Economy Driven Furloughs May Impact Pension, Health, Fringe Benefits

Pension & Benefits Daily: All Issues > 2009 > June > 06/03/2009 > Analysis & Perspective

To save jobs, some private and government employers have instituted voluntary and involuntary unpaid leave programs for current employees to deal with decreased profits and budget deficits. Reduced hours or unpaid leave can have an unexpected negative effect on employees’ benefits, including eligibility in pension plans, matching contributions, and health coverage.

According to a survey by Watson Wyatt, “Effect of the Economic Crisis on HR Programs Update: April 2009,” as of April 2009, employers have decreased hours through reduced workweeks (22 percent), mandatory furloughs (17 percent), and voluntary furloughs (11 percent) as methods to cut costs.

In addition, in the next 12 months, 4 percent of employers expect to continue reduced weeks, 4 percent expect to continue mandatory furloughs, and 5 percent expect to continue voluntary furloughs, the survey said. The report was based on a survey of 141 U.S. companies.

There are a number of state and local governments and companies who have instituted furloughs, including California, the Gannett newspaper chain, and the University of Maryland.

These leaves are often referred to as furloughs, although technically, a furlough is in the context of a union contract, Greta Cowart, a partner in the Dallas law office of Haynes and Boone, told BNA May 14. Recently, however, the term has been used more widely to cover any situation where an employee either voluntarily or involuntarily takes a reduction in hours or unpaid leave.

Steven Friedman, shareholder and chair of the Employee Benefits and Executive Compensation Practice Group for Littler Mendelson, New York, told BNA May 12 that furloughs could cause employees to lose benefits if they participate in benefit plans with eligibility requirements stated in hours.

Pamela Perdue, of counsel at the St. Louis office of Summers, Compton & Wells, told BNA May 28 that the way in which a furlough impacts benefits, “if at all, really depends upon how it’s structured and the company’s own policies and benefit plan provisions.”

An Internal Revenue Service spokesman told BNA May 28 “the subject of unpaid leave and employee benefits is an unsettled area.”

New Interest in Furloughs

Friedman said his practice is seeing a lot of interest in clients who are thinking about furloughing employees, which is something that he says many benefits attorneys have never been asked about before.

According to Friedman, “employers are coming to grips first with the idea of saving money by furloughing employees, and then asking their management how to treat people on furloughs.” He said companies are trying to not have an impact on employees’ benefits and are taking steps to do that. For example, some employers are considering that for the purpose of furloughs, the employee would remain active for plan eligibility purposes, he said. There may be very different factors that need to be addressed with respect to retirement plans and health benefit plans in achieving this goal, he added.

Perdue said that “it used to be that furloughs were really something more often seen by state governments or the car industries. Now, more and more private employers are looking at it as a way to avoid employee layoffs or terminations. For example, some employers that may have traditionally closed down during the period between Christmas and New Years with pay, are now looking at the same practice but without pay. Moreover, there has certainly been more interest in exploring the options, such as whether it should be mandatory or voluntary and how it will impact benefits.”

Impact on Section 401(k) Plans

Under a Section 401(k) plan, once employees become eligible, they often will remain eligible to make employee deferrals irrespective of whether their employee status changes. Section 401(k) plans can require that an employee work for one year before becoming eligible to participate in the plan, and the tax code permits employers to define one year as 1,000 hours of service (although many plans now allow immediate participation). The 1,000-hour threshold is easy to meet for full-time workers, but it may affect part-time workers.

However, for new employees who are put on furlough, there could be an impact on when and if they become eligible, either to participate in the plan or for matching contributions from the employer, Friedman said.

Employers calculate plan eligibility differently. Some plans do it by anniversary year, so if an employee starts working on May 1, 2009, and does not meet the eligibility requirement within one year, that employee would have to wait a full year to become eligible after the hours requirement is fulfilled, Friedman said.

Other plans switch from an anniversary year basis to a calendar year basis after the first year, so if the employee starts on May 9, 2009, and did not make the hours by April 30, 2010, that employee might have to wait until Jan. 1, 2011, Friedman said.

In both instances, if a furlough affects the employees’ hours to the extent that he or she misses the 1,000 hours requirement, that employee might never be able to participate, or might have to wait until the next eligibility period to begin participating in the plan (or to be eligible for certain types of plan contributions), Friedman said. However, the plan may be able to be amended to provide that the furlough period is considered a period of active employment, alleviating the negative effect on the plan benefit for furloughed employees.

