Retirement Plans

Nest Egg or Lemon?

If you're buying another company, make sure you look under the hood of its 401(k) plan.
Virginia Munger KahnApril 1, 1998

As benefits managers know, it’s not easy to keep a 401(k) plan in compliance with every one of the Internal Revenue Service’s rules. But that difficulty is compounded when mergers and acquisitions are involved. Dealing with an acquired company’s plan–preserving it, merging it with one’s own plan, or terminating it–is fraught with regulatory and operational pitfalls. Like Forrest Gump’s box of chocolates, you never know what you’ll get with a 401(k).

Ask Maureen Phillips. As managing director at Putnam Investments, in Boston, Phillips observed a particularly ugly situation three years ago, when a large manufacturing company was acquiring a small niche player in the industry. In the small company’s plan, the buyer discovered not only that a loan had been made to acquire real estate–a generally unsuitable investment for a 401(k)–but that the loan had been made to the company’s outside counsel, who also happened to be the brother-in-law of the plan’s trustee. Such “parties-in-interest” are strictly prohibited from benefiting from a plan. To add insult to injury, the party-in-interest was bankrupt.

This was an “illiquid, illegal, and insolvent investment,” says Phillips. In order to resolve the situation, the large company had to pay back the loan out of pocket, as well as pay fines assessed by the Department of Labor. Only then was it able to merge the smaller plan into its own.

The manufacturer was fortunate to uncover the loan. A company that merges a tainted 401(k) into its own plan may pay a stiff price for the oversight. If the acquiring company doesn’t detect the problem and file a Voluntary Compliance Resolution, its 401(k) could be disqualified by the IRS. Not only would the company lose the tax deduction on the contributions it had made to the plan, but all the earnings in the trust could immediately become taxable.

Unfortunately, this scenario could be in store for a lot of companies. Last year a record 10,700 mergers and acquisitions, valued at $919 billion, were made in the United States, and the M&A pace shows no sign of abating in 1998. Many of those acquired companies will have faulty 401(k) plans; no doubt more than a few will slip unnoticed through the due diligence process.

TAINTED GOODS Merging a tainted plan into an otherwise pristine plan is the most common pitfall for companies involved in mergers and acquisitions. Buying a tainted 401(k) is not hard to do and usually doesn’t involve fraud or negligence on the part of the plan sponsor. Tainting can arise from many sources, such as failure to comply with antidiscrimination rules designed to insure all participants in a plan are treated fairly, failure to make proper and timely filings with the IRS or the DOL, or the inclusion of prohibited transactions and inappropriate investments.

Failure to administer a plan in accordance with the plan document–the legal foundation on which the plan is built–is another compliance problem that can result in the disqualification of a plan. Illinois Tool Works Inc., a diversified manufacturer of everything from screws to auto components, in Glen View, Illinois, brushed up against such a situation a few years ago in the process of acquiring a midsized manufacturing company. The company’s plan checked out in the due diligence phase. But almost two years later, Illinois Tool Works found a discrepancy in how the plan was administered while it was reviewing the operations of the plan, in preparation for merging it with its own.

Although the plan’s documents said anyone who had worked at the company 1,000 hours in a given year was entitled to a profit-sharing contribution, in practice the company was making such contributions only to people who were employed at year-end, recalls Daniel Madden, manager of retirement programs at Illinois Tool Works. “What happens [in such cases] is that the lawyers prepare the plan document, but the administrators don’t read it,” notes Madden.

In the end, Illinois Tool Works filed a Voluntary Compliance Resolution with the IRS. The cost of fixing the problem: $350,000.


Another potential 401(k) pitfall for companies involved in acquisitions is failing to maintain protected benefits, rights, and features. Protected benefits include vesting schedules and distribution op-tions, such as the timing, amounts, and methods of paying out benefits. If plan ABC has a longer vesting schedule than acquired plan XYZ, the latter plan’s more beneficial vesting schedule cannot be eliminated, says Phillips. By the same token, if participants have options for joint and survivor annuities (in which the annuity extends to the surviving spouse) or lump-sum distributions, those distribution options cannot be eliminated.

By contrast, loans, hardship withdrawals, and company matches are generally not protected, according to Phillips. Yet, firms often retain these features to maintain good relations with newly acquired employees.


Another common source of mistakes is distributions. Participants are allowed to take money out of the plan only in certain instances: retirement, separation of service, hardship (which is subject to stiff taxation and penalty), and plan termination. Many companies believe that because they are acquiring another company, they can simply terminate the other company’s plan and move the assets over to their own (see “Terminate, Merge, or Preserve?” below). However, terminations are neither simple nor automatic, points out Phillips. For example, if a company sells only a division to another company, and an employee of the former company is now happily ensconced at the new company doing substantially the same job, that is not considered a separation of service, and a distribution would not be allowed.

