As we have previously discussed on our blog before, business owners close to retirement are increasingly choosing Cash Balance Plans over 401(k) plans. In fact, almost one in four Fortune 500 companies offers a defined benefit pension plan to new hires. Pension plans are often considered one of the most highly regulated and complex areas of benefits, and one of their major complexities is funding.

Because of the uncertainty of predicting the futures of participants and market volatility, funding a defined benefit pension plan sometimes seems little more than a careful guess. As an advisor, you are likely familiar with underfunded plans, such as in Philadelphia, where their city workers’ pension plan, with less than 50% funding, has been branded one of the worst-funded pension plans in the US. However, overfunding can be just as much of a problem for plan sponsors and their advisors.

How Pension Plans are Overfunded

Every year, an actuary calculates the amount that a company must pay into the pension plan that they sponsor based on the benefits the participants receive or are promised and the estimated growth of the plan’s investments. These contributions are tax-deductible to the employer. How much money the plan ends up with at the end of the year depends on the amount they paid out to participants and the growth that they earned on the money.

Because of this, market changes can cause a fund to be either underfunded or overfunded. It is common for defined benefit plans to become overfunded in the hundreds of thousands or even millions of dollars. Regrettably, overfunding is of no use while in the plan, for it does not change participant benefits and cannot be used by the business or its owners.

Why Overfunding is a Problem

With so many pension plans dangerously underfunded like in Philadelphia, you would think that being overfunded would be a good thing. Not so. The money cannot just be withdrawn from the plan unless the plan itself is terminated, such as when the owner retires, dies, or sells the business.

When the plan is liquidated, the sponsor must pay federal and state income tax on excess funds since they were tax-deductible contributions. In addition to the 40% or so of income taxes, the overfunding is subject to a 50% non-deductible reversion excise tax. This tax was put into place in 1986 as a way for Congress to try to protect employees of large companies from corporate raiders that would liquidate the pension plans in order to keep the overfunding. Though aimed at large companies, the excise tax applies to all qualified defined benefit plans uniformly. Many small business owners without an exit strategy end up losing 90% of their excess pension funds to the government.

Ways to Correct Overfunded Plans

There are multiple ways for advisors to help sponsors correct overfunded plans so that the majority of the funds are not lost upon liquidation. Depending on the extent to which a plan is overfunded, certain methods are more effective than others. Be sure to work with an experienced and qualified pension consultant to review all of the options with your clients.

Maximize Retirement Benefits

The plan sponsor can use the surplus funds to enhance the current benefits offered by the plan without changing benefit formulas or actuarial assumptions. A specified amount or percentage of salary can just be added into a subaccount within the existing plan so that the participants retire with even greater benefits.

Match 401(k) Contributions

Overfunding can also be used to match employee contributions to a qualified 401(k) plan, as long as the funds stay in a subaccount in the defined benefit plan instead of going into an individual employee account.

Add Family Members as Participants

A small, closely held family company can simply add more family members as participants in the plan. They don’t need to pay any more into the plan, since it is already overfunded, and the money goes back to the family as benefits instead of to the government as taxes.

Buy Insurance

Companies can use the excess funds in their pension plans to buy disability and life insurance for plan participants as an additional benefit of the plan. A move such as this requires the pension plan to be amended first.

Fund Retiree Health Benefits

Businesses can also set up sub-accounts in the pension plan to fund health benefits during retirement. Participants can use the funds to purchase medical coverage or just take the money as an additional pension benefit.

Strategic Sale

For plans that are significantly overfunded, the most profitable option may be to sell the company to one that has an underfunded pension plan. After the acquisition, the pension plans may be merged and the overfunding of one can balance out the underfunding of the other. Some companies that have found themselves near bankruptcy but with overfunded pension plans have utilized this method with great success. Unable to take any significant amount out of their plan to pay their debts, a sale allows them more money to pay debts and possibly still profit the owners.

The IRS has made strategic sales convenient by ruling that the use of overfunding to fund underfunded liabilities through a plan merger does not trigger income tax or the reversion excise tax. Any profits from the sale are still taxed at the capital gains rate, but it is much more reasonable than paying 90% in taxes.

Restructure or Reorganize

If the business’s owners are not interested in selling but prefer to continue with the business as is, restructuring or reorganizing may be the answer. Such reorganization can usually be carried out in a way that gains value for the overfunding without disrupting the primary business activities.

When it comes to pension plans, especially overfunded plans, it is vital to work with an experienced professional to help your plan sponsors evaluate all of their options. If your clients have a plan that is overfunded, give me a call today at 480.494.8992 or by email at info@ff401k.com.

About Kenny Phan

Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.