The U.S. unemployment rate reached 14.7% in April, its highest level since the Great Depression, as companies looked to cut costs amid the coronavirus pandemic. While downsizing the workforce can help companies remain afloat, plan sponsors need to understand how these decisions could affect their retirement plans.
If layoffs are significant, a partial plan termination may occur and create major financial implications for a plan sponsor.
Determining Whether a Partial Plan Termination Has Been Triggered
While generally speaking a partial plan termination occurs when 20 percent or more of employees participating in a defined benefit or defined contribution plan are involuntarily terminated from employment, there is no perfect formula. Plan sponsors are required to review the “facts and circumstances” surrounding the reductions in workforce. Different rules may apply if the terminated employees work across business lines in an entity or the terminations span more than one plan year.
Simple math is only a starting point:
The first step in determining the size of the layoff for purposes of a partial plan termination is to take the total number of vested and un-vested employees that were involuntarily terminated and divide by the total number of plan participants during the applicable period (usually the plan year). While this calculation is a starting point, the final ruling will be based on the facts and circumstances surrounding the terminations.
Only involuntary terminations apply:
Only employees who are terminated for involuntary reasons count toward the partial plan termination trigger. The IRS says that routine turnovers and certain spin-offs may not count toward a partial plan termination. Employers may provide evidence to the IRS that the turnover rate was not the result of an employer-initiated severance.
Partial plan terminations can be triggered by various reasons:
Partial plan terminations can happen for reasons that are less obvious, such as when plan amendments exclude employees or adversely affect vesting rights, or when reduced or eliminated future benefit accruals result in a reversion to the employer.
Plan sponsors that are unsure whether their facts and circumstances trigger a partial plan termination can request a determination letter from the Internal Revenue Service (IRS).
Consequences of a Partial Plan Termination
Failure to comply with rules and requirements following a partial plan termination can have dire financial consequences for the plan sponsor, including disqualifying the entire plan, which could result in major tax liabilities and penalties.
When a partial plan termination does occur, affected employees (i.e., those who have been terminated that year) automatically become 100 percent vested in all employer contributions, including matching contributions. In general, a plan will remain qualified only if it makes all employees affected by a partial plan termination whole.
If an error in making affected employees whole has occurred, it is possible to fix the error using the IRS Employee Plans Compliance Resolution System (EPCRS).
Considerations for Defined Benefit and Multi-employer Plans
The Pension Benefit Guaranty Corp. (PBGC) wants to be informed of reportable events that could trigger a partial plan termination. These include when the number of active participants in a plan goes below 80 percent or when operations at a facility stop, reducing the number of eligible employees by 15 percent. The PBGC needs to be informed of these events so it can prepare for the possibility of having to take over such plans.
Multi-employer plans need to be aware that partial terminations can happen when there is a partial suspension of an employer’s contributions or a 70 percent contribution decline over a three-year period. A variety of calculations are required depending upon the multi-employer plan’s industry and other circumstances, but the 70-percent threshold is a good barometer to track.
Insight: Plan Ahead for Year-End Calculations and Vesting Payments
Companies often implement layoffs as a way to reduce expenses, but layoffs can lead to some unforeseen expenses of their own. It is important to realize that partial plan terminations can create major cash outflows in the form of vesting payments to affected employees.
While calculations related to partial plan terminations generally aren’t required until the end of the plan year, plan sponsors may decide to take the time up front to determine whether their workforce reductions will trigger this event. By preparing for any potential funding requirements, companies may avoid surprise expenses. Employers should carefully review their turnover rates and plan ahead for the possibility of having to fully vest terminated employees.