But what if a pension fund is overfunded?
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EmailA lot has been written about pension funds, particularly underfunded pension funds. However, the literature is not as robust about pension funds with too much money.
In 2017, the State of Michigan enacted Public Act 202, the Protecting Local Government Retirement and Benefits Act—enacted to increase transparency and accountability in public sector pension plans sponsored by the State’s constituent municipalities.
Public Act 202 requires plan sponsors (public sector employers, i.e., counties, cities, townships, and special districts, etc.) to report the funded status of sponsored plans and annual pension contribution amounts to the State Treasurer.[i] If a pension fund has a funded ratio—the ratio of assets set aside to pay for benefits to liabilities, i.e., the actuarial value of those benefits—below 60 percent the pension fund is declared “underfunded.” Plan sponsors with an underfunded pension plan must also submit a corrective action scheme to the “Municipal Stability Board” created under the Public Act 202.[ii]
Separate and apart from state law, the municipal bond market—in a less official sanction—may force a plan sponsor of an underfunded pension plan to pay more in interest on debt issuances.[iii]
But what if a pension fund is overfunded? A benefit of Public Act 202, other than its intended purpose to increase transparency and accountability, is that reports made to the State Treasurer have created a robust dataset. Of the 883 retirement systems that reported data, as of November 3, 2022 (based on FY 2021 and FY 2022 data), 133 were at or above 100 percent funded.
Much has been written about pension funds—particularly from the consensus view that a pension fund below 100 percent funded has too little money.[iv] Scarcely any mention of pension funds with too much money in news reports, trade, law, or academic journals. Of the 133 retirement systems that were at or above 100 percent funded, per the State Treasurer’s data, 46 were at or above 120 percent funded, and 17 were at or above 150 percent funded.
So, what is to be done with the excess assets within an overfunded pension fund? Excess assets may neither be used to pay for public services, nor transferred to another pension fund that is underfunded. Pension fund monies are contributed for the exclusive enjoyment of plan beneficiaries, and it is for the exclusive enjoyment of plan beneficiaries that those excess assets may be used: except for retiree health care benefits rather than pension income.
City of Ferndale
In FY 2020, the City of Ferndale’s Employees’ Retirement System (ERS) was 301.4 percent funded: $20 million in pension fund assets compared to $6.7 million in liabilities. ERS was closed to new entrants effective July 1, 1996, and in FY 2020 had 105 plan beneficiaries: there was little chance that plan liabilities would increase.[v]
ERS had too much money. But what could be done with those excess assets? The Police and Fire Retirement System (PFRS), the second of the City’s two defined-benefit plans, was 78.8 percent funded. Could those excess assets be shifted to PFRS?[vi] No: not under Internal Revenue Code (IRC) rules that require pension fund monies to be used for the exclusive enjoyment of plan beneficiaries. Rather, the City’s Finance Department requested City Council approval to create an IRC §401(h) account, and permission to initiate transfers from ERS to the special account.[vii]
The City sponsored retiree health care benefits (other post-employment benefits or OPEB) and had set aside $21.9 million in assets within a §115 trust already.[viii] But under IRC §401(h) and §420, the City could transfer excess pension fund assets and use those monies to cover the cost of retiree health care benefits. In FY 2021, after the City Council’s approval and advice from retained counsel on the allowability of a §401(h) account and transfers, the City appears to have initially transferred $666,797.[ix]
The City of Ferndale found a solution to an uncommon problem. So uncommon is the problem, that there is little written on a solution. The City’s decision to create a §401(h) account is a clear demonstration on the applicability of a potential solution found within the IRC, and it should be explored by other plan sponsors identified in the State Treasurer’s dataset that have overfunded pension funds.
Section 401(h) of the Internal Revenue Code
That pension fund monies must remain for the exclusive enjoyment of plan beneficiaries is a stricture from the IRC. The IRC is as important as State law to public sector pension plans, as these plans are representative of a promise to provide income to employees post-retirement.
