How Do Defined Benefit and Cash Balance Plans Become Overfunded?

Even though underfunded defined benefit plans have received more attention after years of bear market returns, overfunded DB plans have problems as well and might occur with both large and small plans. In the case of small plans, the outstanding performance of a single equity or real estate investment -- or even the premature death of a highly-paid employee -- can create an overfunding issue.

Excess assets in a plan are allowed to revert to the employer after a Terminated Plan has paid out all its benefit obligations, but Congress imposes a confiscatory tax system of 90% or greater (see 4980 Excise Tax discussion). Explicitly, a 50% non-deductible excise tax applies to a direct reversion -- in addition to ordinary income taxes that apply.


Actuaries annually calculate the amount that a company must pay into the sponsored pension plan. This tax-deductible contribution is based on the benefits the participants are promised, or receive, and the plan’s estimated investment growth. How much money the plan ends up with at year-end depends on the amount the employer paid to participants as well as the growth earned on the money. Market changes can cause a fund to be either underfunded or overfunded. It is fairly common for DB plans to become significantly overfunded -- even to millions of dollars.


Unless the plan is terminated -- the owner retires, dies, or sells the business -- the money can’t be withdrawn from the plan. Upon liquidation, the sponsor is liable for both federal and state income tax on excess funds since they were tax-deductible contributions. On top of the roughly 40% of income taxes, the overfunding is also subject to a 50% non-deductible reversion excise tax. Created in 1986, Congress passed this tax as a way to protect employees of large companies from corporate raiders intent on liquidating their pension plans to keep the overfunding! Unfortunately, this excise tax applies uniformly to all qualified DB plans. As a result of this, small business owners that don’t have an exit strategy can end up losing 90% of their excess pension funds to the government.


There are numerous ways we can assist with correcting overfunded plans so that most of the funds are not lost upon liquidation. Depending on circumstances, some methods would be more effective than others. It is extremely important to work with us to review all the available options so contact QBI at 818.594.4900.


The plan sponsor can apply surplus funds to enhance the current benefits offered by the plan without changing benefit formulas or actuarial assumptions. A sub-account within the existing plan can be created where the sponsor can specify an amount or percentage of salary to be applied so that the participants retire with even greater benefits.


Providing the funds stay in a sub-account in the defined benefit plan instead of going into an individual employee’s account, overfunding can also be used to match employee contributions to a qualified 401(k) plan.


Another option for a small, closely held family company, is to add more family members as participants in the plan. Since the plan is already overfunded, additional funding isn’t needed, and the money goes back to the family as benefits instead of to the government as taxes.


Companies are also allowed to set up sub-accounts in the pension plan to fund health benefits for retirement. This lets participants use the funds to purchase medical coverage or just take the money as an additional pension benefit.


A profitable option could be to sell the company with the significantly overfunded plan to a company that has an underfunded pension plan. Following acquisition, the pension plans can be merged so the overfunding of one plan compensates for the underfunding of the other. Companies approaching bankruptcy, but with overfunded pension plans have applied this method successfully. Since they are unable to take money out of their plan to pay debts, a sale allows the owner funds to pay debts and possibly still obtain a profit. However it is an unlikely situation of having a large surplus for a company near bankruptcy. Strategic sales are allowed by an IRS ruling that lets the company use overfunding to fund underfunded liabilities through a plan merger without triggering income tax or the reversion excise tax. Any sale profits are taxed at the capital gains rate, but this is far more reasonable than paying 90% in taxes.


Another option, if the owners prefer to continue with the business as is, might be restructuring or reorganizing. Typically, reorganization can be carried out in a way that improves the value of the overfunding without disrupting the primary business activities.


With all of the options mentioned above, by far the first strategy should be proactive prevention rather than a reactive fix! As your consultants, we annually monitor the funded status of your plan on a Plan Termination basis. This is particularly critical for a small plan as the proprietor approaches retirement age. Provided the owner has followed a consistently strong funding pattern, the assets could still marginally exceed the value of accrued benefits for a maturing plan. The plan could be quickly put in a problematic overfunded position if the assets grow sharply during a single year. Provided that 2 or 3 years remain before the owner's retirement, the evolving overfunded problem might readily be avoided through reducing or eliminating contributions to the plan for the plan’s remaining years. Should the assets increase sharply during the final year of the plan, a substantial problem might develop. For this reason, a wise option would be to gradually protect the assets from the danger of sharp fluctuations in value by moving them out of equities and into more stable securities as the owner nears retirement age. It is vital to work with us, your experienced professionals at QBI, LLC to assist you in evaluating all of your options when it comes to pension plans -- especially overfunded plans.