PensionReforms' summary and comments
The contributions that employers make to pre-funded Defined Benefit schemes are based on a lot of guesses about the future, for example: how many employees might join; how their pay increases; who leaves when and why; how long they live after retirement.  Guesses also have to be made regarding the returns on the scheme's assets; and an appropriate rate at which to discount all these estimates back to a current value.  Inevitably, the Defined Benefit scheme's actuary will get the numbers wrong so the employer ends up contributing too much, or not enough.  Whether or not that actually turns out to be the case can only ever be discovered when the scheme stops, but not while it continues.

When a Defined Benefit scheme is discontinued or wound up, there might be more money than the scheme needs to meet the then expected benefits.  Such a 'surplus' means that the employer has contributed too much in the past.  If there is a 'deficit', it means the employer hasn't contributed enough and taxpayers, through the Pension Benefit Guarantee Corporation (PBGC), may be forced to fix the deficiency. 

In the US, the government changed the rules that gauge whether an on-going Defined Benefit scheme has enough money.  Some suggest that the Pension Protection Act of 2006 (PPA), means that pre-funding levels in Defined Benefit schemes may improve significantly. That's because the rules have tightened on the assumptions actuaries can use to amortise shortfalls in the assets of on-going schemes.  That doesn't just afford members better protection - it also potentially protects the government from future claims against the taxpayer-sponsored PBGC.

So, what happens when the scheme is wound up and the scheme discovers that it doesn't need the 'precautionary' assets the actuary had recommended or that had turned up though favourable experience?  The money should really be returned to the employer (a 'reversion') as it has demonstrably contributed too much.

The current rules say that employers must pay tax on any pension scheme reversion at the corporate tax rate.  This unwinds the deduction the employer received when the contribution was claimed as an expense.  There may also be a state tax.  However, on top of this, there is an excise tax of 50% that can reduce if the employer agrees to augment members' entitlements (there are, of course, many rules about this, including the possibility of paying surplus assets to a medical benefits plan).  Apparently, this excise tax was imposed because reversions were considered to be a bad thing and potentially open to abuse by unscrupulous employers.

Given that there is very little net benefit in reversions for employers, the report notes that "Not surprisingly, such transactions have ceased to occur."  If that was the intention of the excise tax, it can be said to have been successful.  However, employers were less likely to allow 'surpluses' to occur so the excise tax seemingly had the unintended effect of reducing pre-funding levels.

Something more than simply taxing the reversion as income could be justified because of the tax favours conferred on the accumulating assets, once in the scheme.  The 'fair' rate depends on the scheme's asset mix but a government-sponsored study suggested an average excise rate of about 19% would leave the average scheme sponsor (and taxpayers) neutral.

The report modelled three alternative propositions involving different mixes of pre-funding coverage of liabilities, excise tax rates and an increase of members' accrued entitlements.

"This analysis shows that a more moderate excise tax rate together with a reasonable funding threshold for asset reversions would not only enable sponsors to spend the excess funds on other corporate needs, thereby lowering the cost of sponsorship of defined benefit plans, but also would open a considerable revenue source for the government, with only a small increase in bankruptcy cost for the PBGC.  Plan participants could also gain in an alternative reform, which would require a partial transfer of excess assets to them along with a still-lower reversion tax rate."

PensionReforms suggests that regulators have a legitimate interest in monitoring pre-funding levels of 'accrued' benefits - those relating to membership already completed.  Taxpayers afford employers and scheme members considerable tax advantages and can therefore claim an indirect stake in outcomes (not just consumer protection).  When an employer wants to stop a Defined Benefit scheme and claim a refund of excess assets, it seems reasonable to insist that 'enough' assets be left behind in the scheme; also that both the employer and other taxpayers are left in a relatively 'neutral' position - as though the excess assets had never left the employer's hands.

That said, PensionReforms thinks that regulators should not insist that more money be left behind in the scheme than is reasonably needed; nor should the law require members' accrued benefits to be improved as the 'price' for the return of excess assets.  Finally, the rate of excise tax should not impose an artificial barrier of the kind that seemingly exists now.  The asset composition of the average Defined Benefit scheme cannot justify an excise tax of 50% and that seems the best reason to reduce it.

Otherwise, PensionReforms thinks employers will continue to exit Defined Benefit schemes and pre-funding levels will continue to fall - the unintended consequences of legislation that was seemingly intended to protect members. (File size 245 KB; 35 pp)  262

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