Per §401(h) of the IRC: plan sponsors can set aside money in a subsidiary account within a pension plan to pay for retiree health care benefits. [x] Money may be contributed to a §401(h) account via (a) a direct contribution by the plan sponsor as a part of its total contribution to the pension fund (the portion attributable to the §401(h) account cannot comprise more than 25 percent of the total contribution) or (b) excess pension fund assets may be shifted into a §401(h) account under §420.[xi]
So-called §420 transfers are how the City of Ferndale shifted assets in a 401(h) account. Note, the City of Ferndale acquired specialized counsel with expertise in tax and employee benefits law to advise—§420 transfers are subject to strict conditions and limitations.[xii] If the City of Ferndale, or any other plan sponsor, attempted to set up a §401(h) account and §420 transfers without appropriate advice and counsel, it could find that it has violated the IRC and jeopardized the “qualified” status of its pension plan.[xiii]
Generally, plan sponsors cannot transfer an amount over what the plan sponsor reasonably projects to pay for retiree health care benefits, and transfers are limited to once per year. But plan sponsors can also use §420 transfers to “pre-fund” health care expenses. With a “qualified future transfer” 10 years’ worth of projected retiree health care expenses may be withdrawn from the pension fund and shifted into the §401(h) account.[xiv]
There is, to some extent, a limited opportunity for enactment. On December 29, 2022, Congress passed an omnibus bill that contained several measures that affected Internal Revenue Service-approved retirement systems and culminated into what is called the Secure Act 2.0. Of the several measures included in the federal law, one measure extended the allowability for §401(h) accounts and §420 transfers from 2025 to 2032.[xv] Will the expiration date likely be extended in the future? Yes. Still, under current law, there is limited opportunity to make use of excess assets within overfunded pension funds.
Conclusion
There are reasons that a pension fund should want to retain excess assets. Pension fund assets are invested after all.[xvi] The market goes up; the market goes down. Excess assets lessen the effect of bad returns. But excess assets, above the threshold of 120 percent, are in a sense wasted. For the fortunate few plan sponsors with overfunded pension funds, those monies may be used to reduce retiree health care costs.
[i] State Legislature, Public Act 202 of 2017, Protecting Local Government Retirement and Benefits Act, State of Michigan.
[ii] Id.
[iii] L. Killian, et. al., “The Hidden Cost of Underfunded Pensions”, The Journal of Government Financial Management, Vol. 65, No. 1, p. 20–24, 2020.
[iv] Tom Sgouros, “Funding Public Pensions: Is full funding a misguided goal?”, Haas Institute for a Fair and Inclusive Society, University of Berkeley, 2017.
[v] FY 2020 Annual Comprehensive Financial Report, Note 10 – Defined Benefit Pension Plans, City of Ferndale, 2020.
[vi] Id.
[vii] Finance Department, Request for Council Action: Internal Revenue Code: §420 Transfer of Excess Pension Assets to Retire Health Accounts and establishment of §401 (H) Retiree Medical Benefits Account Report, City of Ferndale, 2020.
[viii] Id. at v.
[ix] Finance Department, Request for Council Action: Approval to enact a 420 transfer to allocate $666,797 within the GERS Pension reserve to the 401H Fund with an effective date of 6/1/2021 for fiscal year ending 6/30/2021 and to enact a 420 Transfer of $600,000 from within the City's GERS Pension reserve to the 401H fund with an effective date of 8/4/2021 fiscal year ending 7/30/22 to pay for the applicable Medical Expenses of GERS Pensioners who receive Retiree Healthcare, City of Ferndale, 2021.
[x] Katie Bjornstad Amin, et. al., “Surplus Assets Locked in §401(h) Accounts—Is There a Key?” Tax Management Compensation Planning Journal, Vol. 45, No. 2, p. 64, 2017.
[xi] Id.
[xii] Thomas Michaud, Memorandum on Funding on Retiree Health Care Benefits prepared for the City of Ferndale, MI, VanOverbeke, Michaud, & Timmony, P.C., 2020.
[xiii] Id.
[xiv] Id. at x.
[xv] Committee on Finance, “Secure Act 2.0 of 2022,” U.S. Senate, 2022.
[xvi] Mark A. Sarney, “State and Local Pension Plans’ Equity Holdings and Returns,” Social Security
Bulletin, Vol. 63, No. 2, p. 12–16., 2000.
