During this period of global economic turmoil, many employers are experiencing employee turnover rates that far exceed historic levels. Although often overlooked, substantial reductions in an employer’s workforce can result in the partial termination of the employer’s retirement plan(s). For the reasons described below, this is something to be avoided where possible, given that a partial plan termination is costly and administratively burdensome and may lead to class action litigation and plan disqualification.
20% is the Magic Number
Section 411(d) of the Internal Revenue Code (the “Code”) provides that, when a qualified employee benefit plan terminates or partially terminates, the rights of all “affected employees” to benefits accrued under the plan through the date of the termination or partial termination must become “nonforfeitable” (i.e., fully vested). Class action litigation over alleged “partial terminations” frequently occurs when unvested terminated participants seek to enforce these retirement plan rights under ERISA.
Although the Code and IRS regulations have not defined a precise standard for determining when a partial termination occurs, the IRS’s most recent guidance, in Revenue Ruling 2007-43, has generally followed the analysis of the Seventh Circuit in Matz v. Household Int’l Tax Reduction Inv. Plan, 388 F. 3d 570, 578 (7th Cir. 2004). In Household, a series of reorganizations from August 1994 through June 1996 caused more than 20% of the participants to cease participation in Household’s defined-contribution plan. Under the plan’s design, Household matched employee contributions to individual accounts, and the matching contributions were subject to a vesting schedule. Class action litigation followed.
The Seventh Circuit in Household and the IRS in Revenue Ruling 2007-43 both adopt a presumption that a partial termination occurs where at least 20% of participating employees have an employer-initiated severance from employment over the applicable period. The Seventh Circuit stated that a turnover rate between 10% and 20% was presumptively not a partial termination, and turnover rates below 10% were conclusively not partial plan terminations. A turnover rate above 40% “should be conclusively presumed to be a partial termination,” according to Household. The Seventh Circuit also recognized that multiple reductions in force could be aggregated over a period of years if the employment losses resulted from the same corporate event or related corporate events.
How to Calculate the Turnover Rate
The turnover rate is usually calculated by dividing the number of participants who have had an employer-initiated severance by the sum of (i) all participants at the beginning of the applicable period, and (ii) those participants who have been added to the plan throughout the applicable period. Both vested and non-vested participants are included in the numerator and the denominator, but inactive participants are not included in the denominator. Employers have the burden of proving that termination was voluntary, rather than employer-initiated.
Under Revenue Ruling 2007-43, the IRS does not require that the following participants be included in the numerator:
- Participants who become immediately covered by a successor plan in the same controlled group.
- Participants whose termination is due to death, disability, normal retirement, cause or voluntary acceptance of an early retirement program.
Employers should retain necessary documentation to demonstrate the reason for all employee terminations.
What Facts Might Rebut (or Not Rebut) the 20% Presumption for a Partial Termination?
In discussing what facts might rebut the presumption that a partial termination has occurred, the Seventh Circuit in Household discussed the facts in Administrative Committee of Sea Ray Employees’ Stock Ownership & Profit Sharing Plan v. Robinson, 164 F.3d 981, 987-88 (6th Cir.1999). The Court specifically noted that in Robinson, “a 27.9 percent loss of coverage was held not to be a partial termination because the loss was the consequence purely of economic conditions; the employer was not motivated by any desire to obtain a tax benefit or reallocate pension benefits to favored participants in the pension plan.” Having said this, given the position that the IRS has taken in Revenue Ruling 2007-43 — that severances due to economic downturns can be characterized as employer-initiated — plaintiffs and the IRS are likely to challenge such an argument.
Under the same Revenue Ruling, the IRS does make clear that voluntary terminations may be excluded from the equation. However, as noted above, the burden of proof regarding the voluntary nature of the separation is on the employer. Again, clear and unambiguous records showing whether terminations are voluntary or employer-initiated are vital in cases where partial terminations might arise.
Also, the IRS has clarified that the employer’s normal level of employee turnover is another fact that could be used to rebut the 20% presumption. To the extent that it is commonplace for an employer to have annual turnover that exceeds 20% and workers are replaced, compensation remains steady, and the job functions are consistent over time, the employer may be able to demonstrate that this is not the type of situation that the partial termination rules are meant to protect.
Avoiding Unexpected Plan Expenses Caused by a Partial Terminations
Employers that are considering a reduction in force should carefully evaluate whether these decisions will trigger a partial termination of a retirement plan. As the Household case illustrates, years of class action participant litigation could result, special contributions might be required to replenish the forfeited accounts of otherwise unvested, terminated participants, and the IRS could take action to disqualify the plan.
Even if an employer avoids those costs through the timely recognition of a partial termination, the employer will lose access to the forfeitures of those terminated participants that the employer might otherwise be able to use to offset plan expenses and fund future employer plan contributions.
Further, in addition to the direct expenses of a partial termination, there will be the indirect costs and the administrative complexity of:
- Calculating and allocating contributions to terminated participants to fully vest them in their account balances;
- Locating and making actual payments to terminated participants; and
- Properly documenting the correction process through plan amendments and necessary resolutions.
Given the costs of a partial termination, some employers choose to file for a formal determination by the IRS as to whether a partial termination has occurred. Although this provides no absolute defense to class litigation, an IRS determination that no partial termination has occurred would likely be potent evidence the employer could use in court.
Some employers will undergo reductions in force of a sufficient magnitude that will enable them to recognize immediately that a partial termination has occurred and to provide full vesting to affected employees without too much administrative aggravation. However, where reductions in participation may occur over several years or in several tranches, the employer should document the reason for each termination. Where applicable, the employer should also maintain records showing that the reductions resulted from unrelated corporate events and should not be aggregated to form a partial termination.