Designing and Administering Severance Pay Plans

Overview

Severance pay is a benefit offered by many employers when involuntarily terminating the employment of an employee. See Why do employers offer severance packages and what do they include?

There is no legal obligation under the federal Fair Labor Standards Act or any other alternative federal law to provide severance pay to terminated employees. However, many unionized employers may be obligated to provide severance pay benefits under the terms of a collective bargaining agreement, and some nonunionized employers may be obligated to do so in accordance with any relevant state or local law provisions.

Severance agreements providing for a release of claims under the Age Discrimination in Employment Act (ADEA) must comply with several specific requirements of the Older Workers Benefit Protection Act (OWBPA) for such a release to be legally enforceable. See Understanding Waivers of Discrimination in Employee Severance Agreements.

Severance plans other than ad hoc severance agreements must comply with ERISA, as do other welfare benefit plans and defined benefit and defined contribution pension plans.

Apart from situations in which severance pay is mandated by a collective bargaining agreement or state law, ERISA severance plans are implemented mostly by larger organizations. Smaller employers tend to prefer to handle severance pay on an ad hoc basis. Employees who have previously been employed by large organizations are often shocked to discover, upon involuntary termination, that they are not entitled to "two weeks of severance pay."

Business Case

Offering severance pay, either as an ERISA plan or on an ad hoc basis, may benefit an organization in several ways:

• Assisting recruiting efforts, especially in fields where the risk of layoff is high.
• Helping brand the organization as employee-friendly.
• Giving subpar employees a palatable way to exit employment, thereby allowing the employer to fill a slot with a better employee.
• Reducing the likelihood of employment litigation.
• Providing a cost-effective alternative to employment practices liability insurance. See What is employment practice liability insurance?

Communications

For an employer's severance pay policy to be truly effective and defensible, employees must receive clear and accurate information, and spoken or other written information cannot be in direct conflict with the policy. Therefore, employers should take appropriate measures to ensure not only that employees are familiar with the severance pay policy and have the means to ask questions, but also that managers are properly trained to adequately respond to employee inquiries regarding the organization's policy.

Administration and Compliance Issues

It is prudent to review and address any relevant administration and compliance issues prior to implementing a policy.

Administration

The granting of severance pay under certain defined circumstances is a common business practice, with many practical benefits for employers.

However, employers should give careful consideration to several administrative and procedural elements prior to structuring and implementing a severance pay policy.

Sometimes, severance pay is mandated by a collective bargaining agreement or state law. Employers sometimes voluntarily establish a severance pay plan or offer severance pay on an ad hoc basis. When paying severance on an ad hoc basis, employers should be careful to clearly establish that they retain discretion over whether to grant severance pay and that it is not automatic or a vested job right. Some of the more common administrative issues that should be addressed include the following:

• Will severance benefits cease if a former employee obtains alternative employment during the severance pay period?
• How will any benefit payments be handled?
• Will former employees continue to be considered "employees" of the organization during severance pay periods with all the same rights and privileges as active employees?
• Will individuals still considered to be employees be eligible for routine salary increases or adjustment during the severance period?
• What approval process will be required for authorizing severance payments?
• Will there be an appeal process?
• How will severance payments be calculated, and what will be the basis used for calculating benefits?
• Will benefits be paid in the form of a lump sum payment, or over time?
• Will changes in policy have any impact on past and current recipients of severance pay benefits?
• What funding mechanisms are to be used to fund severance benefits?
• Can severance benefits be transferred, assigned or pledged to a third party?
• Will employees be required to sign a waiver or release of claims prior to receiving severance benefits?
• What impact will the employee's receipt of severance pay have on unemployment insurance benefits for the employee and on the future premiums of the employer?

Compliance

Although no federal laws currently mandate severance pay for terminated employees, a small number of states and territories do require employers to provide severance benefits to certain employees upon termination.

Furthermore, the nondiscriminatory handling of severance benefits is subject to federal and state laws regulating equal employment opportunity, employee pension and welfare benefits plans, and taxation.

