U.S. Corporate Pensions—Thoughts on Surplus Assets
By Jeff Passmore
Retirement Section News, October 2024
U.S. corporate pensions have experienced their first consistent period of overfunding since the liability driven investing (LDI) period began. Since the first quarter of 2023, the average funded ratio for these plans[1] has been higher than 100%.
In 2008, pension funding and accounting rules changed in ways that encouraged adoption of LDI. Since then, the majority of plans[2] have derisked their asset allocation by moving assets from stocks to bonds and lengthening their bond portfolios to better align with their liabilities. This derisking will make recent funding improvements more durable.
The LDI era has brought remarkable change to the pension world and the approaches for using pension surplus have evolved since pensions were last in surplus. There are more tax-efficient uses of surplus than plan termination and asset reversion. This article describes several and makes a case for maintaining and growing a surplus.
Paying Retirement Benefits
Restarting the Pension
Retirement actuaries, among others, have advocated the benefits of an open and accruing pension. In the context of overfunding, reopening and unfreezing a pension may make sense.
Many are attempting and struggling to create income solutions as distribution options from 401(k) plans. Savings plans were not designed to provide lifetime monthly retirement income. Pensions do this easily and can be structured to allow a participant to take their benefit as a lump sum, if preferred. Restarting the pension is an efficient use of surplus and can be accompanied by a similar-sized reduction in employer contributions to a 401(k) to monetize the surplus.
New benefit accruals do not have to follow the old plan formula. Cash balance plan designs may provide the sponsor with a lower risk option and a more linear and predictable cost pattern compared to a final average pay benefit, for example.
Restarting a pension is no small undertaking and runs counter to the trend of pension closures. However, the IBM pension reopening provides the paradigm for those willing to consider it, and for overfunded plans, the economics can be compelling.
Qualified Replacement Plan
Terminating plan sponsors can allocate surplus assets into a qualified replacement retirement plan (QRP) and significantly reduce excise taxes. To be qualified, a replacement plan must include 95% of the continuing active employees from the terminating plan and the excess assets must be allocated over seven years, or faster. Qualified replacement plans must receive somewhere between 25% and 100% of the excess and an excise tax of 20% is due on the remainder that reverts to the employer. Without a QRP, excess asset reversions are subject to a 50% excise tax.[3]
Corporate Uses
Paying Retiree Medical Benefits
Many corporate pension sponsors have legacy retiree medical obligations. These are typically closed, frozen and small relative to the pension. They are often minimally funded or unfunded. The combination of a Section 401(h) retiree medical account and a Section 420 asset transfer can potentially use pension surplus to pay some of these medical benefits.
The SECURE 2.0 Act, passed at the end of 2022 added a new and more accessible method for plans to make 420 transfers. Under the Act, plans that are at least 110% funded may make de minimis transfers. Amounts less than 1.75% of the plan are considered de minimis.[4]
Buying a Company with an Underfunded Plan
When a company is acquired, there is typically a discount to the purchase price to account for any pension underfunding. An acquired, underfunded pension can be merged into an existing, overfunded plan to effectively use some or all of the surplus assets. Even if the acquired and existing plans are kept separate, the funded positions will be aggregated on the sponsor’s balance sheet, effectively monetizing the surplus.
Paying More Plan Expenses
Most pension sponsors use plan assets to pay expenses like investment management fees, PBGC premiums, benefit administration costs and actuarial funding valuation fees. In the context of an overfunded plan, sponsors may want to consider paying more from plan assets.
Paying expenses from a plan requires that the plan document permits payment, the expenses are reasonable, and the costs are for the exclusive benefit of plan participants.
In addressing the issue, the Department of Labor has taken the position that settlor functions are not payable from plan assets. These include activities related to the creation, rather than the management of plans. Management and administrative costs are payable from the plan.[5]
Pension Risk Transfer
Pension risk transfers (PRT) have become a popular method of derisking. Premiums written in 2022 totaled $52 billion which was a record level, and premiums were $45 billion last year. Expectations for 2024 are $40 billion or more.[6] Premium levels are primarily driven by large plans executing retiree-only transfers. Retiree-only transfers are purchases of an annuity for some or all of a plan's retirees.
