Defined Contribution Plan Failure: Options for Participants

By Frank Armstrong III

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JULY - 2006 - If an employer fails, or terminates a defined benefit plan, participants may find themselves facing significant shortfalls. Absent outright fraud or theft, however, the failure of a defined contribution sponsor is not usually as troublesome.

Assuming that the required contributions were made on schedule, a defined contribution plan can never be underfunded. Unlike a defined benefit plan, an employer does not promise a particular benefit. While an employer must petition the Department of Labor (DOL) for a plan termination, the procedure is relatively simple compared to a defined benefit plan. All funds in an employee’s account will immediately become vested upon plan termination and eventually will be paid out to each employee.

If a plan is invested in liquid securities, such as mutual funds or separately managed accounts, payout should be fairly straightforward. The accounts are valued as of a termination date, and distributions are made to the participants. There are, however, unfortunate exceptions.

Warning Signs

In a few cases, companies may not have made required contributions to their plans, or may have actually stolen from the plans. The following warning signs are extracted from the DOL website (

  • The 401(k) or individual account statement is consistently late or comes at irregular intervals.
  • The account balance is inaccurate.
  • The employer failed to transmit contributions to the plan on a timely basis.
  • There is a significant drop in account balance that cannot be explained by normal market ups and downs.
  • The 401(k) or individual account statement shows that contributions from paychecks were not made.
  • Investments listed on the statement are not what was authorized.
  • Former employees are having trouble getting their benefits paid on time or in the correct amounts.
  • Unusual transactions have occurred, such as a loan to the employer, to a corporate officer, or to one of the plan trustees.
  • There are frequent and unexplained changes in investment managers or consultants.
  • The employer has recently experienced severe financial difficulty.

Unfortunately, if a plan possesses illiquid investments, such as real estate or limited partnerships, payout may be delayed until the properties can be unwound. For example, the Eastern Pilots pension plan had cleverly invested over 90% of the fund in raw undeveloped land. It took over 10 years for the participants of the Air Line Pilots Association to be paid out and the plan terminated. Even worse, the land had been systematically overvalued by the trustees, so the pilots never recovered the full amount they had expected. Fortunately, these gross lapses in fiduciary responsibility are rare.

Enron provided a stark lesson in the importance of avoiding company stock in a retirement plan. Many Enron employees lost their jobs and their 401(k)s at the same time. Wherever possible, participants should reduce the holdings of employer stock in personal accounts and retirement plans to zero.

Orphan Accounts

Because many company plans hold accounts for former employees, some of these accounts may become “orphans” over time. If a plan terminates and those ex-employees cannot be found, their accounts will likely be liquidated and rolled into an IRA with a third party. The default investment will most likely be cash. Surprisingly, there are many orphan accounts nationwide. Employees should keep their former employers notified of their current address. If the option is provided by a former employer, the account balance should be rolled over into an account that the former employee can control.

In rare cases, the liquidation of a company leaves the pension plan itself orphaned, with no entity responsible for winding up its affairs or making distributions. In such an event, the DOL would appoint an independent third-party trustee to terminate the plan.

The Best Option

When a plan terminates, the best option for most individuals is to immediately roll over the account into an IRA and invest it for future needs. A rollover often allows one to reduce costs, tailor the account to individual circumstances, and upgrade investment choices. Other options may be available, but most participants will benefit from keeping the money in a tax-deferred IRA.

Frank Armstrong III is the founder and principal of Investor Solutions, Inc. (, a fee-only, SEC-registered investment advisor. He is also the author of The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio (Amacom).




















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