Overfunded defined benefit plans happen more than you might think. In fact, we work extensively with clients to solve overfunding issues and avoid excise tax penalties.
There are many ways to solve the problem, but there is one solution that is often necessary when a plan is substantially overfunded. We’ll get to that in a moment.
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Minimum and maximum contributions (as well as benefit limits) are established under the Internal Revenue Code. The main goal of the code is to ensure that a defined benefit plan have enough funds to pay benefits to the participants upon retirement.
As a general rule, all plans are overfunded or underfunded. This is even allowed as long as it is within a tolerable range. The funding is carefully monitored by the plan actuary. But sometimes it can get a little out of control.
If substantial overfunding has occurred, there are huge penalties upon termination. But if you plan right, you can usually avoid them.
How does a defined benefit plan get overfunded?
Overfunding can happen for many different reasons, including day trading of the account or simply hitting a homerun on certain types of investments. We have even seen situations where this happened as a result of certain non-qualified assets like real estate or even bitcoin.
In some respects, this is a good problem to have. But when the plan is terminated it can become a big issue. Any overfunded balance is subject to an excise tax of 50%. In addition, there will be income tax. This can run it as high as 90% in total. Not exactly a good thing!
Besides the excise tax, time value of money needs to be considered. Many companies with overfunded pensions essentially give up on trying to earn any investment return. Why earn a high return on plan assets if it is all going to go to taxes and penalties?
If an overfunded plan has $10 million of assets, even a 5% rate of return is $500,000 annually. As you can see, this issue can result in millions of dollars of lost yield over the life of the pension.
Possible Overfunding Solutions
When a plan is overfunded, there are many ways to get the plan back in line. They typically involve one of the following:
Increasing benefit accruals. The plan can possibly be amended to allow for more generous current benefits. This can often be accomplished without making substantial plan amendments or formula changes.
Employing family members. The company can consider employing family members to perform services in exchange for a reasonable wage. This is a way to essentially reallocate a portion of the excess over to the employees.
Funding life insurance. Companies can often use life insurance strategies to reduce overfunding. This is because life insurance policies will provide significant cost and minimal asset value in early years.
Paying operating expenses. Actuary fees and administrative costs like plan consulting, audit and advisory fees can normally be paid out of plan assets. This is often overlooked because in most situations these costs are paid by the company in order to get the tax deduction and to increase plan assets.
Qualified replacement plan. If the company sets up or maintains a qualified plan in connection with the termination of a defined benefit plan, the excise tax is limited to 20 percent.
Strategic Sale or Plan Merger
The above options can work if a plan is slightly overfunded. But what happens if a plan is substantially overfunded? Maybe $5 million or $10 million overfunded. Then many of these solutions simply won’t work. The plan is too far upside down.
The #1 option we look to in this situation is a strategic sale. This structure can be complex and relies on a lot of professional assistance. But in the right situation, this can be a home run.
A strategic sale is when another company acquires the company that holds the pension assets. These companies are usually large corporations with underfunded pension liabilities. They also look for a discount on the purchase. This discount can vary, but usually averages 20% or so.
Example of a Strategic Sale
Let’s take a look at an example. Let’s assume that a small engineering firm with three shareholders sold the assets of their business to a large international engineering company. The small firm has no other employees. Let’s also assume the following:
- shareholders are in their mid-40s.
- the small engineering corporation that holds the pension is still in existence, but has no assets or liabilities.
- the defined benefit plan has a balance of approximately $10 million.
- the benefit limit currently for the three partners is $4 million.
- the plan is overfunded by $6 million.
The shareholders have considered a variety of overfunding reduction options, but are still stuck with the $6 million amount. The best option may just be a strategic sale of the pension or a merger of the pension with a company who has an underfunded pension.
So the transaction would work something like this:
- the $4 million benefit limit for the three shareholders will get rolled over into their respective IRAs. This then leaves the $6 million overfunded amount to deal with.
- a company with an underfunded pension comes in and buys out the $6 million overfunded plan for $4.8 million (a 20% discount on the overfunded amount).
- The $4.8 million purchase is structured as a purchase of the stock of the old engineering company.
- This $4.8 million stock purchase is then a long-term capital gain for the individual shareholders.
In addition to receiving the $4 million that was rolled into the IRAs, the shareholders will each receive a combined amount of $4.8 million as a long-term capital gain. Let’s assume an overall tax rate of 25%. The shareholders are left with a remaining $3.6 million.
At the end of the day, the shareholders received $7.6 million after discounts and taxes. At first glance, this may not sound like such a good deal. However, look at the alternative. The shareholders had the money just sitting in a cash account. Why earn a high return on your investments if you are just going to end up paying it all in taxes and penalties?
The partners receive $4 million into retirement funds and also receive 4.8 million for the sale of the stock. Of course the partners will have to pay tax on the 4.8 million as long-term capital gains.
Now with the overfunding issue corrected and the excise tax problem solved, the partners can get a little more aggressive in their retirement investing. Being that they are in their mid-forties, the $4 million that they have now in their IRAs may turn into well over $10 million by retirement.
Of course before you consummate a transaction like this you want to make sure that you have appropriate tax and legal assistance.
When a defined benefit plan gets substantially overfunded, the best issue is to deal with it as soon as possible before it gets out of hand.
So even though a strategic sale will reduce results in a discount on the over funding it can still be a home run in the right situation.