Loan Overpayment used for second loan w/o notice

Just discovered an employee with two 401K loans had paid off first loan a year ago. We received no notice of payment and employee did not notice it on loan history website. Twenty-nine overpayments were applied to the employees second loan without authorization from employee or notice. This is the second time the company we hired to manage the 401K has done this with an employee in two years. Is that legal? Employee would have preferred to stop making TWO payments when first  loan ended and continued on amortization schedule for the remaining loan. 

Seems also to be a breach of fiduciary duty as well as illegal. 

Are you asking a question?

Here's a thought with a question:  Any time a plan is administered contrary to plan terms it may be a breach of fiduciary duty.  But who is the fiduciary?  Most service providers, such as your loan administrator, claim not to be fiduciaries, and their contracts say so (for what that is worth). Failure to carry out functions properly may be a breach of contract.  Consequences of breach of contract and appropriate remedies can be interesting. 

Probably not illegal or any kind of breach on the part of "the company we hired to manage the 401K ."  The question of whom to blame depends on your relationships - is one company handling the investments and "third party administration" (in your view, that is probably preparing the Form 5500, although there is a lot more to it than that)?  Or do you have one company that does the investments and one that does administration?

In a perfect world, you and/or the payroll company know enough to stop payments on the first loan when that loan is paid off, and the administrator and/or recordkeeper recognize this and have no reason to ask questions.  In a less perfect world, loan payments keep coming but someone, probably the third party administrator, recognizes this and says "wait a sec, did you mean to keep doing this?"  (Often, participants want to continue the same total payments in order to pay off the second loan sooner.)  In a less, less perfect world, loan payments keep coming and someone shrugs their shoulders (or an automated system effectively does the same thing) and applies the payments to the second loan.  

I like to think of our firm as being in the camp that would recognize and address this right away, but depending on a lot of factors, we might not even know about this until well after the fact.  

Not to be too blunt but ultimately any legal liability lies with the participant and the employer for not knowing enough to stop payments when the loan is paid off.  When an investment company receives money they have to do something with it and applying it to another loan is the most logical option.  Whether someone else c/should have caught this earlier depends on relationships and what you are paying them to do.

I would also say to check the Loan Procedures.  Often, the Loan Procedures will allow early payoff in full, but not partial pre-payments.  Potential operational failure.  

I would also suggest you get with whoever is doing your payroll and make sure they figure out how to get the loan payments to stop on time.  Depending on your state's payroll laws, there may be potential problems with withholding amounts from paychecks that were not authorized by the employee.

SItting by Kevin C -- to me this is more a failure on the side of HR/payroll than the 401k administrator/recordkeeper (depending on what your contract is with them). We internally watch our loans each and every payroll cycle and know exactly when to stop a deduction.

I do know under our plan and loan procedures and for our recordkeeper that they will accept any amount of overpayment by payroll cycle through the payroll feed without question.  They will only flag an underpayment.   But the employee has to go through HR/payroll to change any deduction amount such that we know about it internally.

I have found over the years that vendors are doing less and less checking at any data entry points (in balance forward we had a whole list of checks and error reports and those mostly disappeared with daily recordkeeping unless it is very very obvious  - like a blank file feed)

If the loan deductions were set up correctly in payroll, they would each have a target amount equal to the sum of the principal and interest payments, and the deduction would stop when the target amount is met. The other issue is how the loan payments are reported on the payroll files sent to the record-keeper. Each loan should have a unique #. But if the payments are deducted under one deduction code, and reported as a sum of the amounts withheld on the periodic payroll file upload, the record-keeper will apply the payments to whichever loan is outstanding.  It sounds like the fund company/record-keeper and the Plan sponsor/payroll person need some additional coordination and/or training.