Defined benefit plans and cash balance plans are great retirement vehicles. You get large tax deductible contributions and huge retirement contributions. The best of both worlds.
But don’t think that these plans can’t have funding issues. One of the more common problems we see are overfunded plans.
The reason why overfunding can be an issue is mostly because at termination the overfunded amount is taxed to the company along with an excise tax. This issue is commonly called reversion.
In this post we will discuss reversion and identify our top 10 ways to mitigate it. With careful planning, you can avoid costly penalties and taxes.Table of Contents
- #1 – Keep the plan open for extended time
- #2 – Increase plan benefits
- #3 – Increase compensation for current employees
- #4 – Pay plan expenses from assets
- #5 – Proactive review
- #6 – Review for plan errors and non-deductible contributions
- #7 – Hire additional employees (add plan participants)
- #9 – Roll the plan into a qualified retirement plan (QRP)
- #9 – Consider life insurance
- #10 – Plan merger or strategic sale
Funding for a defined benefit plan or cash balance is a constant juggling act. There are annual contributions that are mostly determined by the number of participants as well as compensation and age. The plan actuary will determine annual contribution levels.
But one thing that is often overlooked by business owners is the return on plan assets. The asset balance is driven mostly by contributions, but also reflects earnings on the investments, like dividends, interest, and capital gains.
At the end of the day, fluctuations in investment performance and contributions can result in plan underfunding or overfunding. This is actually more common than you might think.
Since terminating an overfunded defined benefit plan or cash balance plan can result in many headaches, we are going to cover the top 10 strategies we use to mitigate overfunding issues. Let’s jump in.
#1 – Keep the plan open for extended time
Many owners have their plan open for 5-10 years and then get to a point where they are looking to retire or maybe even work part-time. The thought process is that they can simply terminate the plan and just roll the assets over into an IRA.
In theory this is correct. However, in some situations the plan is overfunded and they cannot close the plan without reversion.
But in most situations this is an easy fix. The owner just needs to keep the plan open for another year or two.
The plan can be frozen so future benefit accruals are not required. But usually another year or two of service without a plan contribution will get the overfunding issue resolved.
If the owner’s maximum benefit can increase by waiting for a year or two before plan termination, this may allow allow the value of benefits to reach the asset value.
The best part about this is for the third-party administrators (TPAs). They get to charge the client for administration work for a couple more years. The clients may not be too happy about that though.
#2 – Increase plan benefits
Simply increasing the plan benefits can be an easy solution. A plan formula that was structured properly many years back to allow for a maximum benefit (415 limit) might no longer be applicable considering law changes, etc.
You may be able to change the plan formula to increase benefits until the value of all benefits equals the value of assets. Another option is to increase the benefits using a basic prorata approach during plan termination. This allows every employee to get the same percentage increase in the overall benefit.
Increasing benefits under the prorata approach during a termination has another advantage. If 20% or more of the excess assets are used in this process the remaining overfunded portion can be taken as a reversion with the excise tax reduced from 50% down to 20%.
However, this approach has one big disadvantage. Many plans are owner only plans or just have a few participants. If the business owner is already at the maximum benefit (again the 415 limit) and there is no way to increase benefits for the owner, it is unlikely that they will select this approach and increase the benefits just for the other employees. This is especially true if the excess amount is sizable. There may be other more appealing options.
#3 – Increase compensation for current employees
There may be key employees that could receive a pay increase. If they are close to the social security cap it might not create a lot of overall added taxes.
It might be possible to simply increase the compensation paid to the owner for a year or two. Even if the owner is already at the 415 limit, it is inflation adjusted each year. Just holding out another year could result in around a 2% benefit limit increase.
If you assume an actuarial increase in the benefit value of 5% this could result in an increase of about 7% in the benefit value. If the assets don’t yield the 7% growth rate, the overfunding problem should start to come back in line. Although the improvement may only be slight. But if the assets outperform the 7% level, the overfunded situation will only get worse.
Waiting things out does not work great in all situations. There are age and service situations when the value of the owner’s maximum benefit will actually decrease. So you will need to weight the pros and cons. But usually this approach will work well for plans that are slightly overfunded.
#4 – Pay plan expenses from assets
Most business owners are so interested in the tax deductions that they pay plan expenses directly from the company. They don’t realize that the plan expenses can be paid out of plan assets. These expenses aren’t often much, but it still should be considered. Don’t forget the following costs:
- financial audits
- actuarial and TPA fees
This may only be a small benefit. But with some larger plans requiring audits and other extensive administrative actions, this could be an option.
#5 – Proactive review
This is an easy one. Don’t let the issue get out of hand to start with.
Actuaries, plan fiduciaries, financial advisors and many CPAs review plans and calculations on an annual basis. The actuary is certainly the first line of defense. But unfortunately, more often that not, the company and it’s actuaries fail to timely communicate.
