Traps for the Unwary: Is your Company’s Severance Arrangement Subject to ERISA?

Severance arrangements generally provide for cash payments to an employee whose employment is involuntarily terminated and may include certain benefits, such as subsidized medical coverage and outplacement assistance.

Severance arrangements take a variety of forms. Formal severance plans often are used as a retention tool for employees across the board with no individual negotiations. In our experience, companies with formal severance plans typically treat them as ERISA plans.

Instead of formal severance plans, many companies have informal guidelines that are applied when an individual’s employment is involuntarily terminated. These arrangements provide more flexibility than a formal plan and allow severance benefits to be negotiated on a case-by-case basis, but may increase the risk of discrimination claims as employees are treated differently. It is less likely that a company will treat an informal severance arrangement as an ERISA plan. However, as discussed below, informal severance arrangements may be subject to ERISA and failure to recognize that ERISA applies could result in significant penalties.

Application of ERISA to Severance Plans

A severance arrangement will be subject to ERISA if it is considered a “plan, fund, or program” for ERISA purposes. The key issue in making this determination is whether the severance arrangement creates the need for an “ongoing administrative scheme.” This is not a bright line test and its application can differ depending on the various circuit courts. However, a severance arrangement is more likely to be considered an ERISA plan if the arrangement provides for installment payments (as opposed to a one-time, lump sum payment) or continued access to benefits.

By way of example, the Sixth Circuit applies two primary factors: (1) whether the employer has discretion over the distribution of benefits and (2) whether there are ongoing demands on the employer’s assets. Applying this test, the Sixth Circuit has held that:

  • A severance arrangement providing for a one-time payment to employees who ceased working did not constitute an ERISA plan because the plan required no continuing administration and a collective bargaining agreement predetermined payment amounts.
  • A severance arrangement was subject to ERISA when (1) the administrator exercised discretion to determine whether benefits offered by an acquiring company were “at least comparable” to the prior benefits and to compute the seniority status of employees to determine the severance benefits due, and (2) the severance arrangement provided for a lump sum payment of salary and bonuses, but medical, dental, and life insurance benefits continued for a period of time following termination of employment.

Implications of ERISA Status

If a severance arrangement is subject to ERISA, it will need to comply with ERISA’s requirements, such as the need to file annual Form 5500 reports, distribute summary plan descriptions (SPDs), and comply with ERISA’s claims procedures. The failure to comply with these requirements can trigger substantial penalties. Failure to recognize the ERISA status of a severance arrangement may prove costly.

However, it is important to note that ERISA’s participation, funding, and fiduciary responsibility requirements may not apply if the severance arrangement covers a select group of employees who are in management positions or highly compensated employees. The determination of whether a severance plan is a top-hat plan and whether the plan is an “employee welfare benefit plan” or an “employee pension benefit plan” is beyond the scope of this post.

The application of ERISA has some advantages. If a severance arrangement is subject to ERISA, the administrator’s decisions under the plan’s claims and appeals process may be given greater deference by courts and participant claims may be less likely to be litigated because of the requirement to exhaust the plan’s claims and appeals process. ERISA claims brought in state court are subject to removal to federal court, which may be a better forum for the defense.

Next Steps

The application of ERISA to informal severance plans/guidelines is an issue that is commonly overlooked. If you would like assistance determining whether your company’s current severance arrangement is subject to ERISA (or if your company is considering adopting a new severance arrangement), please contact a member of our Employee Benefits and Executive Compensation Team.