The same issue applies to profit sharing plans, which often provide that an employee receives a benefit for a particular year if he or she reaches a certain hour requirement (usually the same 1,000-hour requirement).

Another issue for Section 401(k) plans and profit sharing plans is the employer match, Cowart told BNA. “If you don’t have compensation for working, you can’t have a salary deferral election, then there won’t be the match, and there wouldn’t be a profit sharing contribution,” she said.

Regarding plan requirements, any time an employer changes a match, the employer has to look at plan documents, Cowart said. For example, the plan could require that the match be paid every pay period. If the match is “hardwired” into the plan (i.e., the plan document specifies the matching contribution formula), the plan would have to be changed, Cowart said. If the plan provides for a discretionary matching contribution, the board resolution specifying the matching contribution may need to be changed or it may not even be specified for the year, which means that it does not require a plan amendment, she added.

To compensate for a reduction in salary, employees can increase their contribution levels, if the plan allows it, Scott Macey, senior vice president and director of government affairs, Aon Consulting, Washington, D.C., told BNA May 29.

However, companies should be careful that the increased contributions do not skew anti-discrimination testing, Macey said. Section 401(k) nondiscrimination rules prohibit highly compensated employees (HCEs) from deferring too great a percentage of their salary compared to nonhighly compensated employees (NHCEs). In a furlough situation, HCEs might be the only employees able to increase contributions. In the meantime, NHCEs on furlough might have to reduce or stop their contributions. As a result, the percentages might shift, causing a company to fail the anti-discrimination testing. If this is the case, a company can cut back the amount the HCEs can contribute for the rest of the year, Macey said. If, at the end of the year, the HCEs have contributed too much money, the company would have to give that money back to the HCEs, and that money becomes taxable as income, he added. This situation could occur in a small plan, or a large plan with a significant number of HCEs, he said.

Section 401(k) plan loan repayments could also be affected, Cowart said. Loans from Section 401(k) plans are usually paid through salary reductions. If there is no salary to take the repayment from, the employee has to write a check because otherwise, he or she could go into default, she said. Even if there is still a salary, but it is less because of reduced hours, the employee still has to pay back the same amount, she said. This means less money in the employee’s paycheck, she said. Finally, if the employee misses a payment one quarter, and does not make up the payment by the end of the next following quarter, the loan would be deemed distributed, and the entire amount of the loan would be taxable to the employee on Form 1099, she warned.

Impact on Vesting

Some employees may not work enough hours during the plan year to earn vesting credit in their pension plans for the year with reduced hours, Cowart said. If an employee does not work the required number of hours necessary to receive a year of service credit for vesting purposes, the employee may not earn another year of vesting credit in his or her plan.

To fix this problem, an employer could amend its plan on a nondiscriminatory basis, Cowart said. For example, a plan could provide that anyone who takes unpaid leave gets credit for the hours they are on such leave as if they worked at their regularly scheduled work. These amendments have to be in place by the end of the plan year in which they occur because these are discretionary amendments, she added.

Impact on Health Plans

The impact of furloughs on eligibility for health benefits is similar to those regarding participating in Section 401(k) plans, Friedman said, although generally, employers have more latitude when setting eligibility requirements.

For example, employers can provide that everyone who is regularly scheduled to work 20 hours per week is eligible to participate in the company’s health plan. Therefore, an employee who has reduced hours due to a furlough could be brought below the threshold, Friedman said.

There are a couple of ways employers can deal with this, Friedman said. First, an employer can treat the furloughed employees as if they are active, even on days they normally would have worked but for the furlough. Second, an employer can lower the eligibility threshold, so that even after taking into account the furloughed hours, the employee still qualifies to participate in the health plan. The employer might have to amend the plan to provide for these situations, he said.

In addition, if the health plan is insured, the employer might also have to get the insurer on board, Friedman said. The eligibility provisions of health plans are generally set forth in a contract between the insurer and the employer, and the insurer will not cover individuals who are not part of the eligibility group as set forth in the contract. If the furloughed employees would otherwise be ineligible, and the employer wants to make them eligible, the contract between the insurer and employer might need to be modified, Friedman said.

