The Unintended Consequence of Rising Interest Rates: Overfunded Defined Benefit Plans

May 9, 2018Articles For Your Benefit

While many in the employee benefits community have sounded the death knell for defined benefit plans in recent years, there is some mounting evidence that their prediction has been premature. While corporate America has virtually abandoned defined benefit plans as a retirement benefit, these plans are alive and well among profitable, closely-held companies, particularly in the case of professional employers such as doctors and lawyers. To be sure, these plans present opportunities for larger tax deductions and, by virtue of their design, are more easily structured to favor owners and other key employees.

The larger deductions are a function of the nature of defined benefit plans -- which is to pay a fixed monthly pension to participants upon termination or retirement. It is the employer’s responsibility to deposit sufficient funds into the plan so that enough dollars will be available to pay the pensions promised to participants. As a result, fluctuations in interest rates and investment returns affect the amount of the employer’s obligation.

Notwithstanding the large deductions available under defined benefit plans, they are subject to limitations. These limitations are known as the Section 415 limitations and they restrict the level of benefits that can be paid to a single participant. Without going into the nuances of the applicable Treasury Regulations, the maximum annual pension that may be paid to a single participant is $220,000. The approximate lump sum value of this pension under currently mandated conversion rates is $2,800,000.

Therein lies the rub. Current interest have not materially risen from historic lows in more than 20 years. Given recent moves by the Federal Reserve, this appears likely to change. While there will be many “winners” and “losers” as a result of a sustained rise in interest rates, sponsors of defined benefit plans will certainly be one of the affected parties.

The question is whether rising interest rates hurt or help the sponsor of a defined benefit plan. The answer is a simple one for many sponsors of “legacy” defined benefit plans who have struggled to fund them during many years of low interest rates and lean years during the recession of the previous decade. Rising interest rates lower the lump sum value of most pension benefits, and thereby increase their level of funding. However the answer is not so simple for employers of well-funded plans that are structured to favor owners and key employees. Higher interest rates only serves to decrease the value of the pensions promised to the individuals that the plan was designed to favor.  To be sure, a rule of thumb estimate is that pension liabilities decrease by six to seven percent for every one-half percent increase in interest rates. Thus, a one percent increase in interest rates will like result in a $400,000 reduction in the maximum lump sum payable to each key employee receiving maximum permitted benefits.

As a result of the less valuable pensions for key participants, a plan that is already adequately funded will have a surplus of assets. Ostensibly, a surplus may appear to be a positive development. However, it results in lower plan deductions, as well as lower lump sum pension payments. More importantly, in certain situations the excess may be “locked up” inside the plan, because key employees are already receiving the maximum pensions permitted by law. If the excess cannot be eliminated, upon the termination of the plan, it must be returned to the employer as taxable income and, in addition, is subject to a 50% excise tax on that reversion. The net result is that 85% to 90% of the surplus could be consumed by income and excise taxes.

There is a silver lining to this cloud. Unless most of the key participants are close to retirement, excess assets can be a good thing. They serve as cushion against future investment losses, declines in interest rates and lean years in which the employer is unable to make all of the permitted or required contributions to the plan. The pension law recognizes inherent volatility of pension funding status by limiting deductible pension contributions to 150% of the current value of the plan’s liabilities, enabling an employer to establish a reserve against future reversals.

In the event that the surplus is not otherwise eliminated, there are ways that it can be monetized. In some cases, the ancillary benefits such as life insurance can consume part of an existing surplus. In cases where the defined benefit plan is terminated, the excise tax can be reduced or eliminated by rolling the surplus into a defined contribution plan. In other cases, part of the employer’s business, together with the overfunded plan, can be sold to a third parties with underfunded plans. The purchase price in the sale can be adjusted to compensate the employer for the value of the surplus.

In conclusion, employers who find themselves with an overfunded plan as a result of rising interest rates have many options available to them. However, it starts with an awareness that rising interest rates will likely create an overfunded situation. Armed with such knowledge, employers can be proactive and ready to make decisions to address any situation that arises.