This “same-desk” rule can be dealt with in the purchase and sale agreement. The sale document can specify that participant accounts will be moved to a new plan, says Phillips. However, if the issue is not dealt with in the business transaction, typically the employee’s account will have to be left with the previous employer’s plan.

Determining whether there has been a distributable event–whether employment has been terminated for the employee–is “really complicated,” Phillips says. “If there is any doubt, don’t let people take the distribution.” The consequence of allowing premature distributions is, again, disqualification of the plan.


In addition to regulatory pitfalls, mergers and acquisitions pose plenty of operational problems for 401(k) plans. Twentieth Century Mutual Funds, in Kansas City, Missouri, a big player in the 401(k) business, experienced firsthand the complexities of merging retirement plans after it acquired fellow money management firm The Benham Group, in June 1995. (The new entity was renamed American Century Cos.) The process of merging the retirement plans started in January 1996 and took the better part of the year to complete. In the process, American Century had to impose a six-week blackout period on Benham’s plan for reconciling accounts. This did not sit well with employees, especially those who were leaving the company and wanted their money out of the plan, recalls retirement plans specialist David Lasater.

But it was in January 1997, when it came time to audit the newly merged plans, that the hard part began. Auditors had to back out the Benham account data from the American Century system, but the way Benham reported data was very different from American Century’s. Moreover, the longer the process took, the fewer Benham employees were left to answer Lasater’s questions. In the end, it took nine months to get through the audit. “It was not fun,” remarks Lasater.

Had he the chance to do it over again, Lasater says he would have made contact with his counterparts at Benham immediately after the transaction closed, in an effort to learn the ins and outs of the retirement plan and its administration. That way, he would have been able to explain the discrepancies in the reporting systems to the auditors.

Badly administered or out-of-balance plans represent still another common pitfall for acquirers. Such situations aren’t unusual–checks don’t get cashed, contributions may be delayed, duplicate loan checks can be issued that make it difficult to reconcile plan assets with the account balances of individuals. If a plan is out of balance, recordkeepers will not accept it.

Executives say that transferring assets from one recordkeeper to another always creates an uncomfortable situation because the old recordkeeper has little incentive to provide data in a timely manner. Even tougher is the situation in which the trustees of a plan being acquired are individuals who have lost their jobs in the business transaction, says Phillips. She recalls one situation in which the trustees of an acquired firm’s plan were the former owner, the owner’s wife, and a brother-in-law. They were let go as part of the transaction but held up the merger of the 401(k) for months, claiming they hadn’t received the required documents. “You want to make sure these individuals resign as trustees as soon as the business transaction is completed,” says Phillips.


Among the most annoying 401(k) problems encountered in mergers and acquisitions are the back-end loads plan providers impose when assets are taken out of a plan before a certain time period has elapsed. This is particularly common in guaranteed investment contracts and in smaller plans provided by insurance companies, say executives. “We have seen horrendous charges of as much as $80,000,” says Scott Maynard, benefits manager of U.S. Office Products Co., in Washington, D.C.

Like other companies, U.S. Office Products negotiates payment of these fees directly with providers. Although the fees could be imposed on plan participants, both U.S. Office Products and Illinois Tool Works pick up these costs themselves. Plan sponsors need to be careful, however, about how they account for these expenses, warns Illinois Tool’s Madden. If these costs are large enough, they could be considered a contribution to the plan, but they will need to be accounted for separately. Otherwise, they may be considered a payment of administrative expenses.

Illiquid investments in a plan can pose more than just regulatory problems. Some small companies manage balanced portfolios for participants in their 401(k)s. Madden notes that if these portfolios include illiquid assets, such as real estate limited partnerships, those assets will need to be split off from more marketable securities and held until a reasonable effort can be made to realize their value. Moreover, plan participants need to be warned that they will not have access to the entire value of their retirement plan when the merger takes place.


Many problems associated with 401(k)s and mergers and acquisitions can be avoided by beginning the planning process early. Although plan sponsors may be focused on the design of their plan after a merger, their first task should be to “open up the hood and look at the qualifications of the plan,” says David J. Castellani, senior vice president, Cigna Retirement & Investment Services, in Hartford.

Sponsors have until the end of the plan year following the calendar year of the acquisition to make a decision on whether to merge 401(k) plans, says Phillips. That means plan sponsors may have up to two years to decide. If they fail to make a decision within that time, they will be left with the options of preserving the old plan separately or merging the plan down the road.

