The recent economic climate has increased the number of pension plans with a surplus—according to Milliman’s latest Pension Funding Study, over one-third (35) of the 100 plans in our study have excess assets. This article explores four different approaches plan sponsors can take for frozen plans with surplus assets.

What is a pension plan surplus?

A pension plan surplus is a situation in which the plan’s assets exceed the plan’s liabilities. Pension assets represent the aggregation of historical contributions to the plan, plus investment returns, minus benefit payments and expenses paid from the trust. These pension assets are the amount available to pay benefits to retirees in the future. Pension liabilities represent an actuary’s best estimate of the money necessary to fund future benefit payments, using a set of actuarial assumptions about future demographic variables (mortality, retirement) and economic variables (discount rate, inflation).

Why are we seeing more pension plan surpluses now?

Several years of strong asset performance combined with the current regime of higher interest rates (interest rates impacted by the Federal Reserve’s monetary policy) have provided a significant boost to single employer defined benefit plan funded statuses—as strong asset performances have increased the funds available in the trust while rising interest rates have put downward pressure on the plan’s liabilities.

Over the past several decades many single employer defined benefit pensions have been closed (to new participants) and/or frozen (no new benefit accruals). In a frozen defined benefit plan, once the benefits are fully funded, a surplus of assets creates new challenges for the plan sponsor; in the event of a plan termination punitive excise taxes are associated with reverting employer money back out of the plan.

For frozen plans with excess assets, the question becomes—where should we go from here? In this article we explore four different approaches for dealing with a surplus:

• Continue hibernating
• Thawing and redesign
• Transfer to defined contribution after a plan termination
• Transfer to other plans for health benefits

Strategy 1: Maintain the frozen plan (“hibernation”)

Letting a well-funded frozen plan hibernate is a seemingly low-risk endeavor for the sponsoring entity. Asset surpluses, however, can be elusive: calculated under one set of assumptions, asset-to-liability ratios fail to convey the risks—from economic downturns and shifts in the interest rate environment to demographic changes. It would therefore be prudent to consider strategies that could help mitigate some of the potential risks. Plan sponsors wishing to continue maintaining their pension plans have several tools at their disposal to reduce future volatility.

Investment approaches

One such tool that employers often reach for is asset-liability matching (ALM) strategies. These strategies can help minimize balance sheet volatility while significantly reducing potential need for additional funding in the future by locking in favorable asset-to-liability ratios. There are two primary methods to devise a liability-driven portfolio for a pension fund: duration matching and cash flow matching.

The first method, duration matching, involves investing pension assets in a portfolio of bonds such that the portfolio's duration matches the duration of the plan’s liabilities. This can help safeguard pension plans against fluctuations in interest rates: whenever interest rates decrease, the present value of pension obligations increases, but so does the market value of a duration-matched portfolio. Similarly, rising interest rates reduce both the assets and liabilities by the same proportion. The overall outcome is a more stable asset/liability relationship.

The second method, cash flow matching, involves investing in a series of bonds such that the portfolio's cash flows align with expected payouts. Not only does this method match the duration of the plan’s liability and therefore protect against interest rate changes, but it also provides an extra level of stability for a duration-matched portfolio by reducing the need to ”recalibrate” a portfolio as time passes.

The above strategies look particularly attractive today because fixed income securities are historically cheap. It's important to note that, while asset-liability matching helps reduce market risk, employers still face demographic risk, which could potentially undermine the effectiveness of these strategies.

De-risking

Reducing the plan’s demographic risk can be accomplished via risk transfer. There are two ways to mitigate risk via transfer: by either purchasing annuities for a portion of the population or by offering elective lump sum windows. Both strategies are particularly attractive at present because the interest rate environment is the most favorable it’s been since the global financial crisis.

As interest rates rise, the statutory minimum lump sum amounts decrease relative to various liability measures. Similarly, the cost to purchase annuities has gradually decreased over the last decade and a half, as evidenced by the Milliman Pension Buyout Index, which shows the cost of annuity buyouts relative to accounting liabilities since 2010. The index reached its floor during 2022 and remains near its lows. The blue represents the average rates of all insurers in the study, while the red focuses on the rates from a competitive bid process.