The complexity of the associated compliance regulations relating to severance benefit plans precludes a complete discussion of all possible issues within the context of this article. However, the information below highlights some of the more important considerations relating to severance pay plans. It is advisable for employers to seek the guidance of their own legal counsel prior to implementing a formal policy.

State/territory laws

Some states have enacted legislation requiring an employer to grant severance pay to terminated employees when the termination is a result of a plant closing or when the employer is planning a mass layoff affecting a large number of employees. In other states the laws for mandatory severance are applicable only to certain types of employees (e.g., educational and state or public employees).

State contract law may also view severance plan documents as binding contracts. Under general contract law, ambiguities in a contract are resolved against the drafter, which usually is the employer. Therefore, if a severance policy is ambiguous and can be interpreted in more than one way, a court may adopt the interpretation that is most favorable to the employee—a very different result than interpretations under federal ERISA laws.

Equal employment opportunity/anti-discrimination

Employers that are less than forthcoming and fair when providing severance pay risk being sued for discrimination under federal and state equal employment opportunity laws.

Employers providing severance pay must be consistent in the treatment of whom they award severance pay to. For example, employers may not discriminate against any employee age 40 or older with respect to compensation, terms, conditions or privileges of employment because of age. Age may not be used as a basis for limiting, segregating or classifying an employee in any way that deprives the employee of employment opportunities or that otherwise adversely affects employment status. Similarly, discrimination based on race, gender, ethnicity/national origin, disability, family status and any other of the protected classes specified in Title VII of the Civil Rights Act is strictly prohibited.

However, these provisions do not necessarily mean that an employer must provide equal amounts of severance pay to each employee. For example, an employer is permitted to institute a policy that makes the amount of severance pay dependent on an employee's length of employment or position.

OWBPA/Age Discrimination

In 1990, Congress amended the Age Discrimination in Employment Act (ADEA) with the  Older Workers Benefit Protection Act (OWBPA). The OWBPA establishes specific requirements for a "knowing and voluntary" release of ADEA claims to guarantee that an employee has every opportunity to make an informed choice whether or not to sign the waiver. There are additional disclosure requirements under the statute when waivers are requested from a group or class of employees. See Waivers of ADEA Claims.

Voluntary early retirement plans

Voluntary early retirement incentive plans have become a valuable tool in permitting employers and employees to work together in connection with corporate downsizing.

In early retirement incentive programs, an employer offers employees additional benefits to which they would not otherwise have been entitled if they did not opt to retire prior to reaching their normal retirement age. Employers needing to reduce staff often offer an early retirement option as an incentive for older employees to voluntarily leave work.

Such programs are permitted but cannot be used as a pretense for discriminating against older employees. The ADEA and the OWBPA prohibit a plan from denying severance pay to employees eligible for retirement while paying it to other similarly situated employees or from forcing older workers to retire through the establishment of a mandatory retirement age.

The ADEA, however, does allow employers to offer early retirement incentive programs to employees if employee participation in the program is voluntary and free of coercion and the plan is nondiscriminatory.

The considerations that may be relevant in determining whether participation is voluntary include:

• Was the employee given adequate time required to make a decision?
• Was the employee given accurate and complete information about the plan?
• Was the employee subjected to any threats or coercion?
• Were older employees subjected to negative consequences if they rejected the offer?
• Did the employee seek and receive the advice of legal counsel while making his or her decision?

Although the determination of whether an early retirement incentive is voluntary is generally based on the facts and circumstances particular to each case, the test is whether, under the circumstances, a reasonable person would have concluded that there was no choice but to accept participation.

Generally speaking, if an early retirement incentive program is voluntary, an employer may:

• Set a minimum age, or minimum number of years of service, at which eligible employees will be eligible to participate.
• Offer early retirement incentives for a limited period of time (e.g., only to those employees who retire between a specified period of time).
• Offer an early retirement incentive only to a subset of the organization (e.g., only to managers, a specific department or employees at a single location).

ERISA

ERISA is the primary federal law governing employee benefits plans. Though federal law may not mandate severance pay, there is the danger that a voluntary severance plan may qualify as an employee benefits plan under ERISA even though the employer believes it has an ad hoc severance policy not subject to ERISA.

