Plan sponsors have traditionally sought to limit “leakage” from defined contribution (DC) plans. However, in these chaotic times, sponsors should consider how they can support participants in financial distress.
The coronavirus pandemic has led to significant economic tremors, including income insecurity and job reductions. As a result, plan sponsors and participants are looking to manage cash flow and minimize long-term impacts.
Under the Employee Retirement Income Security Act (ERISA), or other applicable law, the primary responsibility of fiduciaries is to run the DC plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. It is important that plan sponsors consider how to balance this duty with short-term financial needs:
- Loan availability: A loan from the DC plan may help mitigate short-term cash flow needs. But participants are required to make regular repayments, and those who miss loan repayments become subject to default. These are complicated issues addressed in full here.
- In-service withdrawals: An in-service withdrawal allows active employees to tap their retirement savings prior to termination. There are limitations based on the money source (e.g., employee deferrals, employer contributions). Typically, age 59½ is the earliest participants can take in-service withdrawals from their deferrals, qualified non-elective contributions (QNECs), and qualified matching contributions (QMACs). Roth deferrals will be subject to penalties if distributed before five tax years have passed from the date of the first contribution to a Roth IRA or Roth 401(k). And any withdrawals prior to age 59½ may be subject to additional penalties.
- Hardship withdrawals: Hardship withdrawals are a form of in-service withdrawal that allows active employees of any age to withdraw amounts from their DC plan account. To be considered a hardship, it has to be an immediate and heavy financial need, and the withdrawal has to be necessary to meet that need.
Some plans may permit hardship withdrawals based on a more nebulous “facts and circumstances” standard. Determining whether an employee has an immediate and heavy financial need requires careful consideration by the plan sponsor. Most plan sponsors rely on “safe harbor” reasons and limit their liability (e.g., expenses due to a Federal Emergency Management Agency-declared disaster, burial expenses, repair costs). Unfortunately, COVID-19 does not currently fall under any of those safe harbor circumstances, although that may change. Some plans may also permit hardship withdrawals based on a more nebulous “facts and circumstances” standard. This standard requires discretion on the part of the plan sponsor or a delegated third party to determine if a hardship has occurred and may require additional resources to verify. Additionally, a hardship withdrawal may not exceed the amount of the employee’s need (including taxes and penalties), which may be difficult to estimate and/or document at a single point in time.
457 plans offer similar “unforeseen emergency withdrawals” that are generally subject to the same rules.
- Distributions: In general, participants may take distributions or withdrawals from the plan following a “distributable event,” which is generally defined as one of the following:
- Termination from employment
- Reaching “normal retirement age”
- Disability or death
- Attaining specific ages, depending on the source of the savings (employee deferrals versus employer contributions)
The terms of the plan can permit participants to structure their distributions as a lump sum, installments (a series of equal payments over a defined period of time), or partial distributions (flexible amounts and timing). Plan sponsors may wish to consider adding partial distributions, if not already available, so that participants can access a portion of their account without requiring a full distribution.
- Managing fees: Recordkeepers may charge fees for some or all of the above transactions. Plan sponsors may wish to work with their service providers to manage or mitigate fees.
The Bottom Line
Aside from the grave threat to public health, one of the greatest challenges COVID-19 presents is the lack of a clear timeline and endpoint. Plan sponsors and participants are seeking to make decisions based on circumstances that cannot be anticipated. Plan sponsors should seek to support their participants’ current needs, balanced with the long-term objectives of the DC plan as required by ERISA, while documenting their fiduciary decisions and the process to implement those decisions.
We will continue to monitor any legislative and regulatory guidance and provide updates as the situation evolves.