Westminster: What advice do you give plan sponsors to prevent operational errors?
Richard: Operational errors are going to occur. In fact, I believe that they are inevitable.
I have clients of all sizes — very large employers (10,000 or more employees) sponsoring retirement plans holding in excess of a billion dollars, and small employers (under 100 employees) sponsoring plans holding only a few million dollars or less. My clients across this rather broad size range have experienced operational errors with respect to the administration of their tax-qualified retirement plans. But that doesn’t mean there aren’t steps that a plan sponsor can take to reduce the likelihood of errors, and perhaps even the severity of the error when one does occur.
Administration of tax-qualified retirement plans is complex; there are many system and vendor “intersections” that provide ample opportunity for something to go wrong. So these “intersections” are a good place to examine if you want to reduce the likelihood of an operational error happening. I do not have expertise working with internal HRIS (human resource information systems) systems, but that would be a good place to start any operational review. An employee is hired. Perhaps you have several categories of employees (e.g., regular full-time or part-time, “temporary”, interns, etc.) that are treated differently under your retirement plan. So an area of obvious concern would be how new hires are categorized in your HRIS system. A mistake at this level can lead to an operational failure relating to plan eligibility and entry. Depending on the scope of such a problem, eligibility and entry mistakes can be costly to remedy for a plan sponsor, particularly if the mistake is systemic.
A deeper dive into plan administration would look into the interaction between the HRIS system and the plan vendor (third-party administrator, or the TPA). Automated periodic feeds to the TPA communicate all sorts of information necessary to properly administer a plan, including, for example, employment status (active, leave of absence or inactive, terminated), employment category (full-time, part-time), compensation, etc. A review of how this information is transmitted between your HRIS system and your TPA can uncover areas of risk.
When reviewing processes such as these, many find it useful to create a detailed “process map” — Each step of a process is documented and illustrated on a chart. This can give all involved parties a better understanding of the process, their role in the process, and possibly even expose areas of potential risk — extra steps that are not needed that merely provide additional opportunity for something to go awry.
And, of course, any review of plan operations would be incomplete without a close examination of the plan documentation itself. I can tell you that many operational errors can rise to the surface when doing a detailed review of a plan’s summary plan description (SPD), and comparing the SPD to the terms of the plan document.
Extra vigilance at particularly error-prone times also is well worth the effort to prevent operational errors from occurring. Corporate transactions that bring a new group of eligible employees into a plan, switching plan vendors or administrative platforms, are just two examples of times when mistakes will get made.
W: When a plan error is discovered, what steps should the plan sponsor take, and when does the attorney get involved?
R: I think the very first step once an operational error is discovered is to get an understanding of what caused the problem and the scope of the error. Was there a particular event that lead to the error (e.g., a plan restatement or a switch in plan platform)? Is it limited to one year, two years or more? How many employees/plan participants could potentially be involved?
As an ERISA attorney, I like getting involved in this process early. I understand that this is quite a self-serving statement. But it all goes back to something my father told me when I was in high school and, let’s just say, when I was doing something I shouldn’t have been doing. He told me very succinctly, “When you’re in a hole, stop digging.” I cannot tell you how many times I have seen plan sponsors taking what they believe are appropriate actions (sometimes at the suggestion of their TPA) in response to a discovered operational error, only to make the matter worse or even create yet another operational error. So, when in a hole, stop digging.
W: As an ERISA attorney, what is the course of action when you find a plan error?
R: Well, that all depends on the particular problem. The first thing you will want to do is understand why the problem arose and take action to avoid the mistake from continuing. In other words, stop the bleeding. Then understand the scope of the problem. I recommend that a sponsor look back and forward to see if the same error took place in a prior year or a subsequent year but went unnoticed. A question I get asked all the time is, “How far back do I need to look?” I hate to sound like a lawyer, but my answer to that question is that it depends.
For purposes of reviewing the annual Form 5500 filing, there is a three-year statute of limitations. Once the statute of limitations closes, the IRS will not be looking to review the 5500 for a closed year. However, when it comes to tax-qualification errors, the IRS takes the position that there is no statute of limitations. If an error is discovered going back to a “closed” plan year, the IRS takes the position that from that date forward, the plan was disqualified and must be fixed.
So I find the need to look to prior years will be different in different situations. If you are able to identify the source of the error and know that the error occurred when you switched TPAs, then look back one year before the new TPA came on board, and if the error had not occurred in that prior year, that’s as far back as you’ll need to go.
