Private-sector pension plans are subject to the vagaries of the economy and the market—nonetheless, they are generally fully funded. In fact, some are a bit more than fully—and there could be a cloud that accompanies that silver lining. 
Where We Are
Data from a variety of sources in November 2023 show that corporate pension plans are fully funded, and then some. October Three, Insight Investment, Aon, and Wilshire report that the plans they track are more than 100% funded; the latter three say funding levels stand at 108.2%, 101.6%, and 105.1%, respectively.
These results are not new. A year ago, Insight Investment reported that it stood at 104.1%; In October 2022, October Three showed funded status at 105.2%; in fact, October Three showed funding levels breaking 100% even at the start of 2022.
What Results in 100%+ Funding
Emparion makes it simple: Pension assets are the fair value of a plan’s investments, while pension liabilities are the present value of expected retiree benefits. All it takes for a plan to be “overfunded,” they say, is for a pension plan’s assets to be greater than its liabilities.
Market forces and government activity are factors behind the higher pension funding levels. For instance, October Three attributes the 100%+ funding levels it has reported in November to lower interest rates and asset values that grew ala the stock market’s performance; Wilshire says that lower Treasury yields and corporate bond spreads were a factor.
Russell Investments in its 2023 Prudent Pension Funding Report points out that what plan sponsors do has an effect on the funding levels of their plans as well.
A key factor, they indicate, is what percentage of cashflow from operations (CFO) the company contributes annually.
It makes no difference what the CFO level is if a pension plan is unhealthy, says Russell Investments—such a plan may not make it to full funding at all. Even at a contribution rate of 5% of CFO, they say, the “most challenged” 1% of pension plans would not be fully funded in even a century.
Of course, it’s different for healthy plans. Russell Investments says that at 1% of CFO annually, more than half of the 1,000 pensions they measure would be fully funded in four years or less, other factors being constant. At 3% of CFO, 90% of them would be fully funded in that amount of time; at 5% of CFO, 85% would be fully funded in one year.
Silver Lining?
But while full funding is a good thing, being more than fully funded may not be, argues Carolyn M. Cumbee of the Ferenczy Benefits Law Center. In “Retirement Plan Correction Solution: The Anatomy of a Qualified Replacement Plan,” she posits that funding at levels above 100% actually may be counterproductive.
The short answer, Cumbee indicates, is that an “overfunded” plan can be a problem—and for a variety of reasons.
Big picture, Cumbee argues, having earnings that exceed full funding is not consistent with the ultimate reason for having a pension plan. She points out that defined benefit plans use assumptions regarding returns to facilitate having a certain amount set aside for retirement.
Robert M. Kaplan, American Retirement Association Director of Technical Education, says that it is not a problem for a plan’s assets to exceed 100% of liabilities “while the plan is ongoing”; however, he says, “it could be a problem when the plan terminates.”
Action Steps
So what can a plan sponsor do if a plan is “overfunded”?
Calculations and formulae. “Very simply, the required future contributions calculated by the actuary would be lowered so that assets and liabilities are closer in value,” says Kaplan. He adds, “a second option would be to amend the plan to a more generous formula so that participants get a higher benefit to use up the extra assets.”
Reallocation or reversion. Cumbee suggests that if overfunding occurs, a plan generally must (1) reallocate the excess amount to participants or (2) revert them to the plan sponsor.
But be careful if taking the second option, she warns, to not reallocate in a way that runs afoul of nondiscrimination rules. Further, reversion can result in the imposition of excise taxes on the plan sponsor—as Kaplan warns.
“The problem is very serious at the time the plan terminates if the participants (or the key employee who the plan is designed for such as the business owner) are at the maximum benefit by law that they are entitled to,” Kaplan elaborates. “In this case,” he continues, “the leftover money can be reverted or refunded back to the employer BUT it comes with a 50% excise tax.”
“So if there is room at plan termination for benefits to be increased (especially for the owner or key employee) then that would be ideal,” says Kaplan. “If the plan is ongoing, then the future contributions would be lowered which might be a negative for the business tax deduction but so be it.”
Qualified replacement plan. Another option is to transfer the excess funds from a terminating pension plan to a newly implemented or preexisting qualified replacement plan (QRP), suggests Cumbee. Any type of qualified retirement plan—such as a 401(k), money purchase plan, profit-sharing-plan, can serve as a QRP.
The amount transferred into the QRP must (1) be allocated directly into participant accounts within the year of the transfer or (2) deposited into a suspense account and allocated over seven years, starting with the year in which the transfer occurred.
There are additional requirements for a qualified replacement plan under Internal Revenue Code Section 4980(d)(1). The transferred excess assets must be allocated as contributions in the replacement plan over not longer than a seven-year period. In addition, at least:
- 95% of the participants of the terminating plan must be covered by the replacement plan; and
- 25% of the excess assets must be transferred to the replacement plan.
It is also possible, says Cumbee, that a plan sponsor may opt for all or a part of those funds to go to employees, even if the owner cannot share in the excess allocation themself. Thus, the plan sponsor could:
- increase compensation for plan participants in order to permit additional benefits;
- add a related entity as a participating employer in the plan; or
- transfer the excess assets to a program used to pay for retiree health and life benefits.
She also suggests that a plan sponsor could include (1) an owner’s spouse or child in the plan in order to transfer wealth from the parent’s business to the child within a qualified plan, or (2) employees who had been excluded from participating.
- Log in to post comments