After years of historically low interest rates (which results in larger lump sum pension amounts), there have been significant interest rate increases during 2022. Prospects for 2023 are for more of the same. While many employers with underfunded pension plan plans will welcome decreases in liabilities, this is bad news for many closely held family businesses with key employee-owners who are fast approaching retirement.

Many of these owners were counting on a specific lump sum payout at retirement, which they were intending to roll into an IRA. These owners will be surprised and disappointed to learn that their lump sum amounts may have decreased by 20% to 30%, depending on whether the lump sum payment occurs in 2022 or 2023.

Even worse, the drop in pension values will likely cause the retirement plan to become overfunded. As explained in this article, an overfunded plan could be a real problem because of the 50% excise tax imposed on any overfunding that is returned to the employer when the plan is terminated. In some cases, the plan pension formula can be increased the to raise the projected lump sum payout to previous levels. However, raising the formula generally requires that the pensions of all plan participants be increased proportionately and not all small business owners want to be in a position of having to provide higher benefits for their employees.

Some business owners are already receiving the maximum pension permitted by law and the amount of the pension cannot be increased. Traditional pension plans are known as defined benefit plans because the amount of each participant’s monthly benefit must be “defined” (usually by formula) in the plan. The increase in interest rates has caused the value of the equivalent lump sum amount to decrease but has no effect on those already in payment status or those who elect to receive their pension as a monthly annuity payment. Indeed, rising interest rates have decreased the cost of a commercial annuity that pay their annuitants a guaranteed monthly pension. If lump sum equivalents did not go down, a participant could conceivably take a lump sum payment and pay it over to an insurance carrier in exchange for a higher monthly pension than is called for under the plan and permitted under the pension laws.

All is not lost, however. Overfunded plans are not a new phenomenon. The 50% excise tax on overfunding has been in effect for more than 30 years. In order to avoid the excise tax (which together with income tax on the amount returned to the employer will exceed 85% of the overfunding amount), many companies will choose to roll the funds into a Qualified Replacement Plan (QRP), which is a 401(k) or profit-sharing plan. Any funds rolled over to a QRP are not subject to an excise tax and if at least 25% of the overfunding is rolled over to a QRP, the excise tax is reduced to 20%. There are certain restrictions that apply. The QRP must cover 95% of the participants in the retirement plan, and the employer has seven years to allocate the overfunding to participants.

In situations where a QRP is not practical, (such as when the business is no longer active) the business owner can engage in a financial transaction with a third party whereby the plan sponsor (or a related entity) is sold, and the potential for use of the overfunding becomes available to the buyer. In many cases, the buyer is the sponsor of an underfunded plan and is in a position to benefit from the overfunding. A sale to a third party is a complex matter that could have significant implications and it's best to seek the advice of a qualified pension attorney before proceeding.

Business owners who are in a position to take plan distributions this year should probably do so, as the full effect of interest rates hikes will not be felt until the new year. It is best to check with your pension consultant and/or actuary to determine whether the plan is overfunded before doing anything.

While the effect of interest rate hikes on many retirement plans is not a welcome development, knowledgeable business owners can take decisive steps to control any adverse consequences.

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