the Plan Administrator discretion on how to use forfeitures, some courts have ruled that using forfeitures to offset employer contributions violates this rule.

Plan sponsors and fiduciaries should review their plan language to determine whether changes would help limit potential liability in the event of litigation. For example, plan sponsors should consider amending their plan documents to specify exactly how forfeitures are to be used. This would eliminate discretionary decision-making by the Plan Administrator. The amendment might stipulate that forfeitures will be used to pay plan-related expenses, or, alternatively, will follow a prioritized order: first, to restore forfeitures for former participants who return, then to pay plan expenses, and finally, the Administrator shall use any remaining forfeitures to offset employer contributions.

If you want assistance with reviewing and evaluating your plan document or forfeiture process, or if you have any questions about the 401(k) forfeiture litigation, please contact any member of our Employee Benefits practice group.