November 9, 2009
With the downturn in the economy, many employers have been forced to lay off employees and alter their benefit plans. Employers should pay close attention to these kinds of changes because they can trigger a partial termination of their qualified retirement plans. When a partial plan termination occurs, IRS rules require that plan sponsors identify and fully vest all plan participants who are affected by the partial termination.
What Can Cause a Partial Termination?
Whether or not a partial termination of a qualified retirement plan occurs is based on the facts and circumstances of a particular situation. The types of events that can give rise to a partial termination include:
- a workforce reduction;
- a plan amendment excluding employees previously covered under a plan; or
- a reduction in the rate of future accruals under a defined benefit plan.
How to Determine if a Layoff Caused a Partial Termination?
Although determining when a workforce reduction triggers a partial termination is not a completely settled issue, the IRS recently provided some guidelines based on a plan’s turnover rate. If the turnover rate is at least 20%, there is a rebuttable presumption that a partial termination has occurred. If the turnover rate is less than 20%, there is a presumption that there has not been a partial termination.
The IRS defines the turnover rate as the ratio of the number of participants who had an employer-initiated termination of employment over the total number of employees who participated in the plan during the applicable period (the number of active participants at the beginning of the period plus the number of employees who became eligible during the period). Employer-initiated terminations generally include all terminations other than terminations due to death, disability or normal retirement and terminations that the employer can demonstrate were purely voluntary. Although not specifically mentioned in the recent IRS ruling, there are cases that also exclude terminations for cause from the group of employer- initiated terminations. Both vested and non-vested participants are taken into account in calculating the turnover rate.
The applicable period for measuring the turnover rate is usually a plan year, but a longer period may be considered if a series of related workforce reductions occurs over multiple years.
Which Employees Must Be Vested?
While clarifying some of the considerations involved in identifying a partial termination, the IRS created some confusion over which participants are affected by a partial termination. Most courts have indicated that participants who voluntarily terminated, were terminated for cause or terminated due to death or disability during the period of the partial termination need not be vested. However, the IRS’s recent ruling appears to require all participants who terminated employment during the period to be fully vested, without carving out an exception for those employees who were not directly affected.
Upon a partial termination of a defined contribution plan, all affected participants must be fully vested. In the case of a defined benefit plan, however, affected participants must be vested only to the extent that their benefits would be funded if the plan were to then be completely terminated. When determining which benefits are funded, unvested benefits (determined without regard to whether there has been a partial termination) are last in line. Historically, because of the significant discrepancy between funding on an ongoing basis versus funding on a termination basis, this often meant that a partial termination of a defined benefit plan did not actually result in additional vesting. However, since the Pension Protection Act of 2006 generally requires that plans maintain a higher level of funding than before, there is a greater chance that a partial termination will require additional vesting for affected participants in defined benefit plans.
Administrative Difficulties of Retroactive Vesting
Identifying that a partial termination occurred well after the fact can lead to administrative headaches related to vesting the affected participants. For example, in the case of a partial termination triggered by a layoff, many of the affected participants may have already cashed out their entire vested benefit. This means that accounts and benefits must be reestablished and funded to the extent that unvested benefits were forfeited and reallocated. In addition, the former participants will have to be located and notified of the additional amount they are owed from the plan.
Why Do Plan Sponsors Need to Be Concerned About Potential Partial Terminations?
If a plan sponsor fails to identify that a partial termination occurred or fails to vest all the affected participants, the plan would be at risk of being sued for benefits by participants who were affected but who were not fully vested or being subject to adverse action by the Department of Labor. In addition, the failure to vest affected participants could jeopardize the plan’s tax-qualified status. Employers will want to make sure that any possible partial terminations are identified and that all affected participants are fully vested so that potential plan qualification issues are timely addressed. If there is uncertainty about whether a partial termination has occurred, plan sponsors can request a ruling from the IRS to make this determination.
Please click here for a PDF of this newsletter.