What Is Overfunded Pension Plan?
An overfunded pension plan is a company retirement plan that has more assets than liabilities. In other words, there is a surplus amount of money needed to cover current and future retirements. Although accounting standards allow the company to record the surplus as net income, it cannot be paid out to corporation shareholders like other income as it is reserved for current and future retirees.
Understanding an Overfunded Pension Plan
Generally, pension plans become overfunded as a result of a stock market boom (provided the pension plan is invested in stocks, as many are), or when a defined-benefit plan is converted to a cash-balance plan. It's usually more common for a pension plan to be underfunded as investment shortfalls tend to be more common. As of January 2020, pensions were 85.7% funded for the 100 largest corporate defined benefit plans. These plans enjoyed surpluses during the dotcom bubble and the years preceding the Great Recession, but failed to benefit from the bull market of the past decade.
The funding level of a pension plan is an indication of the health of the plan and the likelihood that the company will be able to pay your retirement benefits when you retire. If the pension plan is more than 100 percent funded, it's an overfunded plan, and that's a good thing for beneficiaries. It means the company has already saved more than enough money to pay projected retirement benefits for current workers and retirees.
However, estimating the amount of money a company will need to pay its pension obligations is not a simple undertaking. An actuary creates mathematical models to try to predict how long employees and their spouses will live, future salary growth, at what age employees will retire, and the amount of money a company will earn from investing its pension savings. The resulting estimate is the amount of money the company should have in savings.
How Pension Plans Become Overfunded
Actuaries calculate the amount of contributions a company must pay into a pension, based on the benefits the participants receive or are promised and the estimated growth of the plan’s investments. These contributions are tax-deductible to the employer.
How much money the plan ends up with at the end of the year depends on the amount they paid out to participants and the investment growth that they earned on the money. As such, shifts in the market can cause a fund to be either underfunded or overfunded. It is common for defined benefit plans to become overfunded in the hundreds of thousands or even millions of dollars.
Regrettably, overfunding is of no use while in the plan (beyond the sense of security it may provide beneficiaries). An overfunded pension plan will not result in increased participant benefits and cannot be used by the business or its owners.