ERISA plans fall under the categories of either a welfare benefit plan or a pension plan. Whether a severance pay policy is a plan subject to ERISA depends on whether the employer has a legal obligation (such as a collective bargaining agreement) to make severance payments  or if it constitutes a plan, fund or program established or maintained by an employer.

Severance plans that are contingent on an employee retiring and that pay more than twice an employee's annual salary and make payments for longer than a two-year period are considered pension plans subject to ERISA. However, an offer to make a one-time, lump-sum payment triggered by a single event is not considered an ERISA plan.

ERISA also requires that severance pay plans be in writing. Having an ERISA-governed plan not in writing is a violation of ERISA. However, some employers do have unwritten, informal practices. The main reason an employer may wish to maintain an unwritten practice is to preserve flexibility. However, even without a formal plan document, a court may still determine that an informal ERISA plan exists based on oral representations, the existence of a fund or account from which benefits are paid, the actual payment of benefits, past practice, the reasonable expectations of employees, or the intentions of the sponsor.

In addition to the above, severance pay plans qualifying as welfare benefit plans are also subject to:

• Reporting to the U.S. Department of Labor (DOL).
• Reporting and disclosure of the severance pay plan to employees (providing participants with a summary plan description and, for employers of 100 employees or more, filing a summary plan description and annual report with the DOL and the Internal Revenue Service (IRS).
• Providing a claims procedure concerning employee eligibility for severance pay.

IRS Code of 1986

The Internal Revenue Code (IRC) is the primary piece of federal legislation regulating the taxation of compensation and benefits.

When negotiating employment agreements or other arrangements providing severance pay benefits, the parties should carefully evaluate whether the severance pay and other related severance benefits are subject to the deferred compensation requirements of §409A of the IRC. IRC §409A, by the passing of the American Jobs Creation Act of 2004, expanded the definition of deferred compensation to include severance pay arrangements.  

If a severance arrangement qualifies as deferred compensation and does not comply with the stringent requirements of IRC §409A, the amount of severance payments will be immediately included in the employee's gross income (unless subject to a substantial risk of forfeiture), and will result in an additional 20 percent income tax penalty and interest charges being assessed to the employee.

Two exemptions from IRC §409A are currently available that generally apply to most severance benefit arrangements.

First, under the short-term deferral exemption, severance pay that is payable only upon an involuntary termination of employment is exempt from IRC §409A if it is in the form of a lump sum payment made immediately following termination of employment or is paid in full within two and a half months following the end of the year in which the involuntary termination occurred.

Secondly, the two-times exemption allows severance paid solely upon an involuntary termination or under a window program not to exceed 12 months to be exempt from IRC §409A if a) the amount of the severance does not exceed two times the lesser of the employee's annual compensation for the preceding year or $580,000 (for 2021), and b) all payments are made to the employee no later than December 31 of the second calendar year following the year of termination.

IRS Ruling 90-72 also provides that supplemental unemployment compensation benefits (SUB pay) must be linked to the receipt of state unemployment compensation and must not be received in a lump sum to be excludable from the definition of wages for Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) purposes. SUB pay must also meet the same criteria to be excludable from the definition of compensation for Railroad Retirement Tax Act purposes. Therefore, for payroll processing and tax compliance purposes, the IRS has taken the position that severance pay benefits, which are not part of a Supplemental Unemployment Benefit Plan in accordance with IRS Ruling 90-72, are considered supplemental income and therefore subject to FICA and FUTA withholding. See What is a SUB plan, and how can it help my employer save money during reductions in force?

In United States v. Quality Stores, Inc., the 6th U.S. Circuit Court of Appeals had ruled that severance payments are not taxable wages; however, in accordance with a unanimous U.S. Supreme Court decision issued March 25, 2014, severance payments are taxable wages under FICA.

The Supreme Court ruled that the previous ruling did not use FICA's definition of wages, but instead relied on §3402(o) of the Internal Revenue Code, which governs income-tax withholding. The Supreme Court determined that the lower court's opinion was incorrect. The decision reaffirms what has been long-standing law: that severance paid to employees in lump sums, unrelated to SUBs, is taxable as wages for both income-tax withholding and FICA purposes.