I have been involved in plan corrections that go back 10, 20 and — in a few instances — over 25 years. At that point, the challenge becomes finding employment records that can be relied upon to work with. At some point, it may just be that sufficient records don’t exist, and you can explain that to the IRS when you make your corrective filing.
W: What is the biggest issue you run into with plan documents? (Not updated properly and have to do gap analysis?)
R: By far, the biggest issue I see is that sponsors don’t always know the precise terms of their own plan. As noted above a detailed review of the plan documentation often brings to light certain operational provisions that a sponsor is not addressing in accordance with the terms of the plan. Let’s face it, there are so many detailed operational functions and decisions involved in administering a tax-qualified plan, it’s almost impossible to know and understand every aspect.
My very best advice is to read your plan document and SPD. Retain a good TPA to assist in plan administration. Ask questions when something does not make sense to you. Your outside plan advisors are administering dozens of plans, if not more. Who will know the intricacies of your internal systems and capabilities better, you or your TPA?
W: When should a plan “self-correct,” and when should it correct via the VCP process?
R: The Employee Plans Compliance Resolution System (EPCRS) — the formal name of the IRS correction procedure — actually addresses a few different correction protocols. “Self-correction” (correcting without making a filing with the IRS) is permitted to be used at any time to correct a mistake that is “not significant” and for mistakes that are considered “significant,” but only within a limited period of time. The EPCRS includes factors to be considered when determining whether a mistake is insignificant or significant, but many of the factors are highly subjective, often leaving some room for a different conclusion. Nevertheless, there are times when this self-correction procedure is appropriate, but it generally comes down to a judgment call involving the level of risk a sponsor is willing to take with respect to the tax-qualified status of their retirement plan. Whether you decide to self-correct or make a correction filing with the IRS under the EPCRS, the corrective actions should be the same.
One advantage of making a corrective filing is that the IRS will issue the plan a “Compliance Statement” at the end of the process. This means that the IRS will not again review (upon a random audit, for example) any issue disclosed and corrected to their satisfaction under the EPCRS. And a Compliance Statement provides a plan with a degree of certainty as to its tax-qualified status. In many instances, the plan’s independent auditor will require an EPCRS filing for a Compliance Statement. Of course, filing and obtaining the Compliance Statement involves additional cost over self-correction.
W: Can you provide a short case study of a blatant plan error/mistake and the steps taken to fix it?
R: An error that I see all the time involves the definition of “compensation” under the plan. For example, the plan defines “compensation” as W-2 Compensation, but employee salary deferrals, employer match and non-elective (“profit-sharing”) contributions are all being made on the basis of base salary. Special forms of compensation are not being taken into consideration — the failure to recognize bonuses, commissions and overtime, for example, results in the participant’s plan account being shorted contributions. So some corrective actions will be required.
First things first: Stop the bleeding. Decide what the proper definition of “compensation” should be and amend the plan or plan operations as may be needed to fix the issue going forward.
Then we need to understand the scope of the problem. Did this just happen because the plan document was recently updated or restated, and the definition of compensation was inadvertently changed? Did the plan update happen three years ago? How many participants would be affected by this mistake? Keep in mind, any plan participant whose base salary is in excess of the tax code’s compensation limitation (currently $265,000) will not have been impacted by this sort of mistake. Once the scope of the problem is determined, the corrective action would be to make corrective contributions to the plan, and adjust for earnings. It isn’t hard to see that this can quickly become an expensive problem to fix. Was the mistake “insignificant” or “significant” for purposes of consideration of the self-correction approach?
I want to point out that there may be a different approach to address this problem. If the plan document uses the wrong definition of compensation, but it can be shown that plan administration has consistently used a different definition, and, most importantly, employees had no expectation that the plan document’s definition applied, then it might be possible to persuade the IRS to permit you to retroactively amend the plan document to conform to the administrative practice. When the plan utilizes a prototype plan document, you can expect the plan document and SPD to read exactly the same — the wrong definition of compensation. But don’t throw in the towel just yet. Look for other employee communications to support the administrative practice of the plan: For example, enrollment kits or materials, plan election forms and employee communications on the plan vendor’s website. In order to get permission for a retroactive amendment (and therefore no corrective contributions needed), you will have to make a filing to the IRS under the EPCRS. While there is no guarantee that the IRS will accept your proposed correction, if the historic communications with plan participants are compelling, we have had success getting the IRS to approve such a retroactive approach.
Richard Schwartz is a Partner at Seyfarth Shaw, LLP.
He can be reached at firstname.lastname@example.org or 212.218.5516.