When a single employer defined benefit (DB) pension plan terminates in a standard termination, plan assets are used to pay participants’ benefits as either a lump sum or with the purchase of an annuity contract with a reputable insurance company.

A few years ago, it was common to have pension plan terminations in which the plan sponsor would have to contribute cash to complete the termination because the plan was underfunded on a termination basis. In the past couple of years, with higher interest rates that reduce pension liabilities, more terminating pension plans have been in the position of potentially having excess assets leftover after all participants’ benefits are settled in the termination. This shifting environment has led to more questions about the options for such excess assets.

Considerations for plan sponsors when terminating a DB plan

1. Plan document

What can you do with excess assets in a plan termination? First, check the plan document, which should outline the general procedures in the event the plan is terminated. The plan could state, for example, that any excess assets remaining after all liabilities of the plan to its participants have been satisfied may be returned to the plan sponsor, or it could state that any excess assets will be used to increase participants’ benefits in the terminating plan. Note that an employer reversion can only occur if the plan has had a provision allowing reversions in place for at least five calendar years preceding the plan’s termination date.

2. Qualified expenses

Keep in mind any administrative, legal, and investment management fees that may be paid from plan assets before the plan termination process is complete. These fees will reduce surplus assets left after participants are paid their benefits, potentially to $0. Plan sponsors may want to consult with legal counsel to confirm which fees are eligible to be paid from plan assets as opposed to those that should be paid directly by the plan sponsor.

3. Taxation issues

It is important to note that the Internal Revenue Service (IRS) imposes a 50% excise tax on the amount of the employer reversion from a qualified plan; however, this excise tax is reduced to 20% if the employer establishes or maintains a “qualified replacement plan,” or if the plan provides pro rata benefit increases to participants in the terminating plan. Certain rules apply under either of these options in order to reduce the excise tax from 50% to 20%.

Options for excess assets from a terminated pension plan

1. Full reversion

One option when there are excess assets in a plan termination is for 100% of the excess to revert to the employer if the plan allows. In this case, the amount returned to the employer would be subject to the 50% excise tax, in addition to applicable federal and state income taxes. Administratively speaking, this is a fairly simple option, but the heavy taxation is obviously a downside for the plan sponsor.

2. Partial reversion

A second option is a partial employer reversion, where a portion of the excess assets is returned to participants and the excise tax is reduced to 20%. This can be accomplished in two different ways: 1) at least 25% of the amount of excess assets is transferred to a qualified replacement plan, or 2) at least 20% of the amount of excess assets is used to increase benefits in the terminating DB plan.

3. No reversion

A third option is that none of the surplus returns to the employer, but instead 100% of the excess is either transferred to a qualified replacement plan or used to increase benefits in the terminating DB plan. With this option, all of the excess money is used for the benefit of participants and no income or excise tax would be due from the employer with respect to these funds.

Qualified replacement plan

As mentioned earlier, there are certain rules that apply to these situations. A qualified replacement plan for this purpose means a tax-qualified plan established or maintained by the employer in connection with a qualified plan termination, where the following requirements are met:

• Participation requirement: At least 95% of the active participants in the terminated plan who remain as employees of the employer after the termination are active participants in the replacement plan.
• Asset transfer requirement: At least 25% of the maximum amount that the employer could otherwise receive as an employer reversion must be directly transferred from the terminated plan to the replacement plan.
• Allocation requirement: The amount transferred to the replacement plan must be allocated to the accounts of participants in the plan year in which the transfer occurs, or credited to a suspense account and allocated to the accounts of participants no less rapidly than ratably over a 7-year period.

The amount transferred to the replacement plan is not includible in the plan sponsor’s income, and no deduction is allowable with respect to the amount transferred. The remaining portion that the employer receives, if any, is subject to the excise tax and includible in income.

An example of a qualified replacement plan could be the employer’s defined contribution (DC) plan, such as a 401(k) plan, assuming the plan meets the requirements specified above. Private letter rulings issued by the IRS have stated that excess assets from the terminating plan cannot be used to pay for matching 401(k) contributions in the replacement plan that are earned after the date the excess assets are transferred. However, the excess assets can be used for nonelective contributions, such as a profit-sharing component. It may be worth exploring the option of using the excess assets from the DB plan for this purpose, especially if the employer was already planning to make nonelective contributions in the DC plan anyway. In this scenario, participants get the same contribution they would otherwise get in the DC plan, and the employer contribution requirements are reduced, all while lowering the excise tax. The excise tax could even be reduced to $0, if 100% of the excess assets are transferred to the replacement plan.

Note that a qualified replacement plan can be a preexisting plan of the employer’s and does not have to be a plan that is newly created at the time of the DB plan termination. In addition, the IRS has also issued private letter rulings stating that the transferred excess assets are allowed to benefit participants in the replacement plan who were not in the terminated plan, as long as the participation requirement mentioned above is satisfied. There is also some flexibility regarding how the funds can be allocated in the replacement plan, provided that the allocation meets applicable IRS rules such as being nondiscriminatory.

Benefit increases in terminating plan

If, rather than transferring to a qualified replacement plan, excess assets are to be used to increase pension benefits in the terminating DB plan, a plan amendment is typically adopted in connection with the plan termination to provide pro rata increases in the participants’ accrued benefits that take effect on the plan termination date. The aggregate present value of the benefit increases must be at least 20% of the maximum amount which the employer could otherwise receive as an employer reversion, and the benefit increases must be given to all active and in-pay participants as of the plan termination date, as well as to all vested terminated participants (or their beneficiaries) who terminated during the period beginning with the three years preceding the date of plan termination. The excise tax could be reduced to $0 under this option as well, if 100% of the surplus assets are used to increase participants’ benefits.

Additional considerations for plan sponsors during DB plan termination

Here are a few additional items to think about during the initial stages of the plan termination process, to help make the decision about where any excess assets will go:

• Check the existing plan provisions to confirm what options are available and what amendments would need to be made to the terminating DB plan (and a replacement plan, if applicable).
• Has the plan ever required mandatory employee contributions? If so, the portion of the residual assets attributable to these employee contributions must be equitably distributed to the participants who made such contributions, prior to any assets being returned to the employer. Be sure to allow additional time for the calculations and distributions needed to pay these participants a portion of the excess assets.
• Plan assets should be distributed as soon as administratively feasible in a plan termination, so steps should be taken to keep the process moving. Don’t include unnecessary delays in transferring excess assets to a replacement plan after participants’ benefits have been satisfied and other plan termination requirements have been met.
• If excess assets will be transferred to a DC plan over a number of years via a suspense account, discuss with the DC plan custodian in advance to confirm they have the capability to set up and maintain such an arrangement.
• An employer reversion that occurs in connection with a spin-off/termination transaction may be subject to increased IRS scrutiny. Discuss with legal counsel any situations involving a plan spin-off.

Plan sponsors should consult with their actuary, legal counsel, and tax experts prior to deciding what to do with potential excess assets in a pension plan termination. The conversation should take place early in the termination process so that adequate steps can be taken to prepare and the appropriate decision can be made given each plan’s unique circumstances.