Impact on COBRA Subsidies

In enacting the American Recovery and Reinvestment Act of 2009 (ARRA) (Pub. L. No. 111-5), Congress added a temporary subsidy to help individuals who have lost their jobs to pay COBRA premiums for group health care coverage. Individuals who become eligible for COBRA continuation rights because of an involuntary termination of employment between Sept. 1, 2008, and Dec. 31, 2009, pay only 35 percent of the COBRA premium. Initially, the remaining 65 percent of the premium is subsidized by the employer, and reimbursed by the federal government through a credit to the employer’s payroll taxes. The premium reduction applies to periods of health coverage beginning on or after Feb. 17, 2009, and may last for up to nine months.

IRS subsequently released Notice 2009-27, which provided, among other things, that “an involuntary reduction to zero hours, such as a lay-off, furlough, or other suspension of employment, resulting in a loss of health coverage is an involuntary termination for purposes of the premium reduction.”

Perdue said that “ironically, the opportunity to have furloughed employees become eligible for the COBRA subsidy may actually make it easier for employers to consider dropping health coverage for furloughed employees.”

But Friedman said many employers are trying to not terminate health coverage when they put an employee on furlough. If there is no termination of health coverage, then there is no issue, he said.

Cowart said under Notice 2009-27, if reduced hours or unpaid leave results in an employee moving from being covered by the employer’s health plan to not being covered, it could be considered an involuntary termination if the employee is forced to quit in response to the reduction in hours. The reduction in hours without the employment termination can be a qualifying event to trigger COBRA, but not make the individual eligible for the COBRA subsidy. Thus, if the reduction in hours forces an employee to lose coverage, but the employee does not terminate employment, then the employee would still be eligible for COBRA, but not the COBRA subsidy, she said.

Another issue may arise under the Health Insurance Portability and Accountability Act’s pre-existing condition provisions, Cowart said. If an employee has a COBRA event resulting in coverage termination, and does not maintain coverage because of inability to pay, and that employee returns to coverage after 63 days without health coverage, he or she may have a pre-existing condition, Cowart said.

Under HIPAA, prior creditable coverage is not counted to reduce the pre-existing condition exclusion period to the extent that the prior creditable coverage is followed by a break in coverage of 63 days or more, Cowart said. However, there are special rules relating to the break in coverage related to the COBRA subsidy and the special second election period, she said. (The second election period applies to individuals involuntarily terminated from Sept. 1, 2008, through Feb. 16, 2009, who did not elect COBRA when it was first offered or who did elect COBRA but are no longer enrolled. This election period begins on Feb. 17, 2009, and ends 60 days after the plan provides the required notice.)

Impact on Fringe Benefits

Furloughs can also affect flexible spending accounts, since employees may want to reduce their pretax saving due to less need for things like dependent day care expenses or commuter benefits, both of which can be paid for through an FSA.

For day care expenses, people make their elections assuming they are going to work a certain number of hours, and when that amount is reduced, they need less day care, Cowart said.

An employee may want to adjust the amount he or she is contributing to an FSA towards dependent care, but that depends on whether that employee qualifies as having a change in status under tax code Section 125. Taking an unpaid absence could be a change in status triggering an opportunity to change elections, Cowart said. The plan must be designed to include the taking of an unpaid leave of absence as a change of status, however, as employers are not required to recognize all of the change in status options. If the employee has merely had the number of hours reduced, this would not be an unpaid leave of absence and may not enable the employee to change his or her elections with respect to dependent care, she said.

John Graham, regional director of compliance research, for the Segal Co., New York, told BNA May 29 that health FSAs might be an issue if a furlough lasts more than 30 days. IRS has unofficially said that if an individual is not working for over 30 days, the plan can treat the individual as a new employee, and the individual may lose any money that is left in the FSA, Graham said. For shorter absences, the plan can reinstate the individual into the prior election, losing FSA coverage only for the period of the absence, assuming no COBRA election is made, he added.

This position might be based on an example in the Section 125 “change in status” regulations, which allows a plan to state that when over 30 days have elapsed between separation from service and rehiring, then the plan can permit a new election, allow the individual to keep the old one, or make the individual wait until the next year before reenrolling in the FSA, Graham said. It is unresolved as to whether a furlough of over 30 days would be considered a termination, although it is considered a termination for other purposes, such as qualifying for the COBRA subsidy, he said.

Additional Issues

Executive Compensation: If a furlough is long enough to be considered a separation from service, it could trigger an unintended payout from a deferred compensation arrangement, Friedman said.