While the problem of Underfunded Defined Benefit Plans gets the headlines after several years of bear market returns, Overfunded Defined Benefit plans have their own unique set of problems. Overfunding can happen to both large and small plans. In the case of small plans, it can be caused simply by the outstanding performance of a single equity or real estate investment, or even by the premature death of a high paid employee.
While it is permissible for the excess assets in a plan to revert to the employer after a Terminated Plan has paid out all its benefit obligations, Congress has seen fit to impose a confiscatory tax scheme of 90% or greater on such reversions (see 4980 Excise Tax discussion). Specifically, a 50% non-deductible excise tax applies to a direct reversion in addition to ordinary income taxes that apply.
Problem with Reversion
Suppose that a Terminating Plan sponsored by a closely held entity has $2,000,000 in overfunding. If this amount is reverted to the employer, and ultimately to the owner(s), the net amount actually received by the owners varies depending on the structure of the organization, but will be about 10% at the greatest. The following table shows the outcome under different business structures based on the assumed income tax rates shown:
After-Tax to Owner(s)
Observing the confiscatory nature of the punitive excise tax on reversions as shown in this table, there is clearly strong impetus to seek alternative strategies for handling excess assets at Plan Termination. Several strategies are available, falling into three broad categories: increase benefits, transfer some assets to a new plan, or merge the overfunded plan with an underfunded plan. But first, there is the better way--to avoid the problem altogether.
The first strategy is in fact not a reactive fix, but proactive prevention. On an annual basis, as the consultants on a plan, we monitor the funded status of the plan on a Plan Termination basis. This is especially critical for a small plan as the owner nears retirement age. If the owner has followed a consistent strong funding pattern, the assets may very well marginally exceed the value of accrued benefits for a maturing plan. If the assets grow sharply during one year, the plan may quickly be put in a problematic overfunded position.
As long as there remain 2 or 3 years before the owner's retirement, the solution to the emerging overfunded problem may simply be to reduce or eliminate contributions to the plan for the remaining years of the plan. However, if the assets increase sharply during the final year of the plan, a substantial problem may emerge. For this reason, it may be wise to gradually immunize the assets from the risk of sharp fluctuations in value as the owner nears retirement, moving assets out of equities and into more stable securities.
Increase Plan Benefits
Increasing plan benefits may be the best and smoothest way to "eat up" the excess assets in an overfunded plan. Even a plan formula that was properly designed 5 or 10 years ago to achieve the maximum permissible (415) benefit level for a business owner may not achieve that goal any longer due to subsequent changes in the various applicable laws.
The plan formula can be redesigned in order to increase benefits until the value of all benefits equals the value of assets. Or, in the process of Plan Termination, benefits can be increased on a simple prorata basis so that everyone gets the same percentage increase in their overall benefit.
Increasing benefits on a prorata basis in a Plan Termination has the additional positive side-effect that if 20% or more of the excess assets are used up in this manner, then the remaining portion of the excess can be taken as a reversion with the excise tax reduced from 50% down to 20% (see discussion and example of alternative excise tax levels).
However, if the owner of the business is already at the 415 Maximum Benefit level, and there is no way to increase his/her benefits, it is unlikely that s/he will choose to increase the benefits just for the other employees if the amount of excess assets in question is significant.
Allow Additional Accruals
The strategy of allowing additional accruals is similar to the prior strategy, but requires the passage of time to increase benefits rather than a simple plan amendment.
If the owner's 415Maximum Benefit can increase by waiting another year or two for Plan Termination, this may be a viable option for allowing the value of benefits to overtake the value of assets. It generally takes 10 years of Participation in the plan to reach the Maximum Benefit level.
At times, it is possible to increase benefits by simply increasing the amount of compensation paid to the owner for an additional year or two.
Even if the owner has already accrued 100% of the current 415 $-limit, the $-limit is inflation-indexed. Waiting a year could yield about a 3% increase in the benefit limit, and could be compounded by an actuarial increase in the value of the benefit of about 5%, producing a gross increase of about 8% in the value of the benefit. If the assets experience less than 8% growth, any overfunded situation would be marginally improved; but if assets outperform this 8% level, the overfunded situation deteriorates.
However, waiting is not always advantageous. There are age-and-service combinations at which the value of the owner's maximum benefit actually decreases by waiting to take a distribution, so making the distribution as-soon-as-possible minimizes any problem with overfunding.
Adding Plan Participants
Another method of increasing the value of plan benefits is to bring new participants into the plan to accrue benefits. These participants could be family members who will ultimately take over the business at the retirement of the owner. However, in order to accrue significant benefits, significant salaries must be paid by the employer to these new employee/participants, along with accompanying payroll taxes.
Transfer to Retiree Medical Accounts. Provision expired 12/31/05. This option is mentioned only for completeness. It was impractical for small employers because benefits for Key Employees were excluded. The numbers involved were small, typically speaking.
Transfer Assets to Replacement Plan
By transferring 25% of the excess assets to a replacement plan, the remainder of the excess can be taken by the employer as a reversion with a reduced excise tax rate of 20% instead of 50%. The replacement plan can be a 401(k) or Profit Sharing Plan, and the transferred assets can be used for Profit Sharing allocations or for Matching Contributions. The transferred assets must be used up within 7 years, counting the year the transfer is made.
As shown in the discussion of the reversion excise tax, the result of this strategy is that, after taxes, 30% of the excess is returned to the employer. In a small plan environment, since the owner may participate significantly in the allocations in the replacement plan, the recovery of the original overfunded excess assets directly to or for the benefit of the owner might approach 50%. (It should be noted that the 25% transferred to the replacement plan remains in a pre-tax/tax-deferred category until it is withdrawn as retirement income and taxed as ordinary income.)
Merger of Plans
The tax code clearly permits an employer to merge defined benefit plans. This includes the merger of overfunded plans with underfunded plans. The resulting merger of an underfunded and an overfunded plan may either be underfunded or overfunded immediately after the merger. Clearly, the resulting merged plan will be closer to a 100% funded level, and the result will be an elimination of the problems of one of the plans. The problems of the second plan will also be ameliorated.
The tax code and ERISA provide specific mechanisms to protect the benefits of the employees who were participants in the overfunded plan. Their benefits are fully protected.
Many large employers sponsor multiple defined benefit plans, so the process of merging plans to improve the funded status of both plans doesn't necessarily involve any acquisitions or business transactions. Most small employers sponsor only one defined benefit plan, so a business-sale may be arranged. This business-sale can have as one of its motivations the transfer of an overfunded defined benefit plan to an employer who has an underfunded plan, whose intent is to merge the two plans. The sale/acquisition of a business with the intent to merge an overfunded defined benefit plan into an underfunded plan has been used by large corporations as well.