A] Prelude*
* For more general and detailed information about U.S. retirement and pension plans, feel free to visit our dedicated webpages: https://expatpensionholland.nl/usa-expat-pensions
A robust equity market coupled with the strong fixed-income returns that followed the sharp rise in interest rates have restored corporate pension plans to full-funded status, with many enjoying a surplus. This welcome development has sparked conversations by plan sponsors exploring paths for their excess pension assets, from bolstering retirement benefits to addressing corporate financial needs or supporting other business initiatives.
“The pension environment has changed significantly since pensions were last overfunded, and these changes present opportunities to plan sponsors with overfunded plans,” said Jeff Passmore, lead strategist of liability-driven investing at MetLife Investment Management.
Take IBM, for example. With a funding ratio north of 115% and a surplus of $3.6 billion last year, the technology giant reopened its long-frozen defined benefit plan. It replaced its 5% match to its 401(k) plan with a 5% cash-balance pension benefit that it will fund through its pension surplus.
The move, announced by IBM last November, turned heads in the retirement industry — and has opened the door to a wider evaluation by many plan sponsors and asset managers about the utility of surplus assets.
B] Road to full funding
Corporate pension plans in the U.S. haven’t been fully funded since 2007, just before the market downturn that was sparked by the global financial crisis. Since 2008, many plan sponsors moved to implement LDI strategies with derisking glidepaths, leading to increased allocations to bonds and decreased allocations to stocks.
“Many sponsors also launched programs to reduce the size of their pensions, such as closing plans to new entrants, freezing future benefit accruals, offering lump sums to separated participants and transferring liabilities to insurers through the purchase of annuities in a pension risk transfer,” Passmore said.
Fast forward to 2019, when an extended period of strong equity market performance helped bring the average pension plan back to fully funded status — and since 2022, the Federal Reserve’s rate-hiking cycle has further improved pension funding by increasing interest rates, driving down pension liabilities.
By the end of the first quarter this year, the average funding ratio of corporate pension plans in the Russell 3000 reached 104.8%, up from 97.9% at the end of 2021, according to MetLife IM.
“With more in hedging assets and less equity risk, pension surplus is likely to persist. The pension landscape has changed dramatically, and there are now several potential uses of surplus plan assets as well as some benefits of keeping and growing the surplus,” Passmore said.
Sponsors can leverage surplus assets to, for instance, fund a PRT, cover administration costs or help in a corporate acquisition. Depending on a plan sponsor’s goals and philosophy, those assets could also remain in the plan and reap benefits on their own, he noted.
C] Restart benefits
“One efficient option for using surplus pension assets is to restart benefit accruals or reopen the plan,” Passmore said, pointing to IBM’s pension reopening move as an example. “This can be done in the context of reducing other elements of total compensation to achieve savings.”
In pension “restart” situations, the new pension benefit can be structured differently than the legacy benefit, he said. For example, a plan with a frozen final average pay benefit could be reopened with a new cash-balance benefit. Because the Pension Protection Act added safe harbor cash-balance plan designs as a low-risk option for plan sponsors, cash balance has become the predominant new type of pension benefit.
D] Pay health benefits
“Many corporations have legacy unfunded retiree medical plans,” Passmore said. “The ongoing benefit costs of these plans are typically paid from corporate cash. One potential way to efficiently use pension surplus is to pay retiree medical benefits.”
Under Internal Revenue Service rules, defined benefit plans — but not multiemployer plans — can transfer retirement assets to medical benefit accounts via a qualified transfer. That rule was originally set to expire at the end of 2025, but in passing SECURE 2.0, Congress extended the sunset to the end of 2032.
E] Fund a PRT
Surplus pension assets can be used to fund a pension risk transfer, which moves some or all of the pension liability to an insurer through an annuity purchase. PRT transactions have become an increasingly popular way to reduce or eliminate pension financial risk. The number of PRT transactions reached record levels last year, with 850 contracts sold, up 25% from 2022, according to LIMRA.