One simple solution is to have annual calls with all parties to the plan. This way, any concerns can be voiced and companies can get out front of the issue.
#6 – Review for plan errors and non-deductible contributions
Most plan documents will state that if a company makes an excessive contribution due to an error, the company can demand the excess be returned. The company can request this refund the trustee within one year after the date of the contribution.
Another consideration is that plan documents typically provide that a contribution will be made on the condition that the company receives a tax deduction. In certain situations, you might find that a tax deduction was disallowed by the IRS. The disallowed deduction can be returned to the company within one year after a final determination from the IRS that the tax deduction was disallowed.
There are also situations of actuarial calculation error. In a 2014 Private Letter Ruling, the IRS allowed a reversion when a terminating plan purchased an annuity contract.
The surplus was created when the acquisition price chosen to fully plan benefits was actually lower price than originally estimated. The plan’s actuary recommended a contribution that was higher than what was calculated as required by the insurance company. As a result, the IRS allowed the plan to return the excess contribution.
The moral of the story is clear. When a plan is overfunded, make sure you review actuarial assumptions, calculations and corresponding tax returns to make sure that everything was operating correctly.
#7 – Hire additional employees (add plan participants)
Another option is to ultimately bring more participants into the plan. The owner could consider hiring additional employees (including family members) who can accrue benefits.
Many business owners have succession plans in place. If these family members can work in the business this could be a benefit to the owner.
Make sure to also consider employing a spouse. Many spouses work in the business without drawing a salary. In fact, there are many sole proprietors and small business owners where a spouse is inadvertently not on payroll. This is a great option to get the spouse on payroll to limit overfunding.
In addition, the spouse can contribute to a 401k plan as well. We know that most defined benefit plans are done in conjunction with a 401k (what I would call a combo plan).
#8 – Roll the plan into a qualified retirement plan (QRP)
If an employer establishes terminates a defined benefit plan and has another qualified plan, the excise tax is 20% compared to the standard 50% rate.
The plan is called a qualified replacement plan (QRP). The QRP may be a 401(k) plan or a Profit Sharing Plan. The excess assets could be includes as matching or profit sharing allocations.
The company can allocate 25% of the overfunded assets to the QRP, with the remaining amount taken as a reversion. But at least this reversion is taxed at the lower excise tax rate of 20% rather than 50%. The 25% asset transfer to the QRP remains a pre-tax allocation until distributed at retirement and taxed as ordinary income.
The result of this approach is that 30% of the excess assets are returned to the company (after tax). If it is a small company, the business owner may get a large allocation in the QRP.
#9 – Consider life insurance
I know that life insurance does not work well for many business owners. In fact, some owners actually detest it.
I understand. In most situations, I am not a big fan of insurance in a defined benefit plan or cash balance plan. But this is one situation where it can work well.
When a new life insurance policy is funded, a large portion of the initial funding relates to the insurance component. Since the insurance portion is an immediate expense, the plan assets get depleted immediately and overfunding can come back in line. Life insurance may also be something desired by the business owner depending on age and health.
I am not an insurance agent, but it would work sort of like this:
You buy a life insurance policy for around $1 million, which is probably about as high as you can go. This may give you a policy of around $50 million. Essentially all of the $1 million goes to premium and has no value out of the gate. So you have solved $1 million of the overfunding problem.
But the problem comes when you need to continue to fund the plan in future years. This subsequent funding will have a large portion that will go to the cash surrender value rather than immediate expense. So the overfunded pension can start to go back up. You can at some point buy the insurance out of the plan but then you will need to continue to make contributions. So the economics might not work that great overall.
But using the plan assets for insurance will not work for everyone. But it can help in situations when there is larger overfunding issues.
#10 – Plan merger or strategic sale
I have addressed this issue extensively here. The above strategies can work great for small overfunding issues. But what if a defind benefit plan or cash balance is overfunded by $1 million or more? The above solutions often won’t be enough to completely address the problem.
When it comes to substantial overfunding, we often look to a strategic sale and a plan merger. This strategy can be complex and requires qualified legal and tax professionals to guide the transaction. But in many situations, this is the best solution.
The strategy works like this: another company acquires the company that holds the pension assets. These are often large companies with significantly underfunded pensions.
The company with the underfunded pension will usually pay a 20% to 25% discount on the overfunded amount. The transaction is structured as a stock purchase and the two plans are subsequently merged. The purchase price is generally taxes as long-term capital gains to the company with the overfunded plan.
This strategy is the most complex of all, but deserves careful consideration if there is substantial overfunding. We often assist clients considering this option.
Defined benefit plans and cash balance plans are excellent retirement options. But they do come with some complexities.
Overfunded plans are a more common issue than you might think. At termination, the resulting reversion can be taxed in excess of 90%. So you should do as much planning as possible to avoid reversion.
If you have an overfunded plan make sure to reach out to us. We work with clients to solve overfunding issues. A little bit of planning can go a long way.