By Jeremiah D. Wood
The COVID-19 pandemic is causing significant disruptions to normal everyday life, and part of this normal everyday life is retirement planning. This alert is intended to provide guidance to retirement plans in this very unusual time we find ourselves related to retirement plans. The first section is related to defined contribution plans, and the second section is related to defined benefit plans.
Defined Contribution Plans (e.g., 401(k), 403(b), 401(a), and 457(b) plans)
Even though it seems obvious, it is worth noting that contributions to defined contribution plans are based on the amount of compensation an employee receives, thus, if an employee is not paid during a furlough, they will receive less in contributions. In addition, for those employee contributions made pursuant to the employee’s own deferral election (or an automatic enrollment), during this unpaid furlough, the employee will not be entitled to make pretax, Roth after-tax, or traditional after-tax contributions to their retirement accounts. If the employee is receiving paid time off, then typically this is included in compensation that can be deferred from and used to determine employer contributions on behalf of the employee.
In addition to compensation, an employee’s hours of service are typically critical to various portions of a defined contribution plan. For instance, hours of service generally determine an employee’s eligibility, vesting, and/or allocation rights under the plan. During a furlough, employees generally will not accrue hours of service. Accordingly, if an employee is not able to accumulate the requisite hours of service for the year (or for a payroll period), the employee may not be entitled to a year of service for retirement plan eligibility, vesting, or allocation (absent a plan amendment to address this issue). Depending on the terms of the plan, there are complicated rules related to how to treat the employee when he/she comes back to work, and these generally rely on how long the break in service is, how many hours of service the employee worked during the current year, and how many years of service the employee had when the furlough began.
A furlough does not necessarily constitute a severance from employment for defined contribution plan purposes. Therefore, employees who are furloughed may not be entitled to receive a distribution from the plan until an actual severance from employment occurs. This will be unfortunate for some employees running out of resources that need access to the funds in their defined contribution plan. Depending on the terms of the defined contribution plan, an employee may be able to take an in-service distribution. For instance, a plan may provide for an in-service distribution upon the financial hardship of the participant. If your defined contribution plan does not provide for in-service distributions, including hardship distributions, then contact your plan provider if you would like to add in-service distribution options to your plan.
If the percentage of employees furloughed is significant enough, then there would be a partial termination of the plan. A partial termination of the plan results in those impacted employees (i.e., those who had an employer initiated severance from employment during the measuring period) becoming 100 percent vested in their accounts in the plan. Generally, there is rebuttable presumption of a partial termination if there is a 20 percent reduction in the number of participants covered by the plan during the measuring period, which can be a year or more.
Defined Benefit Plans (including Cash Balance Plans)
A defined benefit plan promises a benefit to the participants in the plan upon the participants’ retirement or termination of employment. The benefits promised by the defined benefit plan are set in the plan document, and it is not related to how the investments of the plan perform in the market. Thus, if there is a large reduction in the assets in the defined benefit plan due to a market downturn, there will be a shortfall in the assets in the defined benefit plan compared to what benefits are promised. This funding shortfall may have to be made up by the defined benefit plan sponsor (i.e., the company that started the plan) if the funding shortfall is significant enough at the time the actuary calculates the annual contribution.
Indeed, there are certain minimum funding amounts that would be required if the funding shortfall is significant enough. This required minimum funding is in addition to the normal contribution required for the benefits that accrue each year. Therefore, the amount that is actuarially calculated as being required to be contributed to the defined benefit plan could be significantly more than what the plan sponsor is used to because it would include the normal contribution plus the amount to make up the funding shortfall. If the required minimum funding amounts are not contributed to the defined benefit plan by 8.5 months following the end of the plan year (i.e., September 15 for calendar year plans), then there is an excise tax of 10 percent of the missed minimum funding obligation. Additionally, if the plan is covered by the Pension Benefit Guaranty Corporation (PBGC), then the premiums that are paid to the PBGC may go up if there is a larger than normal funding shortfall because a portion of the PBGC premiums are based on the funding level of the defined benefit plan.
There are steps you can take to avoid having to make larger contributions to the defined benefit plan when there is a significant market downturn. One of these steps would be to freeze the defined benefit plan to stop the benefits that would normally accrue during 2020. This would remove the obligation to make the contribution normally made each year, and this would help ease the financial obligation if there is required minimum funding due to make up for a funding shortfall that is related to investment losses. It is important to remember that any funding shortfalls related to the recent market downturn, and thus any required minimums, would not be required until the year 2021 when the 2020 plan year contributions are due.
Unfortunately, time is of the essences if a plan sponsor would like to freeze the defined benefit plan because the freeze must occur prior to the participants in the plan accruing a benefit. Typically, a participant must work 1,000 hours to accrue a benefit, but some plans only require 500 hours of service (or fewer) to accrue a benefit. Thus, the freeze amendment must be done prior to the participant reaching the number of hours required to accrue a benefit. During a calendar year, individuals working full time would work 1,000 hours of service somewhere around May 15, but this will vary depending on the work schedules of the employees in the plan. In addition, there is a notice that must be provided to the participants, and this notice is typically required 15 days prior to the freeze amendment being effective.
In addition to the partial termination discussed above in the defined contribution plan section which also applies to defined benefit plans, a freeze of a defined benefit plan would also likely be considered a partial termination. This requires all affected participants to become 100 percent vested in their benefits in the defined benefit plan.
If a defined benefit plan is frozen to see how the market comes back during 2020, it would not have to be permanent. A plan sponsor is allowed to unfreeze a frozen plan. If the amendment to unfreeze is not discriminatory in its timing and certain benefits and missed accruals are restored for all employees during those years, then a plan could unfreeze and make up for the frozen year(s). Alternatively, a frozen plan could be unfrozen prospectively so that only future accruals will occur after the unfreezing.
An important distinction here is the difference between a plan freeze and a plan termination. A freeze is not the same as a plan termination because the plan is continuing; the only aspect of the plan that is changing is a cessation of future benefit accruals. A plan termination would result in funding the defined benefit plan sufficiently to ensure there are enough funds to pay the benefits promised to the participants, distributing all account balances out of the plan, and, if necessary, going through the PBGC’s termination procedure.
We expect to see IRS guidance in the coming days and weeks providing relief applicable to all retirement plans, but unless and until that relief is issued, all retirement plans deadlines continue to apply, including, for example, the deadline for making contributions to the plan (including quarterly minimum funding contributions to a defined benefit plan), the Form 5500 filing deadline, and all coverage and nondiscrimination testing requirements.
Jeremiah D. Wood practices in the firm’s Employee Benefits and Executive Compensation Practice Group. His practice includes experience in the design, implementation, administration and termination of tax-qualified retirement plans (including traditional pension plans, cash balance plans, profit sharing plans, 401(k) plans, and ESOPs), 403(b) plans, nonqualified deferred compensation plans (including 457(b) and 457(f) plans and deferral compensation arrangements for executives) and health and welfare plans.
Disclaimer: The information included here is provided for general informational purposes only and should not be a substitute for legal advice nor is it intended to be a substitute for legal counsel. For more information or if you have further questions, please contact one of our Attorneys.