Overreliance on Service Providers: Distributions from Retirement Plans

Blog
February 21, 2022

We have previously discussed the role of fiduciaries in an employee benefit plan and the fundamental concept of overreliance on service providers. In this article, we explore certain areas where this is prevalent.

Overreliance is a result of the recent trend of third party administrators working directly with participants with minimal involvement from the Plan Sponsor. Although this is usually very convenient for plan participants and Plan Sponsors, Plan Sponsors tend to remove themselves from this process and are not directly authorizing transactions. Loans and withdrawals are the two most common classes of transactions that are processed entirely by electronic means and do not require Plan Sponsor approval. There are numerous plan provisions, tax matters, and compliance matters that revolve around these two transaction classes which makes them susceptible to significant risks.

Loans

If the loan process is entirely electronic, Plan Sponsors generally rely on the service provider to receive the request, review the request to make sure the transaction is in accordance with plan provisions, approve the request, create the amortization table, and issue the check. Plan Sponsors need to ensure that the participant is eligible for a loan (there are multiple plan provisions that could trigger a loan request rejection), ensure the amortization schedule is accurate (consistent with pay cycle such as bi-weekly vs. semi-monthly), review spousal authorization if required by the plan, update the payroll records for the proper withholdings for the loan repayment, and make sure the plan records are updated for the newly issued loan.

The most common loan compliance issues we see due to overreliance relate to the term period, the number of loans allowed, and timely withholding of loan repayments. Plans generally allow loans with a maturity period of five years, but some plans allow the maturity date to extend to 15 years (or more) for the purchase of a principal residence. We frequently see instances where Plan Sponsors are not reviewing loans and the service provider that approves loans allowed term periods that were not in accordance with the plan provisions. Most plans have a restriction on the number of loans that can be outstanding at any given point in time. Audit testing often reveals some participants will exceed the limitation due to an absence of proper review. The above issues can be identified  and corrected in a timely manner if the Plan Sponsor is properly reviewing these transactions. Correcting these issues might be simple, but can also be complex depending on a variety of factors such as employment status and how long the loan has been effective.

Withdrawals

Similar to loans, if participants communicate directly with the service provider to take distributions and the Plan Sponsor is not involved, this can lead to significant compliance issues without a proper monitoring process. Assets leaving the plan are generally riskier than assets entering the plan so it is critical to review these transactions. Plan Sponsors generally rely on the service provider to receive the request, review the request to make sure the transaction is in accordance with plan provisions, approve the request, calculate proper vesting, withhold taxes as appropriate (and remit such taxes to regulators), and control the delivery of the funds. Plan Sponsors need to ensure that the participant is eligible for a withdrawal (there are very specific eligibility requirements for certain withdrawals, i.e. hardships), review spousal authorization if required by the plan, ensure the vesting calculation is correct, ensure the distributions are cashed by the participants (if not, perform necessary procedures to get the distribution to the individual), and ensure the plan records are updated accordingly.

The most common withdrawal compliance issues we see due to overreliance relate to incorrect vesting calculations and provisions related to hardships (documentation). Every year we seem to find a plan that has issued a distribution using an incorrect vesting calculation. This is usually due to an error in the vesting schedule used for the calculation, the definition of a vesting period, or due to complexity with multiple vesting schedules and money sources (employer match, safe harbor, non-elective, profit sharing, discretionary contributions, etc.).

It is very important that the Plan Sponsor review the vesting for each withdrawal to ensure the service provider’s calculation appears accurate. It is easier to review this early on because it can be problematic to perform corrective actions for individuals who are no longer employed by the company. We have seen instances where a service provider used an incorrect vesting schedule when they performed their calculations and all of the withdrawals had incorrect forfeitures. This is one of those instances where you just scratch your head and ask yourself, “How could this possibly happen?” It is important to understand that these issues can occur, but the Plan Sponsor can detect and correct these issues timely with a proper level of review and oversight.

It is also important for plans to understand all of the withdrawal eligibility rules and provisions, especially hardships, because this not only involves the DOL, but also involves the IRS. Regulations over the past couple years have changed the landscape of hardship distributions and the eligibility requirements and restrictions. Make sure the plan is in compliance with all of the effective changes that occurred.  The most common issue seen is not obtaining the proper hardship documentation to support the approval of eligibility. Corrective actions related to withdrawals can tend to be complex depending on the individual’s employment status. It is important to implement a proper review and monitoring process to help avoid corrective actions.

Loans and withdrawals are two very common classes of transactions that service providers process which can inherently lead to potential overreliance. If you ever have any comments, questions or concerns, please reach out to us and we will be more than happy to assist.