A guide to resolving common issues with defined contribution plan administration
Defined contribution retirement plans are a complex entanglement of many moving parts and players that can change at any moment.
In earlier articles, Revenue Procedure 2021–30 which is better known as the Employee Plans Compliance Resolution System (“EPCRS”), has been discussed. EPCRS provides IRS acceptable methods to correct operational issues within your retirement plan. Most corrections require an adjustment for lost earnings.
Determination of earnings for a correction would appear to be straightforward but there are nuances to consider when calculating earnings for corrections. The nuances depend on whether the correction will be a corrective contribution/allocation or a corrective distribution/reduction. Another consideration is made for earnings losses for the period of correction.
Earnings for corrective contributions or allocations
If your plan does not allow participant direction of investments, the actual rate of return of your retirement plan beginning when the failure occurred and ending when the failure is fully corrected, should be used to determine the amount of lost earnings owed. The correction is considered complete on the date earnings are deposited to the trust. Earnings on the lost earnings will need to be calculated and added to the correction amount if the lost earnings for the correction are not funded on the same date the corrective contribution is made.
Calculating earnings becomes more challenging if your plan allows plan participants to choose their investment elections. Utilizing the rate of return of each affected participant during the correction period is the best alternative. However, using actual rates of return for each affected participant can become a challenge if the number of affected participants is large. For example, the cost and time to calculate the rate of return of five participants would be far less than calculating the rate of return for 500 participants. Also, plan sponsors may not have sufficient plan transaction history to calculate the rate of return of all participants.
For administrative convenience, if most of the employees for whom the corrective contribution or allocation is made are nonhighly compensated employees, EPCRS allows plan sponsors to use the rate of return of the fund with the highest rate of return under the plan for the period of the failure to determine the earnings rate for all corrective contributions or allocations instead of calculating individual rates of return. If the employee has not made any applicable investment choices, the plan’s rate of return may be used for the earnings. If most of the employees for the corrective contribution or allocation are highly compensated employees, their actual rate of return (or the plan rate of return if no investment election was made) would be your best choice.
Plans with automatic contribution provisions may use an alternative to calculating individual rates of return. The plan sponsor may use the plan’s default investment fund if the affected employee has not affirmatively designated an investment choice.
Earnings for corrective distributions or corrective reductions in account balances
Corrections that require a reduction of a participant’s account balance have different rules for determining earnings. If there has been an overall gain for the period of correction, no adjustment for earnings is required for the affected participants provided that the majority of the affected participants are nonhighly compensated employees. If the plan sponsor decides to remove the earnings from participant accounts, the reduction to the account balance may be adjusted by the lowest rate of return of any fund available for the correction period for administrative convenience. However, if the affected group is highly compensated employees, reductions to earnings are required for corrections and the same method of using the lowest rate of return, noted above, does not apply.
What if there is an earnings loss?
EPCRS does not require a corrective allocation to be adjusted for losses. Accordingly, corrective allocations must include gains and may be adjusted for losses. The option to make an adjustment for losses has an exception for automatic contribution corrections. If the default investment fund experienced a loss for the period of an automatic contribution correction, the loss in the default investment fund can’t result in a reduction in the required corrective contributions relating to any matching contributions.
EPCRS does not address losses in earnings for corrective distributions or reductions in a participant’s account balance. The safest method to calculate earnings in such instances is to make corrective distributions or reductions in account balances without adjustment for negative losses in earnings if the majority of the participants affected are highly compensated employees. If most of the participants affected are non-highly compensated employees, a plan sponsor may choose to apply the loss in earnings to the amount to be recovered.
The period of the failure is the period from the date that the failure began through the date of correction. For example, the beginning of the period of the failure is the date on which contributions of the same type (for example, elective deferrals, matching contributions, or discretionary nonelective employer contributions) were made for other employees for the year of the failure. In the case of a defined contribution plan, a corrective contribution or distribution should be adjusted for earnings from the date of the failure (determined without regard to any Internal Revenue Code provision that permits a corrective contribution or distribution to be made at a later date).
If the probable difference between an approximate determination of earnings and a determination of earnings is insignificant and the administrative cost of a precise determination would significantly exceed the probable difference, reasonable estimates may be used in calculating the appropriate earnings. Additionally, if it is not possible to make a precise calculation (for example, when accurate plan data is missing), reasonable estimates may be used in calculating the appropriate correction.
If it is not feasible to make a reasonable estimate of what the actual investment results would have been, a reasonable interest rate may be used. For this purpose, the interest rate used by the Department of Labor’s VFCP Online Calculator is deemed to be a reasonable interest rate.
Retirement plan corrections under EPCRS typically require an adjustment for earnings for the period of failure. The affected participant’s rate of return is the most conservative method to determine earnings. In some cases, the IRS will allow an alternative method of calculating earnings if calculating each affected participant’s rate of return is burdensome. If it’s not feasible to make a reasonable estimate of actual earnings, a reasonable interest rate may be used.
Care must be taken when calculating earnings to apply for corrective contributions/allocations or corrective distributions/reductions of participant accounts. EPCRS is a valuable resource to determine which earnings calculation methods the IRS will consider acceptable. Milliman has a team of professionals who can assist with addressing earnings calculation questions and corrections.