What Is an Overfunded Pension Plan?

Overfunded Pension Plans Explained in Less Than 5 Minutes

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An overfunded pension plan is a retirement plan with defined benefits that has more assets than liabilities. A plan that is overfunded is on track to meet its payment obligations with room to spare.

Learn how a pension fund can become overfunded and what it means for you.

Definition and Examples of Overfunded Pension Plans

Pension plans can receive contributions from employers and employees. The money in these plans is generally invested to help the fund grow in excess of the contributions. The fund covers plan management costs and pension payouts, and it compensates for market swings. Sometimes, a plan becomes overfunded. An overfunded pension plan has more than enough money to cover its expenses and benefit payouts, based on current projections.

  • Alternate name: Overfunded defined benefit plan

In general, pension funds are managed funds employing actuaries who use statistical and financial analysis to forecast the fund’s future value. For instance, an actuary’s analysis might conclude that a pension fund has $20 billion in future and current liabilities. They might also find that there is $21 billion in plan assets—meaning the pension fund has $1 billion more in capital than it needs after accounting for its expenses and promised pension benefits.

Generally speaking, this pension plan would then be in a financially healthier state than an underfunded one. An underfunded pension plan will need to be boosted by finding additional funding methods or developing a new strategy to ensure growth.

A pension fund is determined to be overfunded by using a simple formula that gives a ratio. This is known as the funded status ratio: the ratio of pension assets to pension liabilities. To find the ratio, divide the total assets by the total liabilities. For instance, if a pension fund with $100 million assets has liabilities forecast at $100 million, it has a funded status ratio of 100% (a ratio of 1:1).

A ratio of more than 100% indicates that the pension plan is overfunded—99% or less indicates the pension is underfunded. In the previous example of $1 billion in excess funds, the pension would have a funded status ratio of 105%.

How Does an Overfunded Pension Plan Get Overfunded?

A pension plan might not become overfunded intentionally, but it does happen. Many factors can increase the value of a fund to the point that it has too much capital. Market conditions play one of the largest roles in a pension fund’s value. For example, from March 2020 to June 2021, pension plans earned returns of more than 25% because the stock market experienced a huge rally following the COVID-19 pandemic.

Interest rates can also create increases in a fund’s value. If interest rates were to rise, the fund managers could reduce the liabilities they are assuming, which could create more growth in the fund.

In other words, the plan can project that the cost of future obligations will be discounted (brought back to present value) based on expected underlying asset returns (the investments that make up the fund’s portfolio).

Higher interest rates generally mean that a pension plan can assume a higher discount rate, or the interest rate used by actuaries to estimate the present value of future pension fund expenses.

For instance, a pension might intend to pay a plan participant $20,000 annually in future retirement benefits. Using the concept of the time value of money, they might forecast that $20,000 at the date a person is set to retire in the future is only worth $10,000 today.

This means that investment returns of $20,000 in 2021 are enough funding to cover $40,000 worth of pension benefits and expenses at the projected benefit date.

Compared to an underfunded pension, an overfunded one is generally a good thing for all stakeholders in the plan. An overfunded public pension plan, for example, may not have to end up in the middle of tough political debates that many pensions face, such as whether to increase government contributions to the pension or reduce public employee benefits.

Overfunded pension plans can matter to both those within pension systems as well as the general population. Public pension plans, such as those for public school teachers or other public workers, are intertwined with government spending.

Criticism of Overfunded Pension Plans

It’s important to note that funded statuses are not set in stone. For instance, an overfunded pension plan can quickly become underfunded if interest rates fall.

Like all retirement plans, pension funds are susceptible to stock market variations because they are built on investments. This means that a stock market decline could dip the fund’s total assets to a level lower than that of its liabilities.

It’s also possible that a pension fund might have been too optimistic about its returns—this would prevent the plan from growing enough to meet all of its future liabilities.

For example, New Jersey’s state pension system was overfunded around the turn of the 21st century. After taking steps like increasing pension benefits and reducing contributions from the state budget, the plan plummeted into a severely underfunded status. That prompted the state to inject billions in public contributions.

For reasons like this, overfunded pension fund managers don’t like to take money out of the fund by increasing benefits or decreasing contributions, even if it looks like they have more than enough to do so. The main concern with taking actions like this is that future market conditions cannot be predicted, so any changes made could have drastic effects on the plan’s future value.

Importantly, if you terminate a single-employer private pension plan, you might have to pay an excise tax if you’re the plan sponsor and there are excess assets left in the fund (called a reversion by the IRS).

Key Takeaways

  • Overfunded pension plans are retirement plans that are currently on pace to have more than enough money to pay its promised pension benefits.
  • An overfunded pension plan can easily become underfunded as conditions change, so plans need to consider what might happen if they use this surplus.
  • Employers with overfunded private pension plans can face additional taxes if there’s a plan termination while being overfunded.