At Emparion, we are not financial advisors. As such, we can’t tell you how to invest your defined benefit plan assets. However, we can help you understand how different asset classes will impact your annual contributions.
While you can invest in almost anything, you will see that cash balance and defined benefit plans do not like volatility. When you invest in more risky assets (like stocks), your volatility will usually increase and with that will be volatility in contribution amounts. This is usually not advantageous as most clients want steady, consistent funding amounts.
This article explains how asset returns impact your defined benefit plan. You can then determine how much risk you want to take, and which asset classes make the most sense. Let’s get started!
Some background
People ask us what they can invest their defined benefit plan assets in all the time. We tell them that you can generally invest in almost anything you want.
However, the investment gains and losses on those assets can substantially impact your plan funding. That’s why you typically want your investment profile to be rather conservative when it comes to a defined benefit plan. For this reason, it is critical that you understand these rules well and have a capable financial advisor who also understands the rules.
Overfunded defined benefit plans present many headaches for clients. As such, it is essential to understand investment returns upfront when you set a plan up.
Defined benefit plan basics
When it comes to a defined benefit plan, actuaries will project numbers out until retirement age. They come up with a defined “benefit” at retirement age based on compensation, current age, etc. In order to project this out to the future, you must use an interest rate. But you can’t use just any interest rate.
The IRS has established rates that you can use. These rates can be fixed or variable but will typically be somewhere between 2% to 6%. In most situations, your defined benefit plan will use a fixed interest rate of 4% or 5%.
The actuary uses this interest rate and the plan assets to determine contributions needed this year to achieve that benefit at retirement. The actuary makes this determination at the plan’s year end, typically December 31st.
This actuarial analysis is done each year. Contribution amounts will be updated for various assumptions but will be impacted substantially by investment returns.
While the parallel is not perfect, I sometimes compare the interest crediting rate in a defined benefit plan to a mortgage rate and a loan amortization schedule. If you’re familiar with an amortization schedule, you have a loan interest rate, and you’ll make monthly payments, which include both interest and principal payments scheduled out over the next 30 years.
Section Summary: With a defined benefit plan, the actuary will calculate a projected account balance at retirement age. They will determine a defined “benefit” at retirement based on W2 compensation, age, years of service, etc. In order to make this calculation, the actuary must use an interest rate. This rate is normally around 5%.
If investment returns exceed this interest rate, future contributions will decrease because the higher asset balance means that lower contributions are required to meet the benefit. However, if investment returns are less than the interest rate, the actuary will require higher future contributions to “catch up” and offset the lower returns.
Difference between a defined contribution plan and a defined benefit plan
It is critical to understand how investments work with defined contribution plans and defined benefit plans. Large investment swings will not impact defined contribution plan contributions, but they have a large impact on defined benefit plans.
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Once you understand why investment returns impact your plans, you can make better investment decisions. Bottom line, your most conservative investments should be in the defined benefit plan and the more aggressive and volatile assets should be in your 401(k) plan.
Investments in a defined contribution plan
A defined contribution plan is rather straightforward. The IRS establishes annual limits and, to the extent you qualify, you can make the contribution and take the deduction for that year. A 401(k) plan is the most popular type of defined contribution plan.
Once the funds are contributed into the plan, it doesn’t matter if the assets go up or down because the limits are established upfront. The investment returns have no impact on future funding.
For example, let’s say you contributed $50,000 into a 401(k) plan. If you bought the best stocks and the plan assets grew the following year to $100,000, this will not impact future plan funding. Alternatively, if you bought stocks that went to zero, it does not affect future contributions. That’s because the contribution is “defined” each year.
Investments in a defined benefit plan
However, a defined benefit plan works a little differently. There is a “benefit” that you are eligible for at retirement. The actuary is merely giving you contribution amounts each year so you will have enough funds to payout that future benefit.
Suppose the investment returns exceed the actuarial interest rate. In that case, the contributions will come down because the higher asset amount means that lower contributions are needed to reach the same benefit.
However, if actual investment returns are less than the actuarial rate, the actuary will require higher plan contributions. Said differently, if the asset returns are lower, the owner must make larger plan contributions to stay on pace to meet that defined benefit.
Is a Cash Balance or Defined Benefit Plan Right For You?
Using that same example above, if the $50,000 contribution doubled and went to $100,000, the actuary will reduce the subsequent year contribution. This is because the actuary has modeled approximately 5% returns and since you have 100% return, the contribution will be reduced to meet this future benefit.
In fact, in this example, the client might not be able to make a current year contribution at all. The asset balance might be so high that no contribution might even be allowed. If your tax planning was dependent on making a contribution and now you are unable to contribute, you might have to find an alternative tax planning strategy.
As you can see, investment gains and losses will impact future funding. That’s because the future benefit amount can be achieved through either contributions or asset returns.
Section Summary: Defined contribution plans (like a 401k) “define” the contribution each year. Assuming you qualify, you can make the contribution and take the deduction for that year. It does not matter if the investments go up or down because the contributions are defined by the IRS each year.
However, a defined benefit plan works differently. This type of plan will “define” the benefit payout at retirement. Because of this, the actuary must use an interest rate to determine the benefit. The IRS only allows certain interest rates, which will normally be around 4-5%.
Investment volatility and asset classes
I know that many people don’t like numbers. I understand this, so I will try to simplify the math.
If you’re investing in bonds or CDs, there is typically not much volatility. But if you’re looking for higher returns in most situations, this will result in much larger volatility. Volatility is not a friend of defined benefit plans.
The S&P 500 has historically earned an average annual return of around 10-12%. However, there can be years where the return might soar by 20% to 30%, followed by a decrease in the subsequent year that is similar in magnitude. Since our actuary uses a 5% interest rate at the end of each year, substantial asset changes will make annual contribution ranges more volatile.
We know that most of our clients seek consistent annual contributions to lower taxable income. That’s why we recommend they invest plan assets conservatively.
As such, we would recommend that you use a conservative investment approach. An investment allocated 100% to stocks is not recommended. If you desire more stock market exposure, please consider increasing stock allocation in IRAs, 401ks, and other defined contribution structures.
You can manage your own plan assets. However, if you are uncomfortable managing these investments, you should consider using a financial advisor who is familiar with these plans.
Section Summary: Defined benefit plans do not cap investment returns. But they do try to build a “benefit” for you at a future retirement date. Our actuary models this out using an interest rate of around 5%.
While you can invest in almost anything you want, large investment gains and losses lead to funding volatility. This can lead to large swings in the required annual contributions. If your gains exceed the 5% rate, your future contributions will trend lower. On the other hand, if your investment gains are less than 5%, it will push future contributions higher.
As a result, you want any defined benefit plan investments to be the most conservative part of your overall investments. The #1 reason these plans are established is for the large, consistent annual tax deductions. Any investment volatility will complicate the plan funding.
Self-directed plans
You can self-direct defined benefit plans. In fact, you can invest in nearly any asset class, such as real estate or stocks.
However, if you aim to achieve significantly higher investment returns, this will reduce your future contributions. While this might be acceptable to you, it’s important to know that both contributions and investment returns will impact the plan.
However, most people prefer to make consistent contributions to maximize their tax deductions. Also, realize that investing in real estate in these plans is challenging because it is tough to get a loan. The loans have to be non-recourse and asset-based. You can have them in your name or co-sign.
Final thoughts
As you can tell, you have to be much more careful with your investments in a defined benefit plan compared to a defined contribution plan. Not only can significant gains or losses result in large variations in funding amounts, these plans do not like volatility.
