Retirement Plans: To Vest or Not To Vest

For many companies, 2020 was a difficult financial year. As a result, many companies had no choice but to implement reductions in force. One frequently misunderstood collateral issue associated with a reduction in force is its potential impact on the company’s retirement plan.

For example, assume a company lays off a number of employees who have nonvested accounts in the company’s retirement plan. The company declares a forfeiture of the nonvested accounts and allocates the forfeitures among other plan participants. Then, in a future IRS audit, the IRS determines that the layoffs resulted in a plan “partial termination” and that the laid-off employees should have been fully vested in their plan accounts. Unscrambling the earlier allocation of improperly forfeited accounts can be both awkward and expensive. As discussed below, the Consolidated Appropriation Act, 2021 (the Act) includes a technique for possibly avoiding a partial termination.

A retirement plan “partial termination” occurs if 20% or more of the plan’s participants become ineligible to participate in the plan during the applicable period, which may be a plan year or in some situations multiple years, due to employer-initiated events such as a reduction in force. This is known as the turnover rate. If the plan’s turnover rate is 20% or more, then a partial termination is presumed to have occurred. If a partial termination occurs, the law requires all “affected employees” to be fully vested in their plan accounts. For these purposes, “affected employees” include all employees who terminated employment for any reason during the applicable period in which the partial termination occurred.

The typical period for calculating whether a partial termination has occurred is a plan year. The relief provided by the Act provides that a retirement plan will not be treated as having a partial termination during any plan year which includes the period beginning on March 31, 2020, and ending on March 31, 2021. This means that if the number of eligible plan participants on March 31, 2021, is at least 80% of the number of eligible plan participants on March 31, 2020, then a partial termination has not occurred. Accordingly, an employer may be able to rehire some previously terminated employees or otherwise modify the plan to allow participation by employees who were not previously eligible to participate after December 31, 2020, and before March 31, 2021, to avoid triggering the 20% turnover rate.

Practical Tips

Plan sponsors should review their plan documents to determine whether the Act’s relief can be applied to their retirement plans. If the plan document simply cross-refers to the definition of partial termination contained in the Internal Revenue Code, the Act’s relief should apply. However, if the plan provisions detail how the partial termination is determined and states that the test must be run on a plan year basis (e.g. January 1 to December 31), the Act’s relief might not apply. In addition, plan sponsors should review their plan provisions which address the timing of forfeitures. More specifically, some plans provide that participants will not be deemed to have forfeited their nonvested account balances until the occurrence of a five-year Break in Service. This type of provision would defer the timing of the forfeiture and prevent an unexpected restoration problem if there is a subsequent finding within the five year period that a partial termination occurred.