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How SMB Retirement Plan Sponsors Grapple with Abandoned Orphan Accounts

4 Mins read

Bureau of Labor Statistics data indicated that in November 2022, the total separations (quits, layoffs and discharges, and other) rate increased in establishments with 50 to 249 employees. The quits rate increased in establishments with 1 to 9 employees. Not only does this mean SMBs are having difficulty sourcing a talented workforce, it also means more 401k accounts may be abandoned by former employees (or an absent plan sponsor) – otherwise known as orphan accounts or orphan plans. These orphan accounts pose a vexing administrative headache for plan sponsors who have no portability procedure in place to move accounts off their plans. Not unlike a decedent leaving assets behind without a will, a former employee leaving behind a retirement account presents complex legal intricacies and, of special concern to plan sponsors, fiduciary risks. Let’s take a look at the most pressing considerations for plan sponsors when accounts are abandoned and steps they can take to mitigate associated risks.

Orphan accounts present administrative burden

Participants who leave money in a former employer’s 401k present a number of challenges for plan sponsors, starting with reporting and disclosure rules. Even small businesses must execute a plan document that complies with requirements in the Internal Revenue Code. The sponsors’ disclosure requirements to maintain complete and accurate census information apply to both active and inactive participants in the plan. Employers must stay in communication with participants, sending out plan disclosure documents explaining eligibility, contributions, vesting, distributions, and other plan provisions. If former employees are not diligent about maintaining contact information, this doesn’t immunize the plan sponsor against non-compliance penalties. The Department of Labor has clear expectations that sponsors and providers must take steps to locate these missing participants. If a retirement plan has a significant number of missing or nonresponsive participants or a significant number of terminated vested participants who have reached normal retirement age but have not started receiving their pension benefit, the Department of Labor will take notice.

Orphan accounts present a cost burden

Terminated balances can increase plan costs, since most 401k recordkeepers are charging per balance held in the plan. Additionally, if the balance in an orphan account is relatively low, it may not be cost-effective for the sponsor to keep it open. Finally, if the former employee doesn’t keep up with their required minimum distributions (RMDs) from the account, it can create problems down the road for plan sponsors. The Employee Benefits Security Administration (EBSA) has outlined a list of best practices for plan sponsors to help mitigate the problems associated with missing former employees and their abandoned accounts. The EBSA recommends maintaining accurate census information, implementing effective communication strategies, conducting missing participant searches, and diligently documenting procedures and actions. Facilitating efficient portability of accounts is also wise, as is putting protections in place.

… And fiduciary liability

But cost and logistical problems do not compare to the potential fiduciary risk orphan accounts can present if plan sponsors aren’t fastidious about staying on top of them. Even with great diligence, errors and missteps occur, and under the high standards of ERISA law, mistakes can result in fiduciary breach allegations. Unfortunately, plan sponsors bear personal exposure for third-party claims of not meeting fiduciary obligations. Some plan sponsors mistakenly think if they outsource administration, oversight, or supervision of employee benefit plans, that they’re also outsourcing the liability. 2022 was the second most active year ever for ERISA retirement plan lawsuits, and 2022 saw 24 settlements totaling more than $160 million. An alarming trend has surfaced of ERISA litigation against smaller plans, as a third of the total suits in 2022 were filed concerning plans with under a billion dollars in assets, including 14 concerned plans at or under $500 million, and three concerned plans under $250 million.

Mitigating risks associated with orphan accounts

A predicted recession could mean that small and medium sized business may join their larger counterparts in needing to trim workforces. A December survey revealed the percentage of small businesses laying off staffers nearly doubled, going from 8% in November to 15% in December. If an employee has been fired or laid off, their orphaned balances present even more thorny issues for plan sponsors. A terminated participant is more likely to bring litigation against a plan sponsor than an active employee. While the ERISA fidelity bond is the only coverage required by the U.S. DOL to protect an employee benefit plan against losses caused by acts of fraud or dishonesty, relying solely on the ERISA fidelity bond for protection is tantamount to buying only the compulsory liability auto insurance, relying on hope that nothing bad happens in an accident. SMB plan sponsors should protect themselves with fiduciary liability insurance in the event of claims of failing to make timely contributions, paying excessive fees, or failing to respond to requests for rollovers, distributions, and investment changes.

SMB plan sponsors must protect the company, employees, and themselves

The fiduciary risks associated with orphan accounts stack up. As long as these funds remain in the company sponsored retirement plan, plan sponsors have fiduciary liability over the funds. Plan sponsors at small businesses bear enormous responsibility for the well-being of their employees, their company, and themselves. Recently, The Consolidated Appropriations Act of 2023, including the SECURE 2.0 ACT of 2022, was passed, bringing a litany of new rules plan sponsors must follow to help employees save for retirement. Along with risks associated with cyber-attacks and theft, retirement plan sponsors have enough on their plates dealing with the elements under their control, so they should pursue remedies that relieve the exceptional burden of all the things they cannot control.

Richard Clarke is Chief Insurance Officer at Colonial Surety Company. With more than three decades of experience, Clarke is a chartered property casualty underwriter (CPCU), certified insurance counselor (CIC) and registered professional liability underwriter (RPLU). He leads insurance strategy and operations for the expansion of Colonial Surety’s SMB-focused product suite, building out the online platform into a one-stop-shop for America’s SMBs.

Retirement stock image by bbernard/Shutterstock

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