Pension plan funded statuses are at the highest levels observed in nearly two decades.[1] Many plans today have found themselves in an overfunded position, potentially for the first time. This means that there are excess plan assets relative to the present value of the future payments. These excess assets can be difficult to utilize due to a punitive excise tax that applies to the reversion of plan assets to the plan sponsor under the Employee Retirement Income Security Act of 1974, as amended (ERISA). Therefore, sponsors need to consider more creative ways to utilize the surplus so that it provides maximum value compared to heavy taxation. There are several considerations with respect to the use of excess surplus assets held in pension plans.

1. Protect the overfunded position 

First and foremost, take steps to protect the funded status improvement. Generally, there is little value to building excessive surplus due to taxation. The way to protect the funded status is to reduce equity exposure in favor of a custom fixed income allocation that has the same characteristics as the plan’s liabilities. To find the appropriate level of risk, a plan must understand what amount of surplus may be valuable and the assets should be positioned so that, at a minimum, there is not more capital at risk than the plan can afford to lose. To determine this, sponsors will often run stress tests on equity and interest rate environments or run more detailed asset-liability studies that utilize Monte Carlo simulations to understand the plan’s financial health based on a range of forward-looking market outcomes. Finally, consider the funding policy of the plan and make sure it fits within the context of the asset allocation changes and desired ultimate funding level.

2. Consider operational strategies

Outside of investment strategies, sponsors may consider non-investment-oriented actions that may manage the level of surplus. First, in certain circumstances, the excess surplus may be used to fund retiree medical plan obligations. This requires analysis for feasibility and eligibility but can offer a way to use excess surplus in the pension to pay for other retirement obligations. Second, the over-funded plan could be merged with an underfunded plan to reduce variable rate Pension Benefit Guaranty Corporation (PBGC) premiums or required contributions between the two plans. Finally, for sponsors that may be reviewing merger and acquisition strategies, the excess surplus could aid in the negotiation discussions with a target company with an underfunded pension.

3. Decide termination versus hibernation path

During a plan termination, the excess assets may be returned to the sponsor after all the obligations of the plan are settled. On the surface, this may sound appealing. The previously mentioned excise tax is the motivation for many of the surplus strategies we’ve outlined in this piece that are important to consider ahead of a plan termination. Alternatively, at termination, the funds could be used to increase benefits to plan participants if permitted under the plan document and ERISA. Or the excess funds could be moved to a defined contribution plan to reduce the excise tax if certain participation criteria are met. Hibernation is an alternative to plan termination that many plan sponsors implement to avoid paying a premium to insurance companies to make annuity payments. Hibernation is the process of fully de-risking the plan investments to allow for a stable funded status. Surplus assets for a hibernating plan provide a cushion against adverse demographic risks such as longevity risk or other changes in actuarial assumptions. 

4. Consider re-opening the plan

In today’s environment, employers struggle to hire and retain top talent. A defined benefit pension plan may be more attractive to workers today than it was 10 or 20 years ago. The landscape has changed significantly with funding relief, dedicated and widely utilized liability-oriented investment strategies, and innovative plan designs that reduce both the balance sheet risk and contribution risk of offering a defined benefit plan to employees. This may be a stretch for firms today with underfunded plans. However, for the sponsor of a frozen plan with surplus assets, this could provide a way to utilize the excess surplus to improve talent attraction and retention.

All of the approaches discussed above require careful analysis and coordination with all stakeholders. This includes the plan’s actuary, auditors, legal counsel and investment advisors. For more information, please contact your local PNC representative.