“The PRT market is comprised primarily of two types of strategies: plan terminations and lift-outs, or partial buyouts, most often of retirees,” Passmore said. “Retiree lift-outs cover participants who have retired and who are already in payment status. Partial buyouts typically drive premiums, but transaction counts are mainly for plan terminations, especially small plans.”
Passmore noted that plan sponsors need to tread carefully when considering a PRT because as transactions and premium volume have grown, so has the PRT provider market with a number of new entrants. Also, the industry is still waiting for the Department of Labor to release its final review on guidelines governing PRTs, which is expected sometime this year.
“Despite the uncertainty associated with this unfinished review, market demand, high interest rates and improved funded status continue to drive PRT transactions,” he said.
F] Recapture surplus assets
When a plan sponsor terminates a plan with a surplus, the surplus assets can revert back to the company. However, such asset reversions are taxed, including through excise taxes, so they may not be the most efficient use of plan assets, Passmore said.
“If at least 25% of the surplus is used in a Qualified Replacement Plan, the remaining surplus assets are taxed at 20%,” he noted. If a QRP is not used, then asset reversions face a 50% excise tax.”
Specific IRS rules govern asset reversion through a QRP, including:
- It can be a new or existing plan, and can comprise multiple plans.
- It can be a Defined Benefit (DB) or Defined Contribution (DC) plan, but cannot fund matching contributions.
- It must include at least 25%, and up to 100%, of excess assets.
- It must allocate excess assets to participants evenly over seven years or faster.
- It must cover at least 95% of active employees in the terminating plan who remain employees after plan termination; other employees can also be included.
- It can include payment of expenses from plan assets for administration of the QRP.
Some sponsors can consider a plan spin-off or termination to capture surplus assets through an asset reversion. It is a two-step process: first, to split the pension into two plans, one each for active and inactive participants; and second, to terminate the plan for the inactive group.
However, Passmore said, “the IRS has stopped issuing advance approvals of spinoffs/terminations, indicating a more negative view of these types of transactions.”
G] Cover administrative costs
“Pension assets can be, and typically are, used to pay plan expenses like [Pension Benefit Guaranty Corporation] premiums, actuarial fees and investment management fees,” Passmore said. “With a plan surplus, plan sponsors may be motivated to consider paying a greater proportion of plan administrative expenses from plan assets. For example, it may be permissible to pay the expenses of staff who support the plan.”
However, plan sponsors must follow specific guidelines when plan expenses are paid from plan assets: Plan documents must allow such payment, the expenses must be reasonable, and the costs incurred must be for the exclusive benefit of plan participants.
Another important detail is that, according to DOL guidelines, plan assets can be used to pay only for activities related to plan management, not the creation or design of the plan — activities referred to as settlor functions.
H] Support an acquisition
Beyond plan-related activities, surplus plan assets can be used in a corporate acquisition that includes an underfunded plan.
“When pensions are included in an acquisition, the purchase price typically includes a pension adjustment to reflect the funded position of the acquired plan,” Passmore said. “A purchaser with an overfunded plan can monetize their surplus by acquiring a business with an underfunded plan.”
For example, if a company with a pension plan surplus of $200 million acquires a company with a plan that is underfunded by $20 million, the acquisition purchase price can be adjusted down $20 million to reflect the underfunded pension. Once the acquisition closes, the acquirer will have a pension surplus of $180 million ($200 million minus $20 million). Post-acquisition, the plans may be merged or left as stand-alone plans.
I] Keep the surplus
Some plan sponsors may simply prefer to maintain and grow a pension surplus rather than finding a near-term use for it. “There are benefits to having an overfunded position in a pension,” Passmore said. “Simply knowing there are potential uses for surpluses may be enough motivation to support this approach.”
First, overfunded plans do not have to make required contributions or pay PBGC variable-rate premiums. Second, the larger the plan’s surplus, the less likely the plan will ever have to make required contributions or pay a variable-rate premium. Third, the accounting treatment for an overfunded plan results in income on the sponsor’s P&L.
With funded status healthier now than at any time in the last 17 years, corporate plan sponsors with a pension surplus have the flexibility to leverage those assets. The good news is that by simply leaving the surplus status quo, plan sponsors can maintain their strong position.