PRT transaction counts are driven more by plan terminations, and these typically represent much smaller plans. Transactions in 2022 totaled 568 and rose to 773 in 2023.
Premiums for retiree-only transactions typically are in a relatively tight range around the accounting projected benefit obligation, e.g. 95%–105%.[7] Premiums for plan terminations are higher relative to PBO.
After a retiree-only PRT, the remaining pension becomes longer in duration requiring adjustments to the hedging strategy and becomes smaller in scale.
Keeping and Growing the Surplus
Once a plan is fully funded, it can manage financial volatility with an appropriate investment hedging strategy and can invest excess assets to grow the surplus further. The greater the surplus, the less likely the plan will become subject to required contributions or PBGC variable rate premiums. Pensions in surplus generate pension accounting income which is often valued at the highest levels of a sponsor.
Some uses of surplus assets are not viable when the plan is slightly overfunded but become possible once the plan reaches higher funded levels, like 110% or 125%, etc. So having a surplus asset allocation that is designed to outpace the liabilities can make sense as a long-term strategy to increase pension efficiency.
Knowing there are efficient uses for surplus assets encourages plan sponsors to continue growing assets relative to liabilities. Having a surplus growth strategy can also motivate maintaining existing internal teams and consultant relationships rather than putting a plan on autopilot through an OCIO arrangement, for example.
Revisiting Asset Allocation for an Overfunded Plan
Many plan sponsors who have adopted LDI have also adopted derisking glidepaths. These glidepaths describe how the plan’s asset allocation becomes less risky as funded status improves. Many glidepaths stop at or around 110% funded and have final asset allocations of around 20% to return-seeking and 80% to hedging assets. With this type glidepath, if a plan were to reach 120% funded, allocating 80% of assets to hedging strategies will result in hedging assets equal to 96% of plan liabilities.
This is probably more hedging assets than optimal. Often, allocating assets equal to 80%–90% of liabilities and the remainder to return seeking will achieve a more efficient risk/return trade-off.[8] As funded status continues to grow beyond 100%, proportionally more of the assets can be allocated to surplus, return-seeking strategies.
Conclusion
This period of U.S. corporate pension overfunding is an exciting and dynamic time for plan sponsors and their advisors. There are meaningful strategic conversations that retirement actuaries can have with their clients about plan overfunding.
Even those companies whose plans have not yet achieved full funding may appreciate hearing about options for and trends of overfunded plans.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
Jeff Passmore, FSA, CFA, is vice president and liability strategist at MetLife Investment Management. He can be contacted at jeff.passmore@metlife.com.
Endnotes
[1] The author estimates the funded status quarterly for the companies in the Russell 3000 who have pensions. The latest version of that report is available on request. June 2024.
[2] Analysis by author using SEC Form 10-K filings via Bloomberg; June 2024.
[3] Internal Revenue Code, Section 4980.
[4] Section 420 of the Internal Revenue Code describes the conditions of a qualified asset transfer from excess pension assets into a health benefits account. Qualified asset transfers preserve the tax-qualified status of the pension, avoid asset reversion taxes and ensure the transfer is not an ERISA prohibited transaction. Section 401(h) of the Internal Revenue Code defines the conditions for a health benefit subaccount to exist within a tax-qualified pension trust.
[5] Department of Labor Guidance on Settlor v. Plan Expenses; American Society of Pension Professionals and Actuaries: What Expenses Can Be Paid from Plan Assets?.
[6] Aon, U.S. Pension Risk Transfer, 2023 Reflections and Looking Ahead, March 2024.
[7] Mercer U.S. Pension Buyout index, March 2024.
[8] Analysis by author using Moody’s Analytics, PFaroe and Bloomberg, June 2024.