Government Accountability Office | Government Accountability Office | Pension Plan Terminations: Effectiveness of Excise Tax in Recovering Tax Benefits in Asset Reversions

Pension Plan Terminations: Effectiveness of Excise Tax in Recovering Tax Benefits in Asset Reversions

Published by the Government Accountability Office on 1990-07-13.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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United
states
General
Accclunring
Offlcr
GAO Wmhington. D.C. 20!348

Human Rewurces Division

July 12. 1990

The IIonorabIe .J.J. Pickle
Chairman, Subcommittee on Oversight
CommittcV on Ways and Means
IIWSC of Representatives

War Mr. Chairman:

On ,\pril 12. 1989, you asked us to evaluate the 1S-percent excise tax
levied on employers who recover excess pension assets by terminating
cr.~funded pension plans-called aset reversions. Iiexwgnizing that
normal corporate income taxation may not offset tax-subsidized gains
(fas benefits) generated through reversions. the Congress imposed a
1O-percent excise tax on reversions in 1986 and increased it to
15 percent in 1988. However, you expressed concern about the ade
quacy of the current excise tax in recovering the tax benefit portion of
reversions that arises from preferentia’ :IX treatment.

II’e agreed to estimate the excise tax rates that would offset the amount
of the tax preference for a sample of reversiorrs. In Kovemher 1989,we
issued an interim report on our preliminary estimates for a sample of
18 terminations for reversion that occurred in 1988.1In this study. we
examine the effectiveness of the excise tax rate in recovering tax bene-
fits for 55 selected asset reversions. This review expands on the results
we previously reported and reports similar findings.

To encourage savings for retirement, tax policy favors defined benefit
Background and other pension plans. A defined benefit plan promises to pay a cer-
tain benefit. based on a specified formula, to each participant at retire-
ment. Consequently, such plans prefund to assure that adequate
resources are available when participants retire.’

Although employer contributions to taxqualified plans are tax deduct-
ible, the essence of the tax preference stems from permitting investment
earnings from pension trusts to accumulate tax free. The favorable
treatment granted to the accumulated earnings in qualified pension

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Many iwsumpti(bm are used in funding wnsion plans. includingcsti-
malrs of of rWllrn on plan ass4Wand. in most cases,assumptions
riltt?i

ilblllt incrwses. Often. plan sponwr3 use conservative assumg
%llil~

tions iIb)ut investment earnings in c%timating the contributions neces-
sary to meet the plan’s prr$wcd liability. Corwrvative assumptions
about earnings increase the amount required to prefund the liahility.
\Vh~n st(H:k and bond markets rally. plans that have been generously
fundt>d according to consen’afivc rates of return can experience a dra-
math* growth in assets, A spom+)r might then tcrminatrr the plan and set
;tside money to cover a liability limited to the benefit each participant
had carncd to date. instead of the long-term liability for which it
prefunded. The excess amount or “surplus” realized can be
considerable.

One rtquirtXmt~nt for a pension plan to qualify under the Internal Rev-
enue Code is that sponsors intend to maintain the plan permanently.
Ifowevur. federal law permits sponsors to terminate their pension plans,
pay each participant only the benefits rhat have accrued up to the ter-
mination date. and keep all residual assets. Some employers voluntarily
terminate their overfunded defined benefit pension plans and use the
csccss fends for nonpension purposes. Since 1980, it is estimated that
rcvcrsions by employers in this way have amounted to over $20 billion..i
..
Among our 55 sample cases,the current 15percent excise tax was not
Results in Brief high enough to offset the tax benefit portion of pension asset reversions.
Otrr analysis assumed that the cr,mpanies in our sample paid historic
maximum statutory tax rates. We estimated that the excise tax rate
required to recapture tax benefits exceeded 15 percent in all 55 cases.
The precise escise tax rate needed to offset tax benefits varied widely.
.
-4ccording to our analysis, the excise tax rates necessary to fully offset
pension tax benefits ranged from Ii to 59 percent (see app. I).

These offsetting excise tax rates were very sensitive to variatkms in the
w-?y different types of income were tased. Plans that primarily obtained

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their investment inrrnne from sources normally subject to the maximum
hr;ttrnory tas rate. such as interest from curporatc bonds. had the
highest offsetting tax rates. Conversely, plans that mainly derived their
income from sources normally subject to the lower rapital gains tax rate,
sut-h ;ts stock prirc appreciation, had the lowest offsetting tax rates.

