Beginning in late 2023, a flurry of lawsuits was filed alleging that defined contribution (DC) plan forfeitures were misused—by not following a prudent process to benefit participants, not following the terms of the plan document, or not using forfeitures in a timely manner. As the litigation percolates, we have noted certain themes summarized below.

Background on DC Plan Forfeitures Suits

Forfeitures are generated when a participant terminates service with an unvested benefit. That unvested benefit cannot be recaptured by the plan sponsor. A 40-plus-year-old IRS ruling explicitly states that forfeitures may be used to pay for a plan’s administrative expenses and/or to reduce employer contributions (Rev. Ruling 84-156). An IRS regulation issued in February 2023 gave formal guidance on how DC plans should comply. (Note: a regulation has the force and effect of law; rulings provide precedence but carry less weight than a regulation.)

This regulation reiterated the approved uses for forfeitures, adding that the assets could also be allocated directly to participants, and addressed when the forfeitures should be used—plans must generally use/allocate forfeitures no later than 12 months after the close of the plan year in which the forfeitures are created. If usage is delayed, it could be argued that it is not benefiting the participants in the plan at that point in time (Treasury Regulations §1.401-7(a)). The plan document will describe how forfeitures may be used. (IRS Revenue Ruling 80-155 states that a DC plan will not be qualified unless all funds are allocated to participants’ accounts in accordance with a definite formula defined in the plan document, and this requirement includes forfeitures.)

More than 80 lawsuits have been filed against large plan fiduciaries since 2023. The forfeiture litigation generally alleges a failure to adhere to Employee Retirement Income Security Act (ERISA)’s fiduciary standards. The suits claim that plan fiduciaries failed to engage in a reasoned and impartial decision-making process regarding usage (aka prudence) and did not act “solely in the interest of the participants and beneficiaries” to provide benefits and defray reasonable expenses (aka loyalty). These lawsuits claim that participants were harmed when the plan fiduciaries did not reduce the expenses paid by participants. Certain suits also claim that the forfeitures were not applied in a timely manner or that the utilization does not follow the terms of the plan document. A review of the litigation shows varied outcomes:

• Dismissal: When a district court has ruled on a motion to dismiss, upwards of 80% have been granted.
• Appeals: For the litigation where the motion to dismiss was denied, appeals are currently pending in the Third, Fourth, Eighth, and Ninth Circuits.
• Settlements: Notably, four lawsuits have led to settlements, with the smallest settlement at $950,000 and the largest at $42,724,532.

The litigation reminds plan sponsors to confirm how forfeitures are utilized and, if needed, the plan document should be adjusted to better reflect actual practice and future plan needs. While changes to the plan document are generally considered settlor functions, determining how forfeitures are applied can be a fiduciary decision (i.e., directing plan assets), and the ERISA fiduciary standards (e.g., prudence) should be satisfied. The fiduciaries should confirm who is authorized to direct the utilization, and the practice should follow a consistent process and the rationale should be documented. Plan fiduciaries (or administrative staff, if delegated) need to monitor plan forfeitures and should ensure that all forfeitures are used in a timely fashion.