Beyond Termination: Reframing Pension Surplus as Strategic Capital

As a result of the generational bull market in equities and recent relief in the form of higher interest rates, many defined benefit (DB) plan sponsors are now on the precipice of what once seemed unlikely: plan termination. For corporations with overfunded DB plans, the board and management face a pivotal strategic decision: continue to maintain the plan or pursue a formal termination. The decision impacts corporate valuation, cash flow, and long-term financial reporting. While termination is often viewed as the desired outcome, a growing cohort of sponsors may benefit more from retaining and actively managing surplus as a strategic corporate asset. The surplus is not simply excess funding to be used to pay for termination costs, but a form of restricted corporate capital that can be deployed strategically to support broader corporate objectives.

Terminating the Plan: The Road Most Travelled 

DB plan sponsors are typically not in the business of managing pension risk – plans are legacy obligations rather than strategic priorities. Most plans were closed and/or frozen many years ago to reduce risk, and plan termination likewise represents the most complete resolution of that risk. The primary benefits of termination are well documented:

• Elimination of Long-term Risk: Termination removes the plan’s liabilities and associated volatility from the balance sheet entirely. This eliminates the risk of market swings, interest rate sensitivity, and longevity risk, in addition to legislative, governance, tax, audit, etc. and all associated costs.
• Corporate Focus: Management can redirect resources previously dedicated to pension oversight and administration toward core business operations. 
• Improved Financial Metrics: Removing pension debt can improve debt-to-equity ratios and other financial metrics. 
• Strategic Surplus Reallocation: Post-termination, companies may be able utilize the remaining surplus to fund other qualified plans (such as 401(k) matching or other defined contribution obligations), reducing future corporate cash outlays for those plans. 

Once a plan reaches a surplus position sufficient to pay for termination, most sponsors opt for a hibernation strategy: aligning the asset portfolio as closely as possible to the liabilities in an effort to minimize funded status volatility until the plan can be removed from the balance sheet. It wasn’t very long ago that hibernation was considered a viable long-term end-state. Increasingly, hibernation is viewed simply as a stepping stone on the path to termination. The rationale for termination has strengthened in recent years as two structural shifts altered the cost-benefit tradeoff between hibernation and termination:

• Higher costs: PBGC fees have increased dramatically since the financial crisis. The flat-rate premium has almost doubled over the past decade, and tripled over the past two. Additionally, sponsors of plans that were more recently less than fully funded are acutely aware of how punitive the variable-rate premium can be, should the plan’s health erode from a surplus to a deficit. Further, years of elevated inflation have increased many administrative costs associated with maintaining a plan. The counterpoint to these higher cost pressures is that plans in a surplus position typically expect to achieve returns in excess of liability growth, which can help cover these expenses.
• Reduction in the premium to terminate: When interest rates were low, insurance companies required additional premia to compensate for the risk of capital losses in a rising rate environment. The risk of capital losses is more balanced in today’s rate environment, and when coupled with increased competition, the “cost” of plan termination, or the premium relative to the plan’s liabilities required for an insurance company to assume the risk, has declined significantly.

Maintaining the Plan: Surplus Changes the Equation

When a plan transitions from (net) liability to asset, the strategic lens through which it is viewed must shift accordingly. Surplus should be viewed not as excess pension funding, but as a form of restricted corporate capital that can be deployed strategically, albeit within regulatory constraints. For the right organization, pursuing a hibernation strategy or managing the plan’s surplus towards another goal may be the more optimal path, as retaining a well-funded plan on the company’s balance sheet offers several strategic advantages:

• Enhances Enterprise Value: An overfunded pension plan can function as a balance sheet asset, improving the company’s net debt metrics and enterprise value. Asset returns within a qualified plan are not subject to taxation, allowing for tax-efficient growth of balance sheet assets. 
• M&A Tool: Organizations pursuing or courting acquisitions may use an overfunded DB plan as an important tool in managing the transaction. For an acquirer, if a prospective acquisition target has an underfunded DB plan, they may be able to negotiate a purchase price adjustment in exchange for taking on the risk and deficit of the acquisition target’s pension plan. Subsequent to purchase, the plans could be merged, using the acquiring firm’s pension surplus to “fund” the acquisition’s pension deficit. On the other hand, a sponsor with a well-funded plan looking to be acquired would not be subject to any purchase price adjustments associated with a DB plan deficit, and the plan may be viewed as an attractive asset depending on the acquirer’s existing DB exposure and earnings profile.
• Earnings Tailwind & Stability: An overfunded plan can generate "Net Periodic Pension Income" rather than expense, providing a tailwind to operating earnings. Coupled with a well-designed Liability Driven Investment strategy, this can result in a relatively predictable contributor to the income statement. 
• Deferral of Loss Recognition: Plan termination results in settlement accounting, requiring actuarial losses previously accrued in Accumulated Other Comprehensive Income to be immediately recognized on the income statement in addition to other charges arising from annuitization. Maintaining an overfunded plan allows for a sponsor to amortize those losses over a multi-year period, avoiding large expense implications in any one year and reducing future settlement charges should they pursue termination at a later date. 
• Strategic Human Capital Tool: Beyond current retention, an overfunded plan provides the rare flexibility to reopen or "unfreeze" the plan to new participants. In a competitive labor market, offering a traditional pension, cash balance, or variable annuity plan could be a powerful differentiator in attracting talent in a market where pensions are increasingly rare. Additionally, assets may be used towards certain other benefits available to support a sponsor’s human capital goals, such as lump sum payments or retirement incentives.
• Optionality and Partial De-Risking: Retaining the plan is not a permanent commitment. Management maintains the optionality to terminate at a later date should internal or market conditions shift. Furthermore, companies can execute partial terminations (e.g., settling liabilities for specific groups, such as retirees or deferred vested participants). This reduces the broader risk exposure and administrative footprint while potentially leaving a higher surplus-to-liability ratio, enhancing the plan's overall health and the efficacy of future retention strategies. 

However, retaining a plan requires ongoing discipline. Sponsors remain exposed to regulatory complexity, administrative responsibilities, and the potential for surplus erosion if risks are not actively managed. The hedging portfolio should be customized and optimized for the plan’s liability profile, meeting cash flow needs while managing balance sheet volatility. An active approach can help mitigate the inherent risks associated with DB plan liabilities (e.g., default risk, inability to invest in discount curves, etc.). Likewise, the portfolio must be positioned to account for ongoing plan costs and managed to the appropriate discount curve, while at the same time positioning the surplus portfolio to achieve longer-term organizational objectives. With diligence, care, and ongoing management, a DB plan can function as a long-term strategic asset. 

Conclusion 

The decision to maintain or terminate an overfunded DB plan depends on each corporation’s financial position and strategic appetite for risk. Retaining the plan offers significant optionality, while termination provides a definitive exit for organizations prioritizing the full elimination of pension-related volatility. Regardless of the path chosen, a tailored approach to risk, both relative to the plan’s liabilities and the plan sponsor, is paramount.

As more plans reach a surplus position, plan sponsors will differentiate themselves not by how quickly they eliminate pension risk, but by how effectively they allocate it. A defined benefit plan is no longer simply a liability to be settled, it is increasingly a strategic asset to be managed.

Author

Information provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company.

This material represents an assessment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research, tax, or investment advice and is intended for educational purposes only.