Pension and Benefits

Pension Surpluses: Nice to Have Except for the Potential Tax Hit

By July 28, 2022No Comments

Pension funds have recovered dramatically but the surpluses many face are a quandary.

Pension plans have not been immune to financial market turmoil this year. The funded status of the 100 largest corporate defined benefit pension plans fell by $13 billion during June, according to the Milliman 100 Pension Funding Index.

  • But stellar asset returns in the last several years—including from private equity investments—as well as rising interest rates that reduce a plan’s liabilities mean that many companies still have pension surpluses. Milliman data show the average funding ratio of large plans stood at 106.3% in June—up from 97.9% in January.

A nice problem to have. Of course, treasury teams face worse challenges than pension fund surpluses. But what to do with surpluses has become a conundrum because corporates with capital remaining when a plan terminates face steep taxes.

  • The issue arose at a recent meeting of NeuGroup for Pensions and Benefits where the director of global pensions for one company noted the difficulties in finding alternative uses for surplus capital.
  • The advantage of surpluses, said a peer, is they provide a capital buffer if, for example, actuaries make a mistake or a company needs to cover future costs related to a pension risk transfer. But what is the correct surplus level?

Alternatives to a brutal tax hit. US pension plans terminate when the last pension beneficiary dies, the director of global pensions noted. At his company, the remaining capital including any surplus would face an excise tax of 50% and a blended federal and state tax rate of 25%.

  • “So doing nothing benefits the tax collectors,” he said.
  • His team has looked to reduce the surplus by transferring pension risk to insurance companies. It has also used it to fund 401(k) matches and to enhance retirement benefits.
  • One approach was offering to reduce employee bonuses by 5% while increasing the company’s retirement plan match to 6%. It was an easy sell, given the extra 1% in employees’ pockets, he said, but those efforts “barely made a dent in the growing surplus.”
  • Roger Heine, senior executive advisor at NeuGroup, asked if a setting up a captive insurance company and transferring the pension’s liabilities, assets and surplus to the captive could reduce the tax burden.
  • The director said captives are used for that purpose in Europe, but he is unaware of a US company using that strategy. “There are consultants who claim you can do it with a US captive and even a global captive that would have multiple countries under it,” he said. “But that’s the mother of all questions.

No credit for funny money. Given the difficulty in managing surpluses, are they at least viewed favorably by credit analysts?

  • The short answer from the director was no, since analysts typically just look at assets and liabilities. The corporate may have a pension surplus overall, but some of its individual plans may still have deficits, and in most cases analysts will consider the deficits to be true liabilities because the company will need to fund them at some point.
  • “But they don’t give us any credit for the surplus, because they think it’s a kind of ‘funny money’ that the company will never get its hands on,” he said.

Secondary market sales. One member said not all of his company’s plans are frozen and so his team retains some growth assets while liquidating volatile ones, leaving the fund holding mainly illiquid private equity investments. However, liquidity needs may arise, whether to manage the surplus or other elements of the fund, and he asked if anyone had pursued selling private equity stakes in the secondary market?

  • The director noted doing so when private equity exceeded the pension plan’s asset allocation limit, and the sale took more than six months. He didn’t know the discount at which the assets were sold, and a peer chimed in that he had heard a 15% to 20% haircut is typical.
Justin Jones

Author Justin Jones

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