Uses and Benefits of Surplus Pension Assets
Executive Summary
Corporate pension plans are sponsored by more than 500 of the Russell 3000 companies.1 During the last few years, many of these pensions have become fully funded for the first time since 2008, and, because of widespread adoption of liability-driven investing (LDI), bonds now represent a majority of pension assets. With more hedging assets and less equity risk, pension surplus is likely to persist. This paper will discuss six possible uses of excess pension assets and the benefits of maintaining, i.e., not spending, a surplus.
Introduction
In the time between passage of the Pension Protection Act in 2006 and the effective date in 2008, pension funded status dropped. At the end of 2007, the average funded ratio was 106%, and by the end of 2008, it had fallen to 79% due to stock market losses during the financial crisis. It is likely the PPA would have been very different had funded levels been in 2006 what they were at the end of 2008. In fact, subsequent legislation has delayed PPA’s most stringent funding requirements. Pension funding relief allowed plan sponsors to wait on favorable markets to rebuild pension surpluses.
After three consecutive years of double-digit stock market returns, year-end 2021 average pension funded status once again achieved a surplus.2 During the 13-year period from 2008 until 2021, many plan sponsors implemented LDI with derisking glidepaths, which drove an increased allocation to bonds and a decreased allocation to stocks over time.
Many sponsors also implemented programs to reduce the size of their pensions, including closing plans to new entrants, freezing future benefit accruals, offering lump sums to separated participants and transferring liabilities to insurers by purchasing of annuities, commonly called pension risk transfers.
Pension Benefit Increases
One efficient option for using surplus pension assets is to restart benefit accruals or reopen the plan. This can be done by reducing other elements of total compensation to achieve savings.
For example, IBM recently announced the unfreezing of its pension, adding a 5% cash balance pension benefit and eliminating a 5% contribution to the 401(k) plan. The new pension benefit will use the surplus and save the 5% that would have otherwise been contributed to the 401(k) plan.
In these restart situations, the new pension benefit can be structured differently than the legacy benefit. For example, a plan with a frozen final average pay benefit could be reopened with a new cash balance benefit. The PPA added safe harbor cash balance plan designs as a low-risk pension option for plan sponsors. Subsequently, cash balance has become the predominant type of new pension benefits.
Chart 1: Hypothetical illustration
Total compensation remains unchanged: the overfunded pension provides a replacement retirement benefit for the eliminated employer contribution to the 401(k) plan.
Source: MIM Analysis; 3/31/24. For illustrative purposes.
Retiree Medical Benefit Costs
Many corporations have legacy unfunded retiree medical plans. 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. This can be done through a combination of a Section 420 asset transfer and a Section 401(h) subaccount.3 The rules surrounding this were recently updated in the SECURE 2.0 Act of 2022.
Corporate Synergies
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. A purchaser with an overfunded plan can monetize its surplus by acquiring a business with an underfunded plan.
In the example below, the acquisition purchase price is adjusted down $20 million to reflect the underfunded pension. Post acquisition these plans may be merged or left stand-alone.
Table 1: Illustration of Pension Surplus Monetized in Corporate Acquisition
| Pensions |
| ($M) | Buyer | Acquisition | Post acquisition |
| Assets | 1,200 | 80 | 1,280 |
| Liabilities | 1,000 | 100 | 1,100 |
| Surplus | 200 | (20) | 180 |
| Ratio | 120% | 80% | 116% |
Source: MIM Analysis, 3/31/24, for illustrative purposes.
Pension Risk Transfer
PRTs have been an increasingly popular way to reduce or eliminate pension financial risk for plan sponsors. PRT growth has driven evolution and concerns have been raised about newer market participants. However, market demand, high interest rates and improved funded status will continue to drive interest in PRT transactions.
Chart 2: PRT Transactions and Premiums by year
Source: Aon, U.S. Pension Risk Transfer, Market Insights, March 2024. Accessed 4/25/24.
Plan 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. With a plan surplus, there may be motivation to consider paying a greater portion of plan administrative expenses from plan assets. For example, it may be permissible to pay the expenses of staff who support the plan, including associated employee pay and benefits costs.4
For plan expenses to be paid from plan assets the plan document must permit payment, the expenses must be reasonable, and costs incurred must be for the exclusive benefit of plan participants. The Department of Labor has taken the position that administrative costs are payable from plan assets, but settlor costs are not. Settlor functions are those that relate to the creation, design and termination of plans.
Table 2: Settlor vs. Administrative Pension Support Tasks
| Settlor Functions | Administrative Functions |
| Plan design work | Plan administration and benefit calculation expenses |
| Work associated with corporate transactions, like mergers, acquisitions, or plan spinoffs | Communicating plan benefits to participants and beneficiaries |
| Accounting calculations for pensions, e.g., ASC 715 | PPA required funding calculations |
| Plan amendments not required to keep the plan qualified and not required to implement the plan, e.g. an amendment to change plan benefits | Plan amendments required to maintain tax-qualified status, e.g., as required for a change in pension law |
| Expenses related to union negotiations | Expenses related to implementing plan changes from union negotiations |
Sources: Department of Labor Guidance on Settlor v. Plan Expenses; American Society of Pension Professionals and Actuaries: What Expenses Can Be Paid from Plan Assets? 3/31/24.
Recapturing Assets Through Plan Termination
Surplus assets can revert to the employer when a pension is terminated. These asset reversions are taxed, including through excise taxes, so other options may be more efficient uses of plan assets.
If at least 25% of the surplus is used in a qualified replacement plan, or QRP, the remaining surplus assets are taxed at 20%. If a QRP is not used, then asset reversions have a 50% excise tax. Asset reversions are also includable as taxable income to the sponsor.
Some sponsors have split their pension plans into two plans, one for active participants and the other for inactives, then terminated the plan for inactives to capture surplus assets through an asset reversion. This two-step process is called a plan spin-off/termination. The IRS has stopped issuing advance approvals of spin-off/terminations, indicating a more negative and potentially aggressive view by the agency.
Table 3: Qualified Replacement Plans Summary
| Qualified Replacement Plans |
|
| QRPs Reduce the excise tax on reverting assets from 50% to 20% |
Source: Internal Revenue Code, Section 4980; Rev Proc. 2022-28. 3/31/24
Growing the Surplus
Some plan sponsors may prefer to keep 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. Overfunded plans do not have required contributions or PBGC variable rate premiums, and the larger the plan surplus, the less likely plans will ever have them. Also, accounting treatment for overfunded plans results in income on the sponsor’s P&L.
Chart 3: Funding Projection Comparing Fully and Overfunded Plans
Source: MetLife Investment Management calculations. Illustrations of plan funded ratio history and a range of possible future outcomes using certain capital market assumptions. The left chart shows a fully funded plan (100% funded ratio), and the right chart shows an overfunded plan (110% funded ratio). The overfunded plan is more likely than the fully funded plan to be overfunded in the future. 3/31/24
Conclusion
The pension environment has significantly changed since pensions were last overfunded, presenting opportunities to plan sponsors with overfunded plans.