By: Bryan Uecker, QPA, QPFC, AIF, AIFA
Defined Benefit (DB) plans are a cornerstone of retirement planning for many employers and employees. These plans promise a specific benefit amount to participants upon retirement, making them a reliable source of income. However, maintaining a DB plan requires careful attention to funding levels, as both minimum and maximum funding requirements are heavily regulated to ensure solvency and compliance with federal laws. In this article, we’ll explore the concepts of minimum and maximum funding levels, why they matter, and how they impact plan sponsors.
Minimum Funding Levels: Ensuring Plan Solvency
What Are Minimum Funding Requirements?
Minimum funding levels are the least amount of contributions that an employer must make to a DB plan to ensure it remains solvent and capable of meeting its future obligations. These requirements are governed by the Employee Retirement Income Security Act (ERISA) and enforced by the IRS. The goal is to protect plan participants by ensuring that the plan has enough assets to pay promised benefits
How Are Minimum Contributions Calculated?
Minimum contributions are determined based on actuarial calculations that
consider:
- The present value of future benefits owed to participants.
- The plan’s current assets.
- Assumptions about factors like interest rates, employee turnover, and life expectancy.
For example, the Pension Protection Act of 2006 (PPA) requires plans to become 100% funded over time, meaning the plan’s assets must equal its liabilities. If a plan falls below this threshold, the employer must make additional contributions to close the funding gap.
Consequences Of Falling Below Minimum Funding
If a DB plan is underfunded, the employer may face:
- Excise taxes for failing to meet minimum funding requirements.
- Increased premiums to the Pension Benefit Guaranty Corporation (PBGC), which insures private-sector DB plans.
- Potential restrictions on benefit accruals or lump-sum distributions until the funding shortfall is addressed.
Maximum Funding Levels: Avoiding Overfunding
What Are Maximum Funding Limits?
While minimum funding ensures solvency, maximum funding limits prevent employers from over-contributing to a DB plan. Overfunding can lead to tax complications, as contributions to a DB plan are tax-deductible only up to certain limits. The IRS sets these limits to prevent excessive tax sheltering.
How Are Maximum Contributions Determined?
The maximum funding level is based on the actuarial value of the plan’s liabilities and the IRS-imposed limits on benefits. For 2025, the maximum annual benefit for a participant is the lesser of:
- 100% of the participant’s average compensation for their highest three consecutive years, or
- $280,000 (adjusted annually for inflation).
Employers must work closely with actuaries to ensure contributions do not exceed these limits.
What Happens If A Plan Is Overfunded?
Overfunding can create challenges for plan sponsors, especially if the plan is terminated. Excess assets in the plan may be:
- Reallocated to participants in a non-discriminatory manner, though owners may not benefit if their formula is maxed out.
- Transferred to a 401(k) plan and used as profit-sharing contributions for up to seven years.
- Reverted to the employer, but this triggers taxation as corporate income and an excise tax of 20-50%.
Balancing Minimum And Maximum Funding
Why Is Balancing Funding Levels Important?
Striking the right balance between minimum and maximum funding is critical for plan sponsors. Underfunding can jeopardize the plan’s ability to meet its obligations, while overfunding can lead to inefficiencies and tax penalties. Proper funding ensures:
- The plan remains solvent and compliant with regulations.
- Contributions are optimized for tax efficiency.
- The employer avoids unnecessary financial strain.
Strategies For Managing Funding Levels
- Regular Actuarial Reviews: Actuaries can help monitor funding levels and adjust contributions as needed.
- Liability-Driven Investing (LDI): This investment strategy matches plan assets with liabilities, reducing volatility and maintaining consistent funding levels.
- Funding Relief Measures: Legislation like the American Rescue Plan Act (ARPA) and the Infrastructure Investment and Jobs Act (IIJA) has provided funding relief by lowering minimum contribution requirements and extending interest rate smoothing provisions.
Conclusion
Defined Benefit plans require careful management of funding levels to ensure compliance with federal regulations and the long-term stability of the plan. Minimum funding levels protect participants by ensuring the plan can meet its obligations, while maximum funding limits prevent over-contributions and tax inefficiencies. By working with actuaries, leveraging modern investment strategies, and staying informed about legislative changes, plan sponsors can effectively manage their DB plans and provide valuable retirement benefits to their employees.