This grace period doesn’t mean that issues surrounding the 401(k) should be left until the end. In fact, the plan should be addressed as early as the due diligence phase for the business transaction itself, say consultants. Problems uncovered in the administration or management of the retirement plan may indicate that further digging is required in other areas of the business.

If it’s going to cost a lot to fix the target company’s plan, should the acquirer negotiate down the purchase price? You could do that, replies Scott Maynard; “you look at it as a liability like any other.” What U.S. Office Products typically does, however, is set aside a certain amount of the purchase price in an interest-bearing escrow account and make its transfer contingent on the seller fixing its plan–and producing a clean bill of health from the IRS.

Virginia Munger Kahn is a financial writer based in New York.

———————————————————————— —————– How can companies make sure a potential 401(k) acquisition is clean? Some employ outside auditors to pick through plans with a fine-tooth comb, but that service isn’t cheap. At the very least, do-it-yourself acquirers should begin their due diligence by obtaining all key plan documents. Among the most important are:

  • * The plan document. This lays out the rights the participants have in the plan, limitations on contributions, the vesting schedule, distribution options, investment choices, and other basic information. This document is filed with the IRS.
  • * The IRS letter of determination. “If you have any brains when you cook up a plan, you’ll send it to the IRS for its approval,” says Maureen Phillips of Putnam Investments. This letter tells the reader that the plan, as written, meets the IRS’s qualifications for favor able tax treatment.
  • * The summary plan description. This is given to participants in lieu of the plan document. In a merger situation, plan sponsors will want to make sure it is consistent with the plan document.
  • * Form 5500. This is the plan’s annual report, which contains listings of all investments, loans outstanding, cash flows, and a balance sheet for the plan.
  • * The results of antidiscrimination tests. These include the ADP/ACP (actual deferral percentage/actual contribution percentage), 410(b), and 415 tests.

By getting their hands on these documents early in the process, not only can plan sponsors head off problems with tainted plans, but they can avoid merging plans that could throw off their own compliance ratios, says Joel Rich, senior vice president at consulting firm The Segal Co. – V.M.K.

———————————————————————— ——————– If a business transaction involves the sale of assets or the stock of a whole company, sponsors generally have three choices about how they will treat the acquired plan. They

or the selling company can terminate it, in which case the assets will be distributed to participants; they can preserve the acquired plan, running it alongside their own; or they can merge it with their own.

In general, plan sponsors want to avoid terminating the acquired company’s plan if they want the participants to leave their money where it is and not take the distributions and sink them into a new fishing boat. That has become a particularly difficult task in the last two years as participant account balances have ballooned with the stock market’s bull run, notes Maureen Phillips, managing director at Putnam Investments, in Boston.

Sometimes, however, because of the way deals are financed, plan terminations cannot be avoided. In such cases, it’s important to launch an aggressive education program to convince participants of the benefits of rolling over their assets into the new plan.

If plan sponsors are preparing to shut down a unit of a newly acquired firm, they must abide by rules governing partial plan terminations, says David J. Castellani, senior vice president, Cigna Retirement & Investment Services, in Hartford. If 20 percent of a plan’s participants are removed from a plan, any benefits that were not fully vested, such as company matches or profit-sharing contributions, may be required to become 100 percent vested. Failure to observe the rule can cause disqualification of the acquiring company’s plan.

Preserving an acquired company’s plan is a viable, and in some cases necessary, option. For example, plans offered by unions generally must be preserved. And because features such as company matches are part of the bargaining process, these plans should be kept separately, says Daniel Madden, manager of retirement programs at Illinois Tool Works, in Glen View.

Also, if the acquired plan has substantially different protected benefits or if it has had compliance problems, it may be best to leave the plan in place, notes Joel Rich, senior vice president at The Segal Co., a benefits and compensation consulting firm in New York. Rich saw a situation recently in which an acquiring company was concerned enough about the seller’s administration that it left its plan in place rather than risk “polluting” its own plan.

Economies of scale

In general, most companies eventually try to merge acquired company plans with their own. The main reason is to take advantage of economies of scale with regard to money management and administrative fees. Most companies also want to provide employees with a consistent benefits package across their organization and avoid problems with employees who transfer between divisions. If too many plans are maintained, companies may have a difficult time administering them and fulfilling their fiduciary duty to provide education programs for each plan, says Phillips.

The easiest way to merge plans is a trustee-to-trustee transfer. Essentially, this involves taking all the accounts from one plan and moving them over in a lump sum to another plan. In doing so, plan sponsors avoid handing participants a distribution, providing them with a fairly seamless transaction. – V.M.K.

roblems uncovered in the management of a 401(k) plan may indicate that further digging is required in other areas of the acquired company.