What to Do With an Overfunded Defined Benefit Plan?
When a pension plan's assets exceed its liabilities, sponsors must weigh various strategic options against significant tax and regulatory hurdles.
A defined benefit plan is an employer-sponsored retirement program where employee benefits are calculated using a formula that considers factors like salary history and duration of employment. These plans can become “overfunded,” a situation that arises when the total assets held within the plan exceed the amount needed to cover all current and future retiree payments. This surplus of assets creates a unique financial position for the employer, known as the plan sponsor, presenting both opportunities and financial complexities.
Causes and Measurement of Overfunding
An overfunded status in a defined benefit plan results from a few factors. Strong performance in the plan’s investment portfolio, where returns outpace the conservative assumptions made by actuaries, is a primary cause. For instance, many plans target returns between 4-5%, but a bull market could yield significantly higher results. Changes in macroeconomic conditions, particularly shifts in interest rates, also play a role; as interest rates rise, the present value of the plan’s future obligations decreases, which can create or enlarge a surplus.
Another contributing element involves demographic shifts within the company’s workforce that differ from actuarial predictions. Higher-than-expected employee turnover or mortality rates can reduce the total benefits the plan is ultimately required to pay out.
The measurement of this overfunding is a formal process conducted annually by an actuary. It involves a direct comparison between the fair market value of the plan’s assets and its Projected Benefit Obligation (PBO). The PBO represents the present value of all benefits owed to employees, factoring in expected future salary increases. When the asset value surpasses the PBO, the difference is the overfunded amount, or surplus.
Strategic Options for the Plan Surplus
When a defined benefit plan becomes overfunded, the sponsoring employer has several strategic paths for the surplus assets. One straightforward approach is to declare a “contribution holiday.” This allows the company to temporarily suspend its required contributions to the plan, freeing up cash flow for other corporate purposes while the existing surplus covers the plan’s ongoing costs.
A different strategy involves using the surplus to enhance the plan’s offerings. The employer can amend the plan to increase the benefit formula, providing more generous retirement payments to current employees and, in some cases, to those already retired. This option directly benefits the plan participants and can serve as a tool for improving employee morale and retention.
A more specialized option allows for the transfer of excess pension assets to fund retiree health benefits. Under Section 420 of the Internal Revenue Code, a company can make a “qualified transfer” of surplus funds from its pension plan to a separate health benefits account. This can be an efficient way to address rising retiree healthcare costs.
The most decisive action is to terminate the plan entirely and reclaim the surplus assets, a process known as an asset reversion. This involves formally ending the defined benefit plan, paying out all accrued benefits to participants, and then transferring the remaining excess funds back to the company. This choice, however, triggers tax consequences.
Tax Consequences of Asset Reversion
Choosing to terminate a plan for an asset reversion subjects the employer to tax liabilities. The process is governed by Internal Revenue Service (IRS) regulations, and the reverted funds are treated as taxable income and are also subject to an excise tax.
First, the entire amount of the reverted surplus is included in the employer’s gross income for the year of the reversion. This means the funds are taxed at the prevailing corporate income tax rate. Since the original contributions to the plan were tax-deductible, the reversion effectively reverses that prior tax benefit.
On top of the income tax, the IRS imposes a nondeductible excise tax on the reversion amount under Internal Revenue Code Section 4980. The default rate for this excise tax is 50% of the surplus. For example, if a company reverts a $1 million surplus, it would face a $500,000 excise tax, and this payment is not deductible from the company’s income.
Mitigating the Excise Tax on Reversion
Employers facing the 50% excise tax on an asset reversion have ways to reduce this liability to 20%. These mitigation strategies require the employer to share a portion of the surplus with the plan participants. The company must elect one of two methods to qualify for the lower tax rate.
One method is to establish a Qualified Replacement Plan (QRP). The employer must transfer at least 25% of the maximum possible reversion amount from the terminated plan to a new or existing defined contribution plan, such as a 401(k). The transferred assets are allocated to the accounts of the participants from the terminated plan, and this amount is not subject to the excise tax. The remaining portion of the surplus can then be reverted to the employer at the reduced 20% excise tax rate.
The alternative path to securing the lower 20% tax rate is to provide a pro-rata benefit increase to the participants of the terminating plan. This involves amending the plan to grant an immediate increase in accrued benefits for all qualified participants. The value of this benefit enhancement must be equal to at least 20% of the maximum reversion amount.