The Financial Advisor for Your Defined Benefit Plan. What You Should Consider.

This article has been updated for 2024.

Introduction

In a Defined Benefit Plan, a business owner is able to make high deductible contributions ($100k to $250k+). Of course, large contributions lead to a large asset pool, so it is important to select a qualified financial advisor to manage Defined Benefit Plan assets.

Defined Benefit Financial Advisor Considerations

When selecting a financial advisor, you must consider several factors. However, in this article, we focus on the additional concerns when you hire a Defined Benefit Plan advisor.

It’s important you understand your financial advisor’s Defined Benefit Plan experience, because Defined Benefit Plans have unique characteristics that may influence how assets are invested. We will explore these characteristics in more detail below.

Understanding the Nuances of Defined Benefit Plans

Managing Defined Benefit assets is more complex than other investment accounts. For example, in addition to regular investment concerns, Defined Benefit financial advisors must consider the Plan’s investment volatility, asset liquidity, and whether Plan investments are permissible and well-advised given fiduciary obligations.

Volatile Returns Create Volatile Defined Benefit Contributions

Advisors with Defined Benefit Plan experience understand that they must weigh investment return against asset volatility.

That’s because Defined Benefit Plans have annual required contributions, which are a function of asset performance. These required contributions are based not only on the value of benefits earned during the year but also on the Plan’s funded status. Because of this, investment volatility usually leads to contribution volatility, creating “contribution surprises” for the business owner. Interestingly, it’s not just poor asset returns that are a concern. Asset returns that are significantly higher than expected also may have a negative impact.

Higher Returns in Defined Benefit Plans Not Necessarily Better

In a Defined Benefit Plan, maximizing investment returns may not be the primary objective. That’s because employers face asymmetric investment risk, and this risk is increased with higher returning, more volatile asset classes.

Specifically, in a Defined Benefit Plan, an employer may only partially realize the reward of excess investment returns but is fully responsible for investment losses. Higher than expected investment returns may create excess assets at Plan termination, and excess assets are subject to both income and excise taxes. After these taxes are levied, only a fraction of the excess assets remains for the employer. Thus, the employer does not fully realize the reward of exceptional investment returns.

On the other hand, higher returning asset classes tend to have more downside risk than more conservative investments. That’s important because business owners are fully responsible for funding any Plan shortfalls. What’s more, large market declines may occur in the same year as declining business revenue. Thus, investing in higher-returning asset classes may expose the business owner to additional funding obligations at inopportune times.

In short, investing in aggressive classes in a Defined Benefit Plan may increase asymmetric investment risk for the business owner. As described, the owner only captures a portion of the reward (due to excise and income taxes levied on excess assets) while bearing the full risk (i.e., contribution “spikes” in market downturns).

Defined Benefit Plan Asset Liquidity

Your investment advisor should understand the importance of asset liquidity in the Defined Benefit Plan.

For example, in many cases, small business Defined Benefit Plans exist for only 5 – 10 years. After that, the employer terminates the Plan and pays benefits to the owner and other Plan participants. The inability to sell an investment at Plan termination often creates issues for the business owner and the Plan. As a result, the Defined Benefit financial advisor must understand the implications of using illiquid investments and have a well-defined exit strategy based on the expected Plan termination date.

Permitted Investments in the Plan

In a Defined Benefit Plan, a business owner may invest in a variety of assets. However, he or she must be aware of and comply with various regulations, including Prohibited Transaction rules. Violating these rules can result in excise taxes.

Also, if employees are covered in the Defined Benefit Plan, the owner must be guided by their fiduciary obligation. Specifically, the Plan and its assets must be for the benefit of the Plan participants, not just the owner. Taking excessive risk with Plan assets may breach that obligation and potentially lead to regulatory consequences and/or legal action.

Holistic Understanding of Your Strategy

Presumably, the Defined Benefit only contains a portion of your assets. As such, your investment advisor should understand how your Defined Benefit fits into your overall