LDI Quarterly Update: 2Q24

In the spotlight: DB plans ponder surplus possibilities

With many corporate pension plans now overfunded, sponsors are exploring ways to monetize those excess assets. The simplest approach, plan termination, is unfortunately not a winner: Excess assets that revert to the employer are subject to a 50% excise tax, plus corporate tax. However, here are a few options for sponsors seeking to access these “stranded” assets:

Reopen the pension plan. An easy use of surplus is to give back to participants by increasing benefits. IBM made headlines in 2023 doing just that. In an act perhaps more opportunistic than paternalistic, IBM reopened its DB plan, with the accrual structured as a “swap” for a DC contribution.

Fund retiree medical benefit costs. Pension surplus may be used to pay benefit costs to a sponsor’s retiree medical plan, referred to as a Section 420 asset transfer. Traditionally, plans needed to be over 120% funded to allow the transfer, but the SECURE 2.0 Act of 2022 relaxed that funding hurdle to 110% (while adding a couple other requirements). With retiree medical plans becoming less common, this may be a viable option for only a subset of plan sponsors.

Acquire a company with an underfunded pension plan. M&A transactions should certainly not be led by a desire to unlock a pension surplus, but it doesn’t hurt to have an overfunded plan to cover the costs and the underfunding of an acquired plan.

Transfer all or a portion of the excess assets to a qualified replacement plan (QRP). During a plan termination, if at least 25% of the surplus is allocated to a QRP, the remaining surplus assets are subject to only a 20% excise tax rate rather than the standard 50% tax. A QRP can be an employer’s existing DC plan or a newly created plan. (Note, however, that IRS private letter rulings have prohibited the use of the surplus in lieu of DC elective contributions.) Various rules and restrictions around this process necessitate consultation with ERISA counsel to ensure viability.

Increase benefits to participants in the terminating plan. In this scenario, some or all of the terminating plan’s surplus is used to increase benefits on a pro-rata basis to all participants (actives, in-pay and deferred vested participants). The benefit increases must have a present value of at least 20% of the reversion amount the employer would have received had it not increased benefits.

Sponsors should review plan documents and consult with legal counsel before embarking on any of the above strategies.

A note about risk

Examples of LDI (liability-driven investing) performance included in this material are for illustrative purposes only. Liability valuations can increase due to falling interest rates or credit spreads, among other things, as the present value of future obligations increases with falling rates and falling spreads. Liabilities can also increase due to actual demographic experience differing from expected future experience assumed by the plan’s actuary. Diversification neither assures nor guarantees better absolute performance or relative performance versus a pension plan’s liabilities. In addition, investing in alternative investment products such as derivatives can increase the risk and volatility in an investment portfolio. Because investing involves risk to principal, positive results and the achievement of an investor’s goals are not guaranteed. There are no assurances that any investment strategy will be profitable on an absolute basis or relative to the pension plan’s liabilities. Information contained herein should not be construed as comprehensive investment advice. For comprehensive investment advice, please consult a financial professional.