Party-in-interest transactions controls for benefit plans

Aug 18, 2020
Audit Financial reporting Business tax Compensation & benefits

With regulators focused more than ever on a plan's controls, it is imperative that plan sponsors have the proper procedures and controls in place. This fourth in a series of articles on the importance of internal controls for employee benefit plans looks at controls for party-in-interest transactions.

The Employee Retirement Income Security Act (ERISA) includes certain prohibited transaction rules to prevent dealings with parties who may be in a position to exercise improper influence over plan assets and to prevent plan fiduciaries from taking actions with respect to a plan that involve self-dealing and/or conflicts of interest. A party in interest is defined by ERISA to include any plan fiduciary (administrator, officer, trustee or custodian), the employer or any affiliate, any employee of such employer, any service provider to the plan (attorney, auditor, etc.) whether paid by the plan or not, or an owner of 50 percent or more of the stock of the employer, among others. It should be noted that ERISA's definition of a party in interest is broader than a related party as that term is defined by U.S. GAAP.

ERISA prohibits various types of transactions between a plan and a party in interest, including sales or leasing of property, lending money or extending credit, providing goods or services, using the income or assets of the plan, and holding employer securities or real property that do not meet certain conditions. In addition, a plan fiduciary is prohibited from using the plan's assets in its own interest or acting on both sides of a transaction involving a plan. Due to the risk of self-dealing, such transactions are illegal—regardless of the intentions of the parties to do what is best for the participants. One of the most common prohibited transactions involving the plan fiduciary is the failure to timely remit participant deferral contributions and loan repayments to the plan in accordance with U.S. Department of Labor (DOL) regulations.

Some party-in-interest transactions are permitted with certain restrictions and conditions. Such "exempt" transactions include: loans to plan participants or beneficiaries; the provision of services necessary for the operation of a plan for no more than reasonable compensation; loans to employee stock ownership plans; deposits in certain financial institutions; contracts for life or health insurance; and distribution of the assets of the plan in accordance with the terms of the plan. If the law or other administrative rulings do not allow a transaction with a party in interest, the plan must ask for permission from the DOL prior to executing the transaction or face the risk of having the transaction undone and penalties imposed on the applicable party in interest.

ERISA and DOL regulations require transactions with parties in interest, other than exempt transactions, to be reported on schedules to the Form 5500, Annual Return/Report of Employee Benefit Plan, which is publicly accessible. ERISA also provides for specific monetary penalties for violations of party-in-interest rules. Such penalties cannot be paid with plan assets.

Summary of procedures
In determining that the plan has the appropriate practices and procedures established to comply with the ERISA party-in-interest regulations, the plan sponsor should:

  • Be aware of potential prohibited party-in-interest transactions.
  • Identify all parties in interest by name, or by class, and distribute the list to all persons responsible for the plan's operations. Provide for periodic updates of such list.
  • Have a clear and well-documented understanding of the restrictions and conditions for common party in interest transactions.
  • Have controls in place that require additional approval for any plan transactions with parties in interest and where applicable, any conditions for the exemption have been satisfied.

Currently, there are three areas related to party in interest transactions that are subject to regular evaluation by the DOL upon examination. Those areas are: the timeliness of deposit of employee salary deferrals or loan payments; participant loan programs; and the reasonableness of service provider fees. The remainder of this article examines in depth the types of processes and procedures that should be in place in each of those common areas.

Timeliness of deposit of employee salary deferrals
Untimely deposits of employee salary deferrals or loan payments are considered prohibited transactions because DOL regulations provide that employee deposits become plan assets as soon as they can reasonably be segregated from the general assets of the employer. That means if the employer (a party in interest) holds the funds for a longer time period, they are holding plan assets in the company's account, unprotected from general creditors and may be benefiting from income on the assets held in its depository account.

This has been the subject of DOL scrutiny since the regulations on this topic were first effective in 1997. Only recently, however, has the DOL inquiry focused on the processes and procedures surrounding the timeliness of deposits. RSM's experience in examination has been that the DOL is more willing to accept the employer's assertion on timelines where it is evident that there is a clear set of procedures that are uniformly applied and demonstrate a deposit pattern that is as fast as reasonable. In contrast, where there is no evidence of such procedures and deposit timing ranges from the day before payroll to two weeks or more following payroll, we have consistently seen the DOL select the first day deposits are made after the payroll date and use that timing as the definition of when plan assets can be reasonably segregated from plan sponsor assets. This results in all later deposits being subject to correction and where applicable, the assessment of a 15 percent excise tax on lost earnings for each year that the error has been outstanding.

