Retirement plan sponsors often focus on current employees when assessing the effectiveness, cost, and risks associated with a retirement plan. However, to fully understand a plan and ensure compliance, a plan sponsor must also understand the costs and risks related to former employees.
With an increasingly mobile workforce, there are numerous articles about different processes that need to be updated to account for that mobility. An important issue that is not addressed as frequently, and that is a focus of the Department of Labor (“DOL”), is retirement plan account balances for former employees. When an employee moves jobs, she may have a 401(k) account balance at the former employer that she forgets about, or that she did not even know about in the first place. As a result, she may not request a distribution from her former plan, and that plan may be required to continue to hold the money for her. As long as she has an account balance in the plan, she is still considered a plan participant and is entitled to many of the same rights that a current employee enjoys. Additionally, fiduciaries are still required to satisfy their duties with respect to the former employee. These duties include providing participant notices (e.g., annual notices, SPDs, and SMMs), ensuring that required minimum distributions (“RMDs”) are made, offering prudent investment options, and paying only reasonable expenses.
In this article, we highlight some of the risks associated with former employee accounts as well as steps plan sponsors can take to mitigate those risks and improve administration.
What are the risks?
Carrying extra employee accounts normally has a cost; it’s just that simple. Whether it is the regular service charge or some other periodic charge, such as annual mailings, there is a cost. As long as a former employee has an account balance, the charges will continue to rack up.
Furthermore, the likelihood that a former employee will go missing increases as more time passes from the termination date. In these circumstances, an individual is missing when they cannot be contacted via email, mail, or telephone. If a former employee does go missing, a whole host of additional issues may arise. Again, even though the employees are missing, the plan sponsor is still required to comply with plan terms and fulfill their fiduciary responsibilities. Ultimately, it will cost even more money to search for those former employees, and the plan sponsor might not know about events that trigger additional required actions. For example, if a former employee dies with an account balance, there may be timing requirements that need to be met in distributing the account to the participant’s beneficiaries. If the former employee is lost and the plan sponsor does not know about the death, those required deadlines might be missed.
Additionally, former employees can cause operational failures if a plan is unable to distribute RMDs at age 70 ½ or as required by the Internal Revenue Code. The Internal Revenue Service (“IRS”) acknowledged the issues presented by RMDs due to missing participants in a memorandum to its examiners in October 2017. In that memorandum, the IRS stated that examiners should not challenge retirement plan compliance concerning missed RMDs if the plan sponsor has taken specific steps to locate those missing participants. This memorandum demonstrates that the IRS knows this is an issue and has provided a measure of relief; however, the relief is only available if the plan sponsor has followed those steps, and the relief was explicitly limited to RMDs. It did not give protections in other areas.
These issues are especially important because the DOL is actively and aggressively auditing former employee account balances to ensure that plans are taking steps to locate missing former employees who are still in the plan. For instance, in its investigative efforts between October 2016 and August 2017, the DOL’s Philadelphia office stated that it had recovered more than $165 million in benefits for former employees. DOL investigations are time-consuming and require significant resources to comply with requests. Effectively tracking former employees can reduce the burden of a DOL investigation and can minimize the costs associated with corrective actions identified in an investigation.
What should plan sponsors do?
For plan sponsors, neither the IRS nor DOL has provided clear guidance on what steps are required to be compliant in tracking former employees in all circumstances. The guidance that the DOL and IRS has provided has been limited to specific situations. Until full guidance is provided on the issue, plan sponsors should diligently track former employees soon after their termination. For example, if a participant’s quarterly plan account statement is returned from the post office with a bad address, the plan sponsor could use a locator service to initiate a search for that participant immediately, instead of at a later date when he or she might be harder to find.
As many plan sponsors recognize, employees often do not take action on their own. Automatic enrollment is an excellent example of how making an action easier for an employee can achieve desired results. One strategy for mitigating the burden associated with former employees is to cash out small balances as soon as possible after an employee’s termination. Currently, plans are permitted to involuntarily cash out vested account balances less than $5,000. Although the distribution rules are different for vested accounts over $1,000 (i.e., they are required to be rolled to an IRA) than they are for account balances under $1,000 (i.e., they are permitted to be cashed out to the participant), both sets of rules have the same effects on the plan—the account is distributed. It appears that Congress may recognize the complexity and cost associated with tracking former employees because there has been recently proposed legislation, the Retirement Plan Modernization Act (H.R. 4158), which seeks to raise the threshold to $7,600 for involuntary cash-outs, and includes an inflation adjustment provision. While the legislation is in the very early stages of consideration, it signals that there may be changes in the relatively near future.
While plan sponsors cannot currently involuntarily cash out individuals with a vested account balance in excess of $5,000, the plan sponsor may adopt a process of contacting former employees whose balance exceeds that threshold to advise the former employee of her distribution options. Since they are keeping employees aware of the account balances, these additional efforts to contact the former employee may result in additional distributions or, at the very least, may allow the plan sponsor to confirm that it has accurate contact information.
Employers can take additional steps to locate missing former employees who are above the involuntary cash-out threshold and who do not elect to take a distribution. One approach that has increased in recent years is the use of commercial locator services. These services provide potential alternate contact information for former employees with whom the plan sponsor has lost contact. This can help the plan sponsor ensure that it is meeting its fiduciary obligations and that former employees receive distributions at appropriate times.
Without tracking former employees and their account balances, a retirement plan sponsor cannot fully measure the costs, risk, and effectiveness of a retirement plan. With the ever-growing regulatory requirements, DOL initiatives, and the costs associated with plan participants, a plan sponsor should establish practices and procedures to ensure that it can timely make distributions to former employees. These procedures should include involuntarily cashing out former employees as soon as possible, making it easy for employees who are not involuntarily cashed out to take a distribution or rollover, and locating and updating contact information for former employees.