Update October 14: This blog has been updated to reflect current guidance about fully vested terminated participants.
Many employers continue to find themselves in the position of furloughing or terminating significant portions of their workforce due to the ongoing COVID-19 pandemic. As employers make personnel reductions in response to the pandemic, it is necessary to consider whether the corresponding reduction in participants in their qualified retirement plan could raise "partial termination" issues, and generate unforeseen costs.
What Is a Partial Termination?
A qualified retirement plan, such as a 401(k) plan, is considered to have undergone a partial termination if, based on the facts and circumstances, it has a reduction in participants due to employer-initiated terminations by a "significant percentage" over an applicable period. Based on IRS guidance and case law, a turnover rate of at least 20% is generally viewed as a "significant percentage" and creates a rebuttable presumption that a partial termination has occured. However, courts have found partial terminations to have occurred with lower turnover rates, particularly if there is bad faith on the part of the employer. Accordingly, the facts and circumstances in each situation should be carefully analyzed to determine whether a partial termination has occurred, as described below.
Determining the Applicable Period
The applicable period for determining whether a partial termination has occurred is generally the plan year. However, in some instances, the applicable period may be longer, such as multiple plan years, particularly in cases where a series of related corporate events (such as phased operational shutdowns that occur over several years) lead to reductions in force.
Determining the Turnover Rate
A partial termination is deemed to have occurred if the participant turnover rate is a "significant percentage." The participant turnover rate is generally determined by a fraction, the numerator of which is employer-initiated terminations (with adjustments in some cases, as described below), and the denominator of which is the number of participants at the beginning of the applicable period plus the number of participants added over the course of the applicable period, as shown below:
Turnover Rate =
Number of employer-initiated terminations
(with adjustments, as applicable)
Number of participants at beginning of applicable period
plus participants added during the applicable period
All employer-initiated terminations, including those caused by circumstances outside of the employer's control (such as economic downturns) must generally be included in the numerator of the fraction shown above. However, courts and the IRS generally permit the following adjustments when determining the number of terminated participants to use in the numerator when calculating the turnover rate:
- Employer-initiated terminations only: Only employer-initiated terminations are counted for purposes of determining whether a partial termination occurred. Accordingly, terminations due to death, disability, normal retirement, or voluntary terminations (other than constructive discharges) do not have to be included in the numerator.
- Normal turnover rate: The resulting percentage of the fraction shown above can be reduced by the employer's normal turnover rate (generally determined as the past two- or three-plan year average) when determining whether a "significant percentage" of participants were terminated. Terminations due to death, disability, and normal retirement do not need to be counted to determine the employer's normal turnover rate. Accordingly, it may be easier for employers with higher normal turnover rates to rebut the presumption that a turnover rate of 20% has caused a partial termination.
There is a split among federal circuit courts as to whether participants who terminated with full vesting must be counted for purposes of determining the turnover rate. However, the safer approach is to include fully vested terminated participants, unless they can otherwise be excluded as described above. In addition, terminations for "cause" (e.g., where the employee is terminated for having engaged in a crime of moral turpitude or flagrantly violating the employer's policy) should typically be counted for purposes of determining the turnover rate. However, an employer may be able to cite to "for cause" terminations as a relevant factor for purposes of rebutting the presumption that a partial plan termination has occurred.
Implications of Partial Terminations
If a partial termination is found to have occurred, the consequence is that all participants who are terminated during the applicable period, whether employer-initiated or not ("affected participants"), must be fully vested in their accounts if they are not already by restoring previously forfeited amounts (or by making additional contributions if forfeitures are insufficient). This means the employer may lose the benefit of forfeitures resulting from unvested or partially vested employees that would otherwise occur during the applicable period.
Deference to Plan Administrator's Determination
Courts have ruled that a retirement plan administrator's determination of a partial termination is entitled to deference and is therefore subject to a more favorable standard of review if challenged in court. Therefore, the best practice is for a plan's administration committee to independently examine the facts and circumstances (with the assistance of counsel and other advisors if possible) and determine whether a partial termination occurred, especially where an employer's turnover rate is close to or exceeds the 20% "significant percentage" threshold.
Dealing With Partial Terminations During COVID Times
Under recent IRS guidance, employees who are furloughed (e.g., due to a pandemic-related business downturn) do not need to be counted as terminated participants when determining the turnover rate as described above if they are recalled into service prior to the end of the plan year (i.e., the applicable period). In addition, because partial plan terminations are often determined as of the end of the plan year, employers should continue to apply vesting schedules to mid-year distributions and forfeit unvested amounts but be prepared for the possibility of a partial plan termination at year-end. For example, if a furloughed employee is called back into service during the same plan year, then the employee can continue to vest in the unvested amount. On the other hand, if a furloughed employee is terminated (i.e., is not called back into service during the same plan year) and requests an immediate plan distribution, only the vested amount should be distributed with the unvested amount forfeited. If at year-end it is determined that a partial plan termination took place, the plan should fully vest the former employee's account with the previously forfeited amount and pay out the balance.
When determining the financial impact of potential personnel reduction decisions, employers should take into account the loss of forfeitures (which are often used to pay plan expenses or offset employer contributions) and, if forfeitures are insufficient, the cost of funding an additional contribution to the plan in order to fully vest the affected participants' accounts due to potential partial terminations, in addition to any other plan-related expenses (such as reimbursing affected participants for additional fees relating to a second distribution of the previously forfeite d amount).
Partial plan terminations can create significant costs and headaches for employers which can be more painful during an economic downturn (such as that caused by the COVID-19 pandemic) and especially when unforeseen. Smaller plan sponsors may be particularly vulnerable to partial plan terminations since it takes a reduction in participants to have a plan's turnover rate be a "significant percentage." However, planning for the possibility and potential costs of a partial plan termination can provide employers with a fuller picture of the financial costs associated with personnel-related decisions. In addition, independently analyzing with the assistance of counsel whether a partial plan termination has occurred can help employers defend their decisions in court if subsequently challenged.