What procedures are expected to demonstrate timely deposit? This cannot be a complete list as the procedures and controls will vary with the specific facts, but consider the following:

  1. Consistent with the discussion in our prior article on plan operations, are controls in place to make sure that participants enter the plan on time, the correct compensation is used for determining salary deferrals, and participant initial deferral elections or subsequent changes to deferral elections are accurately reflected in the plan administration system? These controls are necessary for basic plan operations, but when such controls are functioning, they reduce the amount of time spent reviewing the deferrals calculated for each pay period. One of the most common deposit delays we encounter during plan audits is the need to do several reviews, reconciliations and corrections of the deferral calculations prior to deposit because there was not sufficient assurance that those controls on general plan operations were working effectively.
  2. If an outside payroll service is used, do they provide a data file on the employee deferrals and loan payments that is in the correct form for use by the employer or the investment service provider? Though less common than in the past, we still see situations where someone from HR or payroll is required to translate the data file received from one service provider into a format useable by another service provider. Such manual manipulation increases the risk of error and takes additional time. Where such action is currently required, the employer should document why and what steps they have taken to speed up the process. Further, if such a step is required, another step would be necessary to review the results before transmitting the modified data.
  3. Are procedures in place to enroll participants immediately upon eligibility? Another common source of delay in the timeliness of deposit of employee salary deferrals is that the investment service provider has not established an account for new participants soon enough to accept their initial deposits. Such controls would include the delivery of enrollment notices to the service provider on the first day of the initial pay period; follow up solicitation of required information from the participant before the deposit date; the authorization of the deposit of funds into the plan's default investment account pending receipt of participant salary direction; and the verification of the establishment of the accounts prior to the end of the initial pay period. Related to this issue is the matter of renewing enrollments for rehires, persons whose deferrals were halted due to the hardship distribution requirements of the plan and persons returning from leave. Procedures must be in place to re-enroll these parties. Frequently, their entry dates and deferral election procedures vary from new participants. Thus, the controls must be designed to recognize the participant's status for purposes of setting entry and deferral amounts.
  4. Are the specific duties of each person in the chain of command for processing salary deferrals outlined, with back-up plans for situations where one or more persons are unavailable? Planned absences are not a reason to delay the deposit of employee funds. It is expected that procedures be in place to ensure that another person will cover each required task during any planned absences, for example, vacations and holidays.  
  5. Are controls in place to ensure that the deposit, once approved, is actually made and delivered? With fully automated systems, it is all too common to assume that once the information is entered, the process is completed. Experience has taught us that it is not reasonable to assume that the service provider receiving the funds will notify the employer if a normal deposit fails to arrive. The employer should have controls in place over confirming the deposit was made successfully.
  6. Are controls in place to segregate and separately address the correction of any errors? Even in the best-run systems, errors still happen. We frequently find situations where the entire deposit for a pay period has been delayed while a minor error is tracked down and corrected. The regulations apply a reasonableness standard to the concept of timely. It is reasonable to take some time to track down and correct an error, which may justify an additional day or more to make the deposit related to that error. However, the funds not associated with that error should not be delayed.
The Real World

Earlier this year, RSM was auditing a plan that paid their employees on the 15th and end of the month. Every deposit of employee contributions and loan payments was made exactly on the next business day, except for two times. Each of those was delayed until the next business day for the following pay period. In each case, the payment had been authorized but there was some error in the transmission process so the payment was not actually made. The employer had no control in place to verify that the payment process was actually completed and the investment house receiving the funds had no control in place to inquire of a missing deposit. The employer reported these two deposits as late, as they agreed that controls should have been in place to verify the completion of the deposit. They were required to report this matter on their publicly accessible plan financial statements, deposit lost earnings into the plan and pay an excise tax on the lost earnings.