Design and Structure Considerations

A carefully structured severance pay package can be a useful tool in softening the blow associated with terminations and in discouraging former employees from pursuing lawsuits against an employer. As a result, many employers often choose to provide severance pay benefits to terminated employees.  

An employer may generally structure a severance pay policy in any manner it chooses. As long as all similarly situated employees receive equal treatment, a severance package can be structured by department or workgroup, seniority or age, or tied to years of service or level of position.

What to include

Having a clearly written and communicated policy regarding termination and severance pay benefits is highly advisable. However, unless governed by a collective bargaining agreement or state law, what an employer chooses to include in a severance pay policy is at its discretion.

The amount and type of compensation in any given severance agreement varies according to specific circumstances, but the amount of severance pay is typically based on a number of factors, including:

• Length of the employee's tenure with the employer.
• Circumstances under which the employment relationship ended (e.g., employer downsizing, employee conduct or layoff).
• The employer's financial solvency or particular circumstances (e.g., filing for bankruptcy, experiencing economic growth).

A well-structured policy should reflect the employer's organizational culture and philosophy. In drafting the policy, employers should consider incorporating provisions that:

• Cover a range of common situations, such as downsizing resulting from changes to internal organizational structures or business reorganizations.
• Specify that severance pay benefits will be paid only to employees who are actually laid off as a result of transfers in business ownership due to a merger or acquisition.
• Specify whether periodic severance payments cease when former employees obtain alternative employment.
• Require employees to sign a waiver or release absolving the employer from employment-related liability prior to remittance of any severance pay.
• Stipulate that any waiver or release should comply with the detailed requirements of the OWBPA, which applies when a discharged employee is age 40 or older and is waiving or releasing ADEA claims.
• Clearly spell out the purpose of severance pay benefits. Generally, the purpose defines the group or groups of employees who are eligible under the plan as well as the benefits and constraints of the plan.
• Specifically state that the organization reserves the right to alter or terminate the policy at its discretion.

Additionally, when designing a policy, it is important not to lose sight of the fact that the goal of providing severance to departing employees is to benefit the employer by softening the blow of termination. Therefore, in working toward that goal, organizations should also take the following into consideration:

• Benefit amounts. A severance package often includes one to two weeks' worth of pay for each year of employment. See More Organizations Are Expanding Severance Benefits, Survey Finds.
• Insurance benefits. Some employers agree to continue to provide discharged employees with health care, life insurance and disability benefits for a period of time following termination. The most notable aspect of the federal COBRA is that it requires covered employers that provide group health insurance to allow health care continuation for terminated employees under the employer's group health care plan. Many states also have laws dealing with the continuation of health care, and a few of these states may require employers to pay for a former employee's health care for a period of time.
• Contesting unemployment benefits. Employees terminated for reasons other than gross misconduct often file for unemployment compensation. When employees file for unemployment benefits, their previous employer has an opportunity to contest the employee's claim. Former employees stand a greater chance of being granted unemployment benefits if the employer does not contest their claim for unemployment benefits. See How does a lump-sum severance payment affect unemployment benefits versus payments spread out over a few pay periods? What are the tax implications?
• Outplacement services. One of the key services an employer can offer in a severance package is outplacement services. These services assist terminated employees with career counseling, resume-writing and job search assistance. Outplacement services may be run by the employer or may be outsourced.
• Recommendation letters. These can be a small but powerful tool to offer in a severance package if employees are not required to sign a release in exchange for receiving severance pay benefits. By agreeing to write letters of recommendation, an employer may have a greater opportunity to insulate the company from potential lawsuits by former employees.
• Other benefits. Other things to consider are miscellaneous benefits such as letting terminated employees keep equipment (e.g., cellphones, laptops, printers), releasing employees from noncompete agreements or providing ongoing gym memberships.

