Forfeiture Funds: Legal Requirements, Permitted Uses, and Litigation Risk Management

Forfeiture funds in 401(k) plans represent a unique asset pool with specific regulatory requirements and practical applications. Forfeiture funds arise when participants terminate employment with the company before becoming fully vested in employer contributions allocated to them. Unlike participant contributions which immediately vest, these unvested benefits—the forfeiture—revert back to the plan. Properly managing forfeiture funds is crucial for plan sponsors; as fiduciaries, plan sponsors should ensure that forfeiture funds are used in a manner that complies with both federal regulations and the plan document.

What Are Forfeiture Funds?

Forfeiture funds in 401(k) plans are assets that arise when participants do not fulfill the vesting requirements for employer contributions. The plan document will define how long an employee must remain with an employer to secure ownership of these employer-funded contributions. When a participant terminates employment before fully vesting, the unvested portion of the employer contributions is “forfeited” back to the plan, creating what is known as a forfeiture fund.

The Employee Retirement Income Security Act of 1974, as amended (“ERISA”) and related IRS regulations provide that forfeiture funds may not be retained indefinitely; they must be used for specific purposes that benefit the plan or its participants. These permitted uses should be outlined in the plan document and must align with the plan sponsor’s fiduciary duties under ERISA, which mandate that plan assets be used exclusively for the benefit of participants and beneficiaries. The IRS and DOL specify that forfeiture funds must generally be used within the plan year in which they arise or as soon as administratively feasible. Recent IRS guidance requires use of forfeiture funds by the last day of the plan year following the plan year in which the forfeitures occur. Failure to use or properly allocate forfeiture funds within this time frame may raise compliance issues and expose the plan sponsor to claims of misuse or improper administration.

Permitted Uses of Forfeiture Funds

Permitted uses of forfeiture funds are typically outlined in the plan document and may include:

• Reducing Plan Expenses: Forfeitures can be used to pay for reasonable administrative expenses related to the plan, such as recordkeeping, accounting, or legal services.
• Reducing Employer Contributions: Forfeiture funds can offset future employer contributions, thereby reducing the employer’s cash outflow to fund the plan.
• Allocation to Participants: Some plans allow forfeitures to be reallocated to the accounts of other plan participants. If reallocation is permitted, the plan document must specify the method for allocation among participants to ensure it is equitable and non-discriminatory.

Each permitted use must align with both ERISA’s fiduciary obligations and the plan document’s specific language. Decisions on how to use forfeiture funds is a fiduciary decision; when confronted with options, fiduciaries must choose to act in the best interest of plan participants, not in the best interest of the company. Recent litigation advances claims that using forfeiture funds to reduce employer contributions rather than to bolster participant accounts could be deemed a breach of the fiduciary duty of loyalty and that  using forfeiture funds to reduce employer contributions instead of offsetting administrative costs could also be viewed as a breach of loyalty. While these theories have not been fully litigated at this point and strong defenses to these claims exist for plan sponsors, the burst of cases being filed highlights the need for a review of the plan document and processes for dealing with forfeiture funds.

Using the Plan Document to Limit Litigation Risk

The plan document is the foundation for properly managing forfeiture funds and minimizing litigation risk. Here are key strategies for using your plan document effectively to limit risk exposure related to forfeiture funds:

1. Clearly Define Forfeiture Fund Uses: Ensure that your plan document explicitly lists all permitted uses of forfeiture funds and complies with IRS and DOL regulations. This clarity prevents fiduciary missteps that could arise from ambiguous or outdated plan language.
2. Establish a Clear Allocation and Timing Policy: The plan document should specify a timeline for the use of forfeiture funds, aligning with the requirement to apply these funds within the plan year or as soon as administratively feasible. Clear timing provisions help mitigate compliance risk and prevent participant claims of mismanagement or delay.
3. Outline Specific Procedures for Expense Payments: If forfeiture funds are used to pay plan expenses, the plan document should detail the types of expenses covered and the approval process for these payments. Documenting this process provides a safeguard against claims that the funds were misused for arbitrary expenses.
4. Consider a Regular Review Process: Incorporate language that supports periodic review of the forfeiture fund allocation process, perhaps annually. This review process ensures the plan stays compliant with evolving regulations and reinforces prudent fiduciary practices.
5. Implement Participant Communication Provisions: Communicate clearly with participants about the purpose and management of forfeiture funds. Transparency in explaining how these funds are applied can build trust and reduce the likelihood of litigation stemming from participant misunderstandings.
6. Work with Legal and Financial Advisors: While the plan document should provide a comprehensive framework, engaging experienced advisors to regularly review forfeiture fund policies and practices can help ensure ongoing compliance and identify areas for improvement.

Conclusion

Forfeiture funds, while a valuable resource for 401(k) plans, require careful management to ensure compliance and mitigate litigation risk. By thoughtfully crafting and regularly reviewing plan document language, plan sponsors can create a robust framework for using forfeiture funds effectively and in compliance with ERISA fiduciary standards. This proactive approach minimizes risk exposure and provides clear guidelines for plan fiduciaries to follow, ultimately helping to safeguard both the plan and its fiduciaries from litigation.