Participant loans
As discussed earlier, the general rule is no extension of credit between the plan and a party in interest. While all employees are included in the definition of party in interest, ERISA does provide a specific exemption for participant loan programs. Like all exemptions, the plan is required to comply with the specific terms and conditions of the exemption regulations. The good news is that one of those requirements is the creation of a written set of participant loan procedures. These may be in the plan document, the plan's Summary Plan Description or in a separate loan procedures document. The existence of the written loan procedures is the first step in establishing the appropriate control system, as it establishes an agreement of how such a program should operate. Such a written document is only the beginning of the control system. Other items to consider include:

  1. Have the loan procedures been communicated to all relevant parties? Has it been confirmed with all parties that they understand the terms of such procedures?
  2. Is a periodic review performed to ascertain that the plan's rules governing loans are being properly applied? This would include checking things like interest rates, terms, calculation of allowable loan dollar limits and plan imposed limits on things such as the number of loans that may be outstanding at any point in time.
  3. Where the loan program is fully automated through a service provider, is sufficient documentation retained to evidence compliance with the prohibited transaction rules? Frequently, a sample loan document is provided to the plan participant and their signature on the loan check is the only evidence of their taking the loan. In such circumstances, a copy of the signed check and the specimen loan document applicable to that loan should be retained for as long as the loan is outstanding, as well as records of the receipt and application of each payment.
  4. Are procedures in place to ensure that the relevant information pertaining to loan repayments through payroll withholding is communicated to payroll completely, accurately and timely to commence withholding on time? Is someone charged with reviewing this procedure at least quarterly to avoid a loan going into default due to nonpayment? During the last two audit seasons, this has been the most frequently omitted process we have observed in participant loan programs. The unfortunate consequence can be that the participant goes into default and is subject to tax on their loan balance, even though the failure to make payments was not their fault. The good news is that this failure can be corrected under the IRS correction program. However, the result, in that case, is frequently larger monthly payments than what the employee originally anticipated. It is much better to have the proper controls in place to avoid this problem.
The Real World

An all too common failure in controls over plan loan programs was identified in a recent audit engagement. Plan management selected a new third-party administrator during the year. In the process of moving plan operations to the new provider, the automatic loan payment process was inadvertently turned off. This error was not recognized until eight months had passed when they were reconciling plan activity for the year! This resulted in all the participant loans violating the default rules and being subject to reporting as taxable distributions, subject to income tax and potential penalties. The good news was that the IRS has a relief program for this kind of error to protect plan participants from taxation and penalty. The point is that if controls had been in place to reconcile not just what happened but what should have happened, the error would have been caught before a default event occurred.

Reasonableness of service provider fees
Reasonableness of service provider fees is the most recent of the DOL's prohibited transaction inquiries. This is the result of the requirement for all covered service providers to disclose to the plan fiduciary specific details on the services provided and the revenue collected either directly or indirectly from the plan for such services. These disclosures were first required in the summer 2012. This means that the entire benefit plan industry has less than two years experience with the DOL making inquiries about the plan fiduciaries' procedures governing the reasonableness of such fees.

The good news is that, to date within our practice, it appears that the current DOL inquiries are more data collection and education. However, this does not mean that plan sponsors should be too casual in their duties in this area. We suggest the processes, procedures and controls in this area include the following:

  1. Create a list of all covered service providers to the plan.
  2. Verify that information regarding services and fees, or basis for fees, has been provided by each covered service provider on a timely basis.
  3. Review this information for completeness. If it is incomplete, a request should be made by the fiduciary to the service provider for the missing information. If it appears complete, the fiduciary should evaluate the fees relative to the services provided and conclude whether they believe the fees are reasonable. The fact that this review happened and the conclusion should be documented in writing by the fiduciary in the form of committee meeting minutes applicable or a contemporaneously drafted memo to the file. There should also be a control in place to determine that such documentation has been completed each year.
  4. Establish a procedure to reconsider the conclusion in the event the service provider revises fees or services.
  5. Establish a procedure to verify that all fees are included in the evaluation.

If you need more information on the requirements for the evaluation of fees, RSM has prepared a white paper on this topic.

These are only a few of the prohibited transaction exemptions that are relied upon by plans in their day-to-day operations. Others may include short-term advances to cover the plan's liquidity needs, ESOP loans, the purchase or sale of qualifying employer securities or qualifying employer real property, the use of proprietary investment funds of plan service providers, and numerous other examples. The general rule here is that the plan fiduciary must recognize where the plan is relying on a prohibited transaction exemption, have a clear understanding of the applicable requirements of the exemption and have procedures in place to comply with those requirements, verify and document such compliance.

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