When I think of October, I think of pumpkin spice everything, sitting on the sidelines of my kids’ soccer games, football season and retirement plan corrections. I relate plan corrections to October, not because I enjoy them as much as my pumpkin spice latte, but because it is the time of year that we receive many calls about plan corrections. This timing is due to calendar year plans who have extended their Form 5500 having to file by October 15th. We recently wrote a post about it being important to have a playbook hen it comes to corrections, and I think it is equally as important to understand how you have to calculate earnings when there is a correction due.
Recordkeepers often play an integral role in calculating earnings for plan sponsors on corrective amounts. However, it is important that the plan sponsor give the recordkeeper specific direction on how they would like earnings calculated or the recordkeeper may default to calculating them under the method that is easiest for them. The method that is usually easiest for them is to use the DOL calculator. The DOL provides an online tool that calculates lost earnings for plan sponsors when they owe earnings to their retirement plans due to a prohibited transaction. This calculator uses an interest rate that is intended to reflect the amount of money the plan sponsor could have earned on the use of the money involved in the prohibited transactions. The calculator is what should be used for calculating lost earnings on late deferrals.
However, it is not the default method of earnings for operational corrections such as improperly excluding employees or using the wrong definition of compensation. Those errors are supposed to be corrected under the IRS’s Employee Plans Compliance Resolution System (“EPCRS”). Under EPCRS, the IRS provides that to the extent possible earnings on any corrections should be calculated using actual earnings. In a participant-directed defined contribution plan, actual earnings would be based on the actual investment elections that a participant had on file. If the participant does not have an investment election on file, the plan can use the default investment fund to calculate earnings as long the any cumulative loss will not result in a reduction of any corrective matching contribution due. Alternatively, a plan sponsor can use the plan’s overall earnings rate over that period of time.
There are also several rules of administrative convenience that may be used when the correction involves increasing a participant’s account. If most of the employees being corrected are non-HCEs, the earnings can be based on the rate of return of the fund with the highest rate of return under the plan during the period of the failure. In this case, the plan could also use a pro rata portion of the earnings rate for a partial period using the rate for the entire valuation period. For example, if earnings for the year on a fund were 6% and the error lasted 6 months of the year, the plan could apply a 3% earnings rate. If the correction involves the employer making a corrective allocation, they may ignore any losses.
There are different rules of administrative convenience that may be used when the correction involves decreasing a participant’s account. If most of the employees being corrected are non-HCEs and there was an overall gain from the date of the error to the date of correction, no earnings adjustment is required. Another option where the correction involves mostly non-HCEs is that the plan may use the lowest earnings rate of any fund in the plan during the correction period.
If none of the above options are possible (e.g., due to a change in recordkeeper during the period of the failure) or if the probable difference between the approximate and precise restoration is insignificant and the administrative cost of determining the exact amount would significantly exceed the difference, the plan sponsor may use a reasonable estimate to calculate earnings. EPCRS provides that 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. EPCRS provides that for this purpose, the interest rate used by the DOL Calculator is deemed to be a reasonable.
Determining how to calculate earnings can be tricky for employers, but most recordkeeping systems today are able to calculate actual earnings fairly easily. Therefore, unless the correction is related to a prohibited transaction such as late deferrals, the default earnings method for operational corrections in most participant-directed plans should not be to use the DOL calculator.
If you need assistance with a plan correction, please reach out to any member of our employee benefits team.
