Avoiding the Top-Heavy Landmine
There are limitless reasons why retirement plan service providers get sued. In the past few years, we have seen claims arise out of such diverse circumstances as failing to advise clients about restricted lump-sum distributions, plan designs that fail to meet client expectations and failing to operate a plan in accordance with its terms. Currently, however, claims relating to a plan’s top-heavy status seem to be one of the leading sources of service provider disputes. In this article, we discuss the trend and suggest ways to avoid claims relating to top-heavy issues in your practice.
Generally, a qualified retirement plan becomes “top-heavy” when the benefits of certain executives (called “key employees”) account for more than 60 percent of the plan’s benefits. When a plan is top-heavy, the employer must generally make a minimum three percent of pay contribution to the accounts of “non-key” employees. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made a number of modifications to the top-heavy rules. According to the House Committee Report on EGTRRA, these changes were designed to simplify the top-heavy rules and reduce the number of plans that ultimately are deemed to be top-heavy. However, in some cases, EGTRRA seems to be having the opposite effect.
Recently, we have noticed an increase in claims against retirement plan service providers based on the top-heavy status of their clients’ plans. Although it is somewhat counterintuitive given Congress’ stated intent, some plans are testing as top-heavy when pre-EGTRRA rules yielded the opposite result. Thus, while the EGTRRA changes may have been designed to reduce the number of top-heavy plans, it is difficult—if not impossible—to know with certainty whether a particular plan will be top-heavy before testing it at the close of the plan year.
Although the facts of each case differ greatly, there are certain common themes throughout most of the claims. In general, the claims are brought after the plan sponsor has learned it has incurred a large top-heavy obligation for a particular year or years. When the contribution is greater than the sponsor anticipated (or when the sponsor did not anticipate a contribution at all), they begin to look for someone to “share the blame” and ease the cost of the contribution. Because the service provider is typically the one who conducts the test, the sponsor often alleges the service provider is somehow to blame for the top-heavy status of its plan, or for the failure to give advance warning of the plan’s potential top-heavy status.
Plan sponsors often argue that had they known the plan was going to be top-heavy (or that the top-heavy obligation was going to be so great), they would have taken some action to avoid or reduce the liability. That is, the sponsor claims it either: (i) never would have adopted the plan; (ii) would have frozen the plan before it became top-heavy; or (iii) would not have permitted key employees to continue to defer income into the plan, and thereby would have avoided the top-heavy obligation.
All of these arguments are subject to attack. First, it strains credibility for the plan sponsor to argue that it would not have sponsored a plan at all. This is especially the case when the sponsor’s competitors offer a retirement plan as part of their compensation packages. Moreover, since businesses depend heavily on their key employees, it may be unrealistic for a plan sponsor to contend that it would have prevented key employees from deferring income to the company’s retirement plan had it known the plan might be top-heavy.
Companies that provide services to retirement plans need to deal with this rising trend of top-heavy based claims. Clear communication with your clients regarding their wants, needs and expectations from their retirement plan is imperative. For example, statements to the effect that the sponsor only wants to provide a benefit for its employees and does not want to incur any unnecessary costs may be a sign that an unexpected top-heavy liability will be a problem. If you sense that top-heavy status could be an issue, you should have conversations with the sponsor about the top-heavy rules and their impact on the plan. Those conversations should be confirmed in writing. Your staff should be trained to be sensitive to these issues as well—particularly if they have the most contact with the sponsor.
Any and all communications about the results of a top-heavy test, the plan’s current or prior top-heavy status, and any related topics, should be put in writing. For example, if the service provider cannot perform the required testing because the sponsor has been slow in gathering the necessary census and ownership information, the provider should document the reason for the delay.
Service providers should use a professionally-prepared services agreement that explains (in at least summary form) the top-heavy rules and the consequences of having a top-heavy plan, and that confirms that unless you are notified otherwise in writing, you will assume that the sponsor intends to allow key employees to continue to defer income to the plan regardless of the plan’s top-heavy status. The agreement should be signed by the plan sponsor and clearly indicate that any delay in providing requested information, which results in a delay in preparing test results will be attributed to the delay on the part of the sponsor.
Finally, service providers should make sure they are properly insured. Litigation is expensive—even when you are not at fault. Failing to have the proper level of coverage can have a significant impact on the profitability of your company. As the number of top-heavy claims continues to rise, take the necessary steps to protect your company from liability. While the steps outlined above may not keep you from being sued, they will minimize the adverse impact of litigation.
© 2003
Reish Luftman Reicher & Cohen. All rights reserved. The ERISA Controversy Report is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman Reicher & Cohen does not warrant and is not responsible for errors or omissions in the content of this report.
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