By choosing to transfer a portion of risk, employers can reduce the size of pension liabilities while maintaining, or in some cases improving, their financial standing.

Pension income

For some employers, pension liabilities comprise a significant portion of the balance sheet. Overfunded plans can generate pension income on an employer’s financial statements whenever expected asset returns exceed the sum of interest cost and service cost. This pension income is reflected in the employer’s income statement.

One important caveat is that the volatility of investment returns can reduce or eliminate surplus in some years. Over the long run, however, well-funded plans can be a considerable source of income on the employer’s financial statements.

PBGC premium strategies

The Pension Benefit Guaranty Corporation (PBGC)—the insurer in the private pension world—charges plans two types of premiums: a flat per-participant rate premium and a variable rate premium that is based on the amount of unfunded liabilities (the excess of liabilities on the PBGC basis over the plan’s assets). Variable rate premiums can constitute a significant portion of the plan’s recurring costs but, unlike the flat fee, these premiums can be avoided if the plan is sufficiently funded. In fact, some plan sponsors build their funding strategies around completely eliminating any unfunded liability used to calculate the PBGC premium, which can result in significant PBGC premium savings.

As interest rates have broadly increased, variable rate premiums have generally come down. Plans that are in good funding positions stand to benefit from immunizing liabilities against increases in variable rate premiums. These strategies are similar to the asset-liability matching methods described above, but the focus of the bond portfolio becomes duration matching of liabilities calculated on the PBGC basis. By locking in their favorable asset/liability ratios employers can protect themselves against future fluctuations in their unfunded PBGC liabilities and thereby reduce their variable rate premium costs.

Strategy 2: Awaken the frozen plan (“thawing”)

The poster child for this strategy is IBM—which announced in late 2023 that it would reopen its frozen pension plan to new entrants. Rather than simply reopening the same plan it froze nearly 20 years ago, IBM embarked on a redesign of the plan.

The redesign is an important part of IBM’s story—without these changes IBM may have repeated history. The economic pressures still exist that caused IBM to freeze the plan in the first place and may have caused the company to refreeze the plan after the surplus dries up. Instead of reopening its traditional defined benefit plan design, IBM adopted a cash balance plan. Unlike a traditional defined benefit plan, where the benefit accruals are independent of the funded status of the plan and other economic variables, a cash balance plan can be designed to restrict the growth of defined benefit liabilities based on a market index (in the case of IBM, the yield on 10-year Treasuries).

In tandem with the reopening of the cash balance plan, IBM decided to cease its existing 401(k) defined contribution plan match, effectively shifting the current benefit spend from the 401(k) plan (which requires annual cash contributions to fund) to the pension plan, where the annual benefit accruals can be paid for through use of the existing pension surplus. The cash balance plan operates from the participant’s perspective similarly to a 401(k) plan—participants get a contribution added to their “accounts.” These accounts grow at a guaranteed rate stated by the plan (the “interest crediting rate”), which can look like the returns a participant might see in their 401(k). The big difference is that investment of these funds is not directed by participants. The employer invests the funds on behalf of all participants.

IBM’s choice of a cash balance plan is an increasingly common design choice. Over 20,000 new cash balance plans have been set up since 2000. Nearly 50% of all defined benefit plans now in existence are cash balance plans, up from around 15% in 2010 (and less than 5% back in 2000).¹ There are other choices that plan sponsors can consider:

• Market return cash balance plan: Providing even more risk mitigation than the design IBM selected, a market return cash balance plan uses an interest crediting rate that is based on the actual return of plan assets (even if negative!). This ties the performance of the liabilities to the assets in a very explicit way and nearly eliminates investment risks for the plan sponsor.
• Sustainable Income Plan: A type of a variable annuity pension plan (VAPP), this design also significantly reduces investment risk to the plan sponsor, as the benefits are adjusted at regular intervals based on the actual asset performance. In the purest form, these plans exhibit no investment risk to the plan sponsor; however, in order to reduce the participant’s exposure to market volatility, many designs include stabilization mechanisms that reduce benefit volatility at the expense of retaining exposure to investment risk (albeit much smaller risk than in the traditional design). See the following link for more information about the Sustainable Income Plan: "Milliman Sustainable Income Plan – Single Employer Plans".