Coverage and eligibility

A severance policy can be designed to exclude on a nondiscriminatory basis persons who may be part of a group otherwise eligible to receive benefits. For example:

• Conditioning the receipt of severance benefits based on an employee signing a release or waiver of claims against the employer. However, if the plan requires a waiver or a release for the employee to receive benefits, then the benefits that the employee receives must be greater than benefits the employee would have received had he or she not signed the waiver or release.  
• Ineligibility for severance benefits based on specific reasons for termination such as gross misconduct (this should be clearly stated in the policy).
• Requiring employees to enter into noncompete agreements before receiving severance benefits.
• Limiting coverage to employees who are involuntarily terminated when their position is eliminated due to economic reasons and when no alternative positions are available within the organization.
• Providing benefits for situations other than termination, such as relocation to a worksite more than 50 miles away.
• Restricting eligibility to certain classes of employees such as certain grade levels, exempt or nonexempt status, or executives.
• Limiting eligibility to certain qualifying events, for example, if the organization is purchased by another, and job losses result, or the organization relocates a facility, resulting in job losses.
• Expanding coverage to include various types of terminations such as reductions in force, layoffs, downsizings, termination for cause, discharge for disability, retirement with pension, discharge for poor performance, elimination of position, voluntary resignation, or retirement without benefits, including pension.

Benefit amounts and offsets

Most employers having a severance plan pay a fixed benefit amount, which is generally the equivalent of either one or two weeks' pay based on length of service (usually one to two weeks' pay per year of service) or on other factors such as employee classification. When basing benefit amounts on length of service, employers are wise to base payments on the number of years of continuous service from the most recent date of hire. Otherwise, employees who are laid off and recalled may be able to claim that they should receive benefits based on the date they were originally hired by the organization.

Terminated employees may also be eligible for other benefits pursuant to federal or state laws. With the exception of reducing benefits by amounts an employee earns under a defined contribution or defined benefit, an employer may wish to have a policy provision offsetting certain benefits against any severance paid under the employer's plan. Absent such a provision, it is possible for a terminated employee to recover full severance from an employer and be allowed to recover his or her full benefit amount under any statutory schemes.

However, most employers generally do not reduce severance payments by the amount of any other nonstatutory benefits the employee may be entitled to, such as compensation paid under an incentive pay plan and vacation pay.

Deductions from severance for monies owed to the company may also need to be considered. See What deductions can be made from severance pay?

Waivers/releases

If an employer undertakes an involuntary reduction in force, it should consider offering a severance package in exchange for a release that complies with the waiver provisions of the Older Workers Benefit Protection Act (OWBPA).

In a typical severance release agreement, the outgoing employee agrees not to sue the employer for any reason, and the employer agrees to give the employee some form of additional compensation, often called a "severance package." Such compensation is required for the departing employee's release of liability to be valid; this is called "legal consideration."

If the employee is age 40 or older, the OWBPA dictates what must be included in a release. The OWBPA imposes the following requirements on any release that purports to waive any age discrimination claim:

• Employees must receive something of value to which they are not already entitled or over and above anything that they would receive upon termination even if they did not execute a release of claims.
• The release must be part of an agreement between an employer and employee, must be written in simple English and must specifically make reference to the employee's rights under the ADEA that are being waived.
• The release must be limited to claims or rights that arose before the employee executed the release.
• The employee must be advised in writing to consult with an attorney before signing the agreement.
• The release must allow the employee a seven-day period in which to revoke the agreement after it is signed.
• When the release is requested in connection with an early retirement incentive program offered to a group or class of employees, each employee must be given at least 45 days to consider the agreement; for a release outside an early retirement group termination program, each employee must be afforded 21 days to consider the agreement.
• When a release is requested in connection with an early retirement program offered to a group of employees, the employer must provide at least 45 days for deliberation by the affected employees.

Furthermore, an employer is required to disclose in writing, in plain English, the class, unit or group of individuals covered by the program; the eligibility factors and time limits applicable to the program; the job titles and ages of all individuals eligible or selected for the program; and the ages of all individuals of the same job classification or organizational unit who are not eligible or selected for the program.

Additionally, severance agreements for departing employees must not include waivers of awards from the Securities and Exchange Commission. See SEC Cracks Down on Waivers in Severance Agreements.

Templates and Tools

Samples

• Older Worker Act (OWBPA) Waiver
• Reduction in Force Selection and Severance Pay Policy
• Severance Pay Policy
• Voluntary Reduction in Force Separation Program