What Does Surplus Contribution Mean in a Pension Plan?
Excess funds in a defined benefit plan create choices for employers regarding contributions, benefit levels, and navigating complex tax rules on asset reversions.
A surplus contribution in a pension plan refers to a scenario where the funds held within the plan exceed the projected costs of its future obligations. This situation is specific to defined benefit pension plans, where an employer guarantees a certain retirement payout to employees. It is not a concept found in more common defined contribution plans, such as 401(k)s, where the retirement benefit is simply the amount in an individual’s account.
How a Pension Surplus Occurs
One primary driver of a pension surplus is strong investment performance. Pension assets are invested in a mix of stocks, bonds, and other securities; when these investments generate returns that are higher than the actuary’s assumed rate of return, the plan’s asset base grows faster than expected, creating a surplus.
Another significant cause is the occurrence of actuarial gains. Actuaries make long-term assumptions about employee demographics, such as retirement ages, salary growth, and mortality rates. If employees retire later than projected, if their final salaries are lower than anticipated, or if employee turnover is higher than expected, the plan’s ultimate liability decreases.
Changes in the workforce or the plan’s structure can also lead to a surplus. For instance, if a company downsizes, it reduces the number of active employees earning benefits, thereby lowering the plan’s future liabilities. Similarly, if a plan is “frozen,” meaning employees no longer accrue new benefits, the liability becomes fixed. Over time, if investment returns continue to grow these assets while the liability does not, a surplus can develop and expand.
Determining the Surplus Amount
The official determination of a pension surplus is a technical process managed by the plan’s actuary and guided by federal tax law. A key concept in this calculation is the “full funding limitation,” a ceiling under the Internal Revenue Code that defines the maximum tax-deductible contribution an employer can make. A surplus exists when the plan’s assets grow large enough to exceed this limitation.
As part of the plan’s annual valuation, the actuary performs a complex assessment of the plan’s liabilities—based on current interest rates and demographic data—and compares them against the market value of its assets. It is this actuarial certification that officially confirms the existence and amount of a surplus, dictating whether the employer must stop making contributions or can consider other actions.
Employer Options for a Surplus
Once an actuary certifies that a pension plan has a surplus, the employer has several strategic options. The most common choice is to take a “contribution holiday.” The employer temporarily suspends or significantly reduces its required payments into the plan. The existing surplus is then used to cover the cost of benefits being accrued by employees, freeing up corporate cash flow for other business purposes.
A second option is to use the surplus to increase benefits for plan participants. The employer can amend the plan to provide a cost-of-living adjustment for current retirees or enhance the benefit formula for active employees. This approach uses the excess funds to directly improve retirement security for the workforce.
A more complex and less frequent option is an “employer reversion.” This involves terminating the pension plan entirely. After purchasing annuities from an insurance company to cover all benefit promises to participants, any remaining assets can revert to the employer. This action is highly regulated and a carefully considered decision.
Tax Consequences of Employer Reversions
When an employer terminates a pension plan and takes a reversion of the surplus assets, the withdrawn amount faces two substantial layers of federal tax. First, the entire reverted amount is considered ordinary corporate income and is subject to the prevailing corporate income tax rate.
On top of the income tax, the IRS imposes a steep excise tax on the reverted funds. The standard excise tax rate is 50% of the surplus amount. This punitive tax is designed to discourage employers from terminating plans simply to access surplus assets.
The 50% excise tax can be reduced to 20% if the employer shares a portion of the surplus with employees in one of two ways. The first option is to establish a “qualified replacement plan,” which requires transferring at least 25% of the surplus to a new or existing plan for the same group of employees. The second option is to provide pro-rata benefit increases to the plan’s participants, which must have a total value of at least 20% of the surplus amount.