When a defined contribution (DC) retirement plan is awarded damages or receives a settlement from a lawsuit, it is incumbent on the plan administrator to figure out how to award the funds to participants.

Initially, the funds are placed into a holding account, says Daniel Johnson, head of the employee benefits and compensation practice at Moore & Van Allen in Charlotte, North Carolina. Then, the first distribution of the settlement goes to pay attorney fees, adds Mike Kasecamp, retirement plan consultant at CBIZ Retirement Plan Services in Columbia, Maryland. Their fees are typically 25% to 30% of the settlement. “It is unfortunate that with many of these settlements, the participants receive such small funds, while the attorneys can get millions,” he says.

Next, the administrator must figure out how to distribute the funds to participants, relying on the detailed files of their recordkeepers to help them determine how to allocate the funds, Johnson says. Sponsors typically divide the settlement by each participant’s balance at the time of receipt to figure out a percentage to pay them, Kasecamp adds.                                       

If the settlement was determined in a relatively short period of time, it could be easy for the administrator to allocate the funds, Johnson says. However, in most cases, lawsuits carry on for several years, and participants may have left a plan, which makes it challenging for the administrator to locate them, and that can delay payment, Johnson says. “Plans don’t stay static. People move their money around, and some people may have paid out or have left the company.”

NEXT: No guidance about settlement payments

It is important for sponsors to be very meticulous about how they allocate the settlement moneys, as, “unfortunately, current regulations do not give specific instructions, and the process for allocation to participants may not be the same for every single plan receiving a settlement,” says Rick Skelly, client executive at Barney & Barney’s retirement services division in San Diego. “When the plan receives the actual settlement check, it doesn’t come with specific allocation instructions to the participants. The plan sponsor must determine the allocation themselves.”

However, some settlement agreements “include a formula for allocating the funds to participants,” says Marcia Wagner, principle with Wagner Law Group in Boston.

As to how participants receive the funds, for those who are currently still in the plan, it is placed into their accounts, Johnson says. For those who have left the plan, “it will be a trailing distribution.”

Some plan sponsors may decide to allocate the funds only to those who are currently in the plan, Skelly says. However, if it is not “administratively feasible” to allocate the funds to the participants, “the payment may, to the extent permitted by the retirement plan, be used to pay reasonable administrative expenses associated with maintaining the retirement plan,” he explains. “The money would then be deposited into the forfeiture account in this instance.”

In addition, if the lawsuit has dragged on for a long period of time and many of the participants have left the plan and are unreachable, this could also prompt the sponsor to allocate a settlement to the plan’s administrative expenses, rather than to participants, Skelly says.

When the settlement payments are issued to participants, because they typically are so small, they are simply added to the participant’s earnings on their account statement, Johnson says. “Most of the time, these settlements end up being pennies to a few dollars” per participant, Kasecamp agrees.

However, “If it is a big number and has gotten a lot of press, the sponsor will probably ask the recordkeeper to represent the figure as a line item,” Johnson says.

While most retirement plan accounts are daily valued, and issue statements to participants each quarter, a few plans value participant accounts less frequently, Kasecamp says. “These are balance-forward accounts, and in these cases, these plans would hold the funds until the [next valuation period],” he says.

If the settlement is awarded to a defined benefit plan, “damages and settlement proceeds would be comingled with the plan’s other assets, and no participant would have a claim against any specific portion of the assets,” Wagner says. “Plan benefits under these plans are generally determined under a formula based on a participant’s compensation and length of service.”

As to when taxes are paid on settlements, because DC plans are tax-exempt, the settlements are not taxed, Wagner says. Participants pay taxes when the funds are distributed.

As to other considerations sponsors must keep in mind when handling settlements, Johnson says that “a lot of times, these settlements involve the stock of the sponsoring employer. As a party in interest, it is a prohibitive transaction for the employer to receive such settlement money. Therefore, the employer has to go through a prohibitive transaction class exemption to make sure the settlement is exempt.”

And just like any other fiduciary action, it is important that the sponsor “make sure that the funds are allocated to the correct participants and document how they came up with the figure,” Kasecamp says. “The best way to handle any fiduciary best practice is to ensure it is a prudent process and that is documented.”

In addition, it is important for the plan sponsor to determine whether accepting a settlement is a better option than pursuing a lawsuit, Wagner says. “Prior to opting for a settlement, [the Employee Retirement Income Security Act (ERISA)] requires a plan fiduciary to conduct a prudent evaluation of whether the settlement is reasonable and the settlement proceeds are at least as valuable as the likely recovery from pursuing all aspects of the claim, including both securities fraud and ERISA causes of action,” she says.

“The plan fiduciary should consider whether the receipt of the settlement proceeds outweighs the possibility of receiving a larger recovery by not participating in the settlement and pursuing the ERISA claims,” according to Wagner.