Strategy 3: Eliminate the frozen plan (“termination”)

High market interest rates and a hot annuity placement market with an increasing number of players competing for business has translated into lower premiums paid to an insurer to take over responsibility for benefits. This has led some plan sponsors to engage in plan termination.

Plan termination is a long process that effectively ends the employer’s sponsorship of a defined benefit plan. The process can take over a year to complete from start to finish and includes significant engagement among all of the key players working on the plan: the plan sponsor, plan administrator, actuary, investment consultant, and ERISA counsel, among others.

The process involves multiple filings to several government agencies that oversee pensions and an audit period that extends well after the final benefit liabilities are offloaded.

In the past, it was not uncommon to estimate a “termination liability” as 110% to 120% of the plan’s accounting liabilities. This load was to account for the risk premiums that would be charged by an insurer to take over responsibility of payments. A higher load was considered for plans with atypical features or higher proportions of “deferred” lives—those who are not currently in payment status. The landscape has changed dramatically over the last several years, as new players have entered the annuity purchase space and competition has increased. As a result, a plan may not need that much surplus to effectuate a plan termination.

In any case, a surplus above the amount needed to terminate the plan can be problematic for the plan sponsor, as there are limited options for dealing with a surplus:

• Employer reversion (full): After all benefit liabilities have been satisfied, a plan sponsor could (assuming the plan document allows it) revert the surplus back to the company. The problem with this approach is that it involves a 50% excise tax and such reversion is then subject to ordinary corporate income tax.
• Employer reversion (partial): An employer can reduce its exposure to the excise tax from 50% to 20% if the company uses a portion of the surplus to improve benefits to pension plan participants or transfers a portion of the surplus to a qualified replacement plan.
• Qualified replacement plan: As noted above, the tax can be reduced if a portion is transferred to a qualified replacement plan. If the entire surplus is transferred, then the tax is effectively eliminated as there would be no reversion. The qualified replacement plan has certain requirements that must be met, but in this strategy the plan sponsor could hold the surplus asset in a suspense account and allocate it to participants’ defined contribution accounts over a period not to exceed seven years. This allows the sponsor to reduce its annual defined contribution budget while using up the pension surplus over time.

Strategy 4: Repurpose the surplus of the frozen plan (“420 transfers”)

If the plan sponsor also provides a plan for retiree health benefits, then the funding surplus, subject to various conditions, may be transferred to a retiree medical or life insurance account to pay for those benefits. Only a portion of the excess assets may be used for this purpose, those over 125% of the plan’s liabilities (110% if the transfer amount is less than 1.75% of pension assets), and only one transfer may be made in any taxable year.

These transfers are often called “420 transfers” after Internal Revenue Code (IRC) section 420, which describes the transfer. These 420 transfers are a rare way for a plan sponsor to use the excess assets while maintaining the pension plan.

Summary

This article summarizes several approaches that an employer can use to help mitigate future volatility and risk. Beyond risk mitigation, there are multiple ways for employers to get the most out of their plans—from redistributing the surplus toward funding new benefits, like IBM did, to funding retiree medical or life benefits, to using the surplus to generate pension income on the financial statements. While it may be tempting for a sponsor of a well-funded defined benefit plan to switch to autopilot, potential pitfalls are best avoided through careful planning and selecting a strategy that best fits a particular set of goals.

¹ National Cash Balance Research Report 12th Edition https://assets.futureplan.com/futureplan-assets/FuturePlan-National-Cash-Balance-Research-Report-12th-Edition.pdf.