What Is an 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 monthly benefits to retirees. 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.

Key Takeaways

  • An overfunded pension plan is a company retirement plan that has more than enough funds to cover current and future benefits to employees.
  • Pension funds are usually invested in financial securities, including stocks, mutual funds, and bonds.
  • Over time, pension plans can become overfunded as a result of long periods of stock market increases.

Understanding an Overfunded Pension Plan

A pension plan is a type of defined benefit plan in which employers contribute money on behalf of their employees based on a formula that considers the employee's salary and length of employment. The funds in many pensions are invested in individual securities, such as stocks, and a basket of securities, such as mutual funds. Many pension funds are also invested in bonds, which are debt instruments that typically pay interest payments during the life of the bond.

The goal is to have the pension fund grow as a result of investment gains and any interest earned from the securities. The growth in the fund's investment earnings is extremely important since the majority of the monthly benefits paid out to employees is usually from these earnings while employer contributions make up a smaller portion of the monthly benefits. Over time, pension plans can become overfunded as a result of long periods of stock market increases. As a result of an overfunded pension, there are more than enough funds to pay both current and future monthly benefits to employees.

However, it's usually more common for a pension plan to be underfunded as investment shortfalls tend to be more common. An underfunded pension is when there are not enough funds in the plan to cover current or future pension benefits.

Funding Ratio

How well a pension plan is funded is determined by calculating the plan's funding ratio. The funding ratio is the result of dividing the total assets in a plan by the amount of benefits that are due to be paid out. A pension plan that has a funding ratio of less than 100% means that it doesn't have enough funds to cover future liabilities or monthly benefits. A pension that's overfunded would have a funding ratio of more than 100%.

However, just because a funding ratio is below 100%, doesn't necessarily mean the pension is in trouble or in danger of not fulfilling its financial commitments. Typically, a pension that has a funding ratio of 80% or more is considered stable. For example, as of July 2020, pensions were 81.1% 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.

Benefits of an Overfunded Pension Plan

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 the monthly retirement benefits when employees retire. If the pension plan is more than 100% 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. A well funded or overfunded pension plan can provide peace of mind for employees that their monthly retirement benefits should be there in their golden years.

How Pension Plan Benefits Are Estimated

Estimating the amount of money a company will need to pay its pension obligations is not a simple undertaking. An actuary is a professional that uses mathematical and statistical analysis to measure risks and financial obligations for companies in the future. Actuaries create 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 saved in the pension fund.

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 was earned on the money. As such, shifts in the market can cause a fund to be either underfunded or overfunded.

In some cases, defined benefit plans can 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.