\\I* iris) crmducted two sensitivity analyses on the offsetting excise tax
tatrs ;Ls!!uming the current statutory tax prdsions and historic
~nriust~-wide average tax rates. The sensitivity analyses yielded similar
n-stilts.’

Ikt~d tm agreements with your representatives. this report provides
Objective, Scope, and information on the excise tax rates needed to offset tax benefits
Methodology embedded in a sample of asset reversions. In conducting our analysis,
we reviewed 55 cases from the universe of 202 pension plans with
reversions for S1 million or more that terminated or announced their
inccnt to terminate in 1988.~Using simulated investment portfolios, we
~al~\rlated an offsetting excise tax rate for each case. For the purpose of
this study. the offsetting excise tax is the rate that equated the rever-
sion’s after-tax vahie with the balance that would have existed had the
sut-plus assets been invested the same way and taxed.

+veral recent legislative proposals, in pursuit of policy objectives such
as protecting workers’ retirement income, have sought to prohibit or
restrict asset reversions, or to use the reversion excise tax to deter
revcr+nns more effectively. In this review, however, we consider only
f he excise tax rate’s effectiveness at recovering pension-related tax
benefits.

The excise tax rate required to offset or recapture pension tax benefits
depends on an employer’s income tax liabilities. which in turn are based
on marginal tax rates.” However, we did not know the actual tax rates
paid by plan sponsors. Therefore, our estimates used the maximum stat-
utory tax rate that prevailed from 1975 to 1986, when the plans in our
sample accumulated their excess pension assets.
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1. ..I fiscd US rate ~)f:1-I percent. TI!is prospective analysis usesthe cur-
rt-nt maximum statutclq taCEte in conjunction wit!* ine prt5ent tas

retlvct f!itb excisetaws
trcatmcnt {In capital gains and dividcncls. These estimates may better
necessary for plans that develop cxccss zz*bts
undw currrnt statutory tax stipulations.

2. Ilistoriv average tax rates. This approach uses estimated industry-
~vide avcrap tax rates for each year of the period we amdyzed. Average
I AS rates ;lrc lower th;in !he statutory rates because they take into
;lccount the use of tax credits and deferrals. These rates may better
rvflcct the tax position of firms and also give us a lower bound on our
cst imates.

Our review was done in accordance with generally accepted government
;ulditing standards. As requested by your office, we did not obtain
ivritrsn comments on this report. but WCdid discuss our methodolog,v
d
\vit h officials from the Pension Benefit Guaranty Corporation ( PHCC
j and
the Departments of Labor and Treasury. A morr detailed discussion of
our methodology is provided in appendix II.
I

According to our analysis, the IS-percent excise tax failed to fully
Current Excise Tax recapture tax benefits from any ass43reversions in our sample (see
Rate Not High Enough fig. I 1.Offsetting excise taxes are estimated using circumstances that
to Offset Tax Eknefits arc particular to each plan and employer. We estimated that the escise
tits rate sufficient to offset tax benefits ranged from 17 to 59 perct-nt.
~rnrmp our 5.5cases. the escise tax rate needed to recover pension tas
bcbncfits I 1) averaged about 37 percent, (2) had a median rate of 39 per-
cent. and (3) equaled or exceeded

. 20 percent in 53 cases (96 percent).
- :jO percent in 41 cases (75 percent).
l $5 percent in 34 cases (62 percent), and
l 45 pcrccnt in 15 cases (5 percent).

PIBe 4 GAO’ HRIbWlzd Taxing of Pen&on Plan Trrmlrudoiu
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Figure 1: Offrettlng Exclrc Tax Rates
AssocuNtd With Histonc Slatutory Tax
Rates

Plan Asset Allocation the incomr. As ;I result. the excise tax rates newssay to 4tffwt tas bvntr-
Influenced Offsetting fits wew very sensitive to the types of investment instnlmcnts that
Excise Tax Rates wre held in the pension trust. Plans that obtain much of their income
from WII~WSthat receive the least favorabk treatmcm tmder rhc tas
wdr rcwd to have the highest offsetting tax rates. FIR-csampk. t hc
r(~v~~sion~its~‘swith the two highest offserring cwiw tax rat<%I 55 and
39 pvr~~w rcspwti\-cly) on average reccivvd abwt 8(t pw+wnt of f hr,lt
invvstmrbnt inccbmcfrom interest-bearing vchiclvs. such :LSccqwratc
bonds. t Ililt ;1rc’wbjcct to full tasation (ivith no cwhlslon~).
. -

*’-. Ttw amrnlnt of timt. escess asets were tas-sheltered in the pension
trust. Plans that heldyxcess ;issets the longest and thercbv continued
gtncratmp tas bvnrfits t hc longest accumulated more tax benefits
t hrrmgh rc*vcrsions. Thercforc. plans that retained esc’eszs
assets longe%
~t~nerallg needed rciat+ly higher excise tas ratw to offset tax benefits.

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‘l‘ht~ asset rcvcrsirm phenomc~nctnh;rs gcncratcd considerable discussion
Cmclusion ;trntu1g t~Gcyrnakcrs and pnsion esperts. Tax policy favors defined
benefit and other pension plans to encourage employers to provide
ret n-emtInt income security for workers. The special tax treatment asso-
ciated with pension plans cause’ssignificant federal revenue losses.
\V hen re\crsions rrccur. there may be no commensurate gain in income
5ccurit)’ for workers.

So fixed-rate esclse tax will prcQs44y recapture tas benefits from all
reversions. X single-rate tax IS not responsive to the underlying vari-
abltbs that gi\.r rise to tas benefits. Two of these factors-asset alloca-
tion and rates of return-fluctuate often. Thus, no single tax rate will
recapture Al tas benefits and only tas benefits from every reversion.

A schedule of rates is likely to recover tax benefits more accurately than
a fised tas. A schedule ur “rough justice” table of excise taxes would .
take into account the factors that affect offsetting excise taxes. This
tvould require employers to select a rate that best approsimates their
particular circumstances.

Page g GAO HBD9@126 Tuing ot Pm&w~ Plam Tcmkution* .
Page 7
Abbreviations

IRS
FtKXIntwnal Revenue &nice
Pmsion knefit Guaranty C0rporation
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BLANK PAGE

Page 9
pp!‘~~\ !

>ffsetting Excise Tti Rates
‘or 55 Reversion Cases

-Oftt~t$g s_xch*rLals [percent) assuminq
Excess Hlrtonc Historic Current
assets statutory avemge statutory
(thousands) ial fates tar iates
20
tax rates

44
32
36
28
40
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25
22
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37
3t
31
27
37
24
37
13
40

29
33.
17
32
20
30
17
27
44
37
1-l
41
28

19
40

31
;3
49
38
33
25
(cant wed)
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Otfuning excise tair rate lcmcent) arwm
Excess
asrettr 8mutofy
tax
rates rvemgo5tamt
tax
Historic Histolic

$4344
(thousands)

4400 19
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mter
23
tar -f8t

4600
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41 26
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58.ooa
976 31

0607
rc:a3
12560~ 42 26
13.361
13m
12659

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4052929 577
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30

‘Less than 1 oercenl
Ppe

b~~%ive, Scope, and Methodology

The Chairman of the Stbctrmmittcu on Oversight. f Iouse Committc! oti
\Vays and Means. exprcsscd concern about whether the current excise
tas rate is sufficient to recapture the portion of asset rcvcrsions that
results from tas benefits. Xt the CkG-rnan’s request, we csamined
recent reversions to assess the effectiveness of the IS-percent excise tag
in recapturing the financial gains that resulted from the tax-free
accumulatmn of pension fund earnings.

We examined empirical financial performance data from the universe of
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pension plan reversions for %1 million dollars or more in which the plan!
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fi terminated clr announced their intention to terminate in 1988. From this
i

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universe of 202 plans. we randomly .sclected 14s reversion cases. We
rxcluded 3.5plans with fewer than 100 particiPants, because their Form
5.500 t eports did not require the level of detail needed for our study.: WC
. diminated the other plans because the Form 5500 information was not
d available. Sufficient data were available on .iFj plans to conduct this
1 . r; analysis. Our rcsufts are not representative of the universe of plans wit1
_ ahstatreversions because the study is bawd on a limited sample. Conse-
qutbntly, we did not perform tests of statistical significance.

N’e designed a simulation modet to calculate the offsetting excise tax for
individual rcvcrsion cases. For the purposes of this study, the offsetting
cscise tax rate is the rate that would have left employers no better off
financially than if the surplus assets k,ad earned the pension fund’s
pretas rate of return in a nonpe-.;ion fund. Our model generated an
alternative investment scenario that differed from the actual experienct
. t)f the Pension trust only in the imposition of tax liabilities it would haw
incurred had it paid taxes each year. For each reversion case, we calcu-
lated the balance that would have existed were the same flow of excess
. 1’ funds trcatcd as identical taxable corporate investments.

In a manner comparable to an rndividual retirement account, the tax
Income Tax treatment of pension trusts permits employers who terminate for rever-
Advantages Examined .smns to augment their after-tax rate of return. The effect of the ta?c
advantage for pension trusts on the rate of return can be separated into
. two distinct components, a compeunding effect and a tax race effed.
~-4
.

I The compounding cffcct ih the additirm to the after-tax rate of return
thatxists because the investment return camed on pension contribu-
tions is pcnnittpd to accumulate without being ended by taxes. Con-
~~rscly, the invc:,tmcnt return carncd on regular cnrporatc rcswves is
tascd clachyear. Thrrcforc, the taxvd pcn-tion can not c%xWibutc to the
rrt urn trn future mvestmrnt earnings.

2. The tax rate effect is realized when a sponsor’s tax rate at the time of
ti\tr rcvcrsicjn is IIIWW th:an its tax rate at the time the deductions for
contribution% were taken. The tax advantage from having deferred
inconw 1:~sliabilities is inversely relitted tu marg:inal tax rates. There-
f(Jrc. dwlwws in tTl;lrgl~~il~tas rates cau.seincreases in the tax advan-
tages on tax-deferred inerlme. The decrease in marginal income tax rates
from Iii tn :3-Ipercent could have added about 22 percent to the after-
tau return of each reversion case.

To compute thi> offscttmg cscise tax, our mode1cx)mpared the net value
Excise Tax Rate of asset reversion with a cr,rrcsponding value generated from the simu-
Calculated lated invt%tmc*nts.Our assessment rcquircd (1) appraising the initial
funding surplus. (21 calculatmg annual grnwth rates, and (3) simulating
tax effects.

Overfunding on a To apprarse the initial funding surplus, we computed the plan termina-
tion funding position. This is the difference between pension assets and
Termination Basis benefit liabilities-the cost to purchase annulties or provide lump sum
payments to workers and retirees covered by the pension plan. A pen-
sion plan is overfunded on a termination basis when plan assets exceed
t hesr benefit ii&Air irs.

Because the interest rates that pension plan administrators use to esti-
mate benefit liabilities can vary widely from p!an to plan, we adjusted
benefits reported on the Form 5,500 using rnterest rates used by the Pen-
sion Benefit Guaranty Corporation. Becau.sePEW’Srates are bwd on
annuity purchas.? prices, they provide a conservative estimate of plans’
funding status.’ These adjusted estimates of benefit liabilities then xvere
, compared with the plan asset data reported on the Form SSOOto deter-
mine the plans’ funding positions.
1
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*
s

I~CXUWthe tax trratment of incnmc varied depending upon its origin,
\c’(’diffcrtWatcd between varioris sour(*csrlf plan income. Our analysis
awlmcd that the sources of incume-such ifi dividends and interest
pil)‘mentS -were symmetrical berw~n the pension trust and the simu-
lilted portfolio. For example, if interest constituted 20 percent of income
from Iw’nsion trust investments during a plan year. WCassumed that 20
p~r~~~ntc,f the in\.c-tment return yaincd from the simulation also was
attributable To interest for that year.

Several pomts regarding the simlllatcd investment portfolios and rates
4 return need clarification:

I. Our rxcisc tax rate calculations arc basedon t hc actual rates of
rrturn rclalizcd by the sample of pension plans. Some pension analysts
consider the high returns that prevailed during that time wriod-19’75
tc) 198)3-an aberration. Had we substituted lower rates of return to
~encratc our calculations. the offsetting excise tax rates would have
bwn lower.

2. The portfolio management practices of a pension trust typically differ
from the investment practices of taxable investment funds. The factors
involved in prbrtfolio management decismns include the investor’s ability
to bear risk. current income needs, and tas cnnsequences. For example,
pension trusts arc primarily growth-oriented and stress long-term price
appreciation and capital preservation. In addition, due to the trusts’ tax-
‘. rscmpt status. investment managers tilt the asset mix towards the least
tax-advanta$cd assets. such as corporate bonds.

in contrast, corporate investment trusts are primarily income oriented
and stress current dividend and interest return. According&, because
earnings on corporate reserves are exposed to taxation, investors weight
the portfolio with the most tax-advantaged assets. such as real estate,
preferred stock, and municipal bonds.

Our analysis may have overstated the tax liabilities that employers
would have incurred from an alternate investment of excess pe.nsion
assets, because we assumed that they would not have altered their port-
folio strategy.

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a
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Sensitivity Analysis
P-
I-. s Future Reversions Under ~Ilttiou~h this rt*port ~WS nut spcculatf~ on future corporate tax rates,
r;lthcr than incrl&ng tax ratm, current revenuccnhanccment efforts
the Current Tas Code 1’~~s on &sing Itw~ph~~lcs. eliminating deductions. and limiting credits.
Some ptMon plans that have bccomc overfunded since 1988 may termi-
- natc for rL%V~iOnSWhile the ~rp0rate tax rate is zt its current IWet. To
give sornc pwsptrctivc on zx5s.e tax rites that would be necessary to
offset futur? rcvcrsions occurring under today’s tax environment, we
. Winiared tIffsetting tas rates by using the ~~lrrrrtt maximum statutory
tas rate of 34 ptwent and the prmenc tax treatment on corporate
, income from dividends and capital gains.

I’nder the current statutory tax rare, rarely did the 15percerlt excise
tax rate offset tax benefits-it did so in only 9 cases {see fig. II. 1). For
AI 5.5GLNX the offsctting excise tax rates averaged about 3 1 percent.
The escisc tax rate ncydcd to recover tax *benefitsequaled or exceeded

. 20 percent in 50 cases(90 percent),
l 30 prcent in 33 cases(Ml percent). and
l :35 percent in 2’r cases(40 percent).

.. Historic Average Tax Hecognizing that income tax payments vary by the availability of tax
Rates c-r-editsand deferrals. we calculated the offsetting excise tax rates using
industry-average tax rate. These rates may better reflect the actual
year-to-year historic tax position of firms in our sample. I We used esti-
mates of average corporate tax rates realized by fu-rns in industries sim-
ilar to those in our sample to approximate the annual tax position of
individual companies in our sample. These industry-wide averages are
an approximation of the effect of lower marginal taxes on firms in our
sample.

t’nder the industry-average tax rates scenario. the 15-percent excise tax
failed to offset tax benefits in the majority of our 55 cases(see fig. 11.2).
The 15~percent excise tax fully offset tax benefits in only 10 cases.The
offsetting excise tax rates averaged about 24 percent. Among the
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Figure 11.1: Ottrotting Excise Tax Rates
Associated With the Current Tar Code

90 -
m

*- 1L L
P Jo IS

0 20 puwnt in 4) cases(73 percent),
9 30 pcrccnt in 14 ca.sw(2.4 percrnt). and
l 35 pcrcrnt in 8 cases( 1.5percent).

XI1 things being equal. cstimatcd historic average income tax rates
wsultcd in lower offsetting excise tax rates than the other scenarios. On
average. using the lower tax rates reduced the offsetting es&e tax rate
;rbout 3.5 percent rclativc to the analysis that used historic statutory
ratrs.

Tax on Retained Earnings We did not incorporate the special tax assessedto corporate reserves
when they accumulate beyond specified limits-termed the accumu-
lated earnings tax. This penalty surtax is intended to discourage stock-
holders from using corporations to avoid personal tax on dividends by
retaining carrnngs in the corporation rather than distributing these

Page I6 GA01lUtDSQl26T~af Pension Plan Tenmin~tl~na
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6
1.
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Apprndlx 11
objecUvr. .Smw. and McUimdo~ogy

Figure LLP: Oftsettkg Excise Tax Rates
Associated With Average Tax Rats* so Pe#wnaolTdalcna

70
d
00

earrllngs XYdividends. In estimating offsetting excise tax rates. only reg-
ular wrporntc income taxes were assessedon our alternative invesf-
mrnt scenarick

\VP obtain4 information for this report from PRGC. the Departments of
Labor atId t hc Treasury, and private pension plan administrators.

Page If GAO/HBDBDII Taxing of Pendon Plan Temhutions
Donald C. Snyder. Assistant DirwTor I 2oP1535-8358
Human Resources iVaync D. I’pshaw, I’roject ?Janager
Division, Sheila H. Sichdson, ~~valuatnr
Washington, D.C. \‘irginia T. Douglas. iVriter-Editor
I~relei I,. Prlzcr. Typist

Office of the Chief
Economist

San Francisco t

Regional Office

Hichard 13.Smith, Evaluator
Dallas Regional Office

(105a14) Page 18
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