Defined Benefit Plan Investments: What happens if the account goes up 100% plus?

As a result of the huge investment gains, you likely won’t be able to fund the plan for the next several years. As you are aware, defined benefit plans should be conservatively invested.

Our actuaries assume an investment return of normally 5%. So as a general rule, you should try to mimic this return. You won’t be able to exactly equal 5%, but usually somewhere between zero to 10% won’t have a significant impact on your funding.

In this post, we will discuss what your options are when you have high investment gains. Let’s dive in.

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How does it work with stock investments?

With a defined benefit plan, you can invest in almost any asset class, like real estate, stocks, etc. But you need to be very careful. The S&P 500 will earn around 11% annually on a historical basis. But there will be a lot of years where it might be up 20-30% and the next year down around the same. Because our actuary has to use a 5% interest rate each year-end, large increases in asset returns will reduce contributions and of course large losses will increase contributions.

For example, if you contributed $200,000 into a plan today and invested it in one stock and it went to zero, then you’d have to make a contribution in the following year that could be almost double what you thought it would be to make up for those losses. As long as you have the money to make the contribution that’s fine. But most people just want reasonably consistent contributions so they can take substantial tax deductions.

Impact on future contributions?

So if you earn much higher investment returns, this will reduce your future contributions. You may think this is fine. But of course contributions and investment returns work both ways.

As a result of the conservative nature of defined benefit plans, most of our clients invest in CDs, money market accounts and other conservative investments. Stocks and aggressive mutual funds should generally be limited in the defined benefit plan. Volatile and aggressive investments should always be in a defined contribution plan (401k) or an IRA. But of course we are not investment advisors and you should discuss this issue with your financial advisor.

Again, I would anticipate that you will likely not be able to fund the defined benefit plan for the next several years. But you also should review your W2 compensation to potentially increase your benefit.

We discuss this issue extensively on our webinars, so I encourage you to attend in the future. Also, here is a good video that discusses the topic: https://www.youtube.com/watch?v=CLGAe_hWlz0&t=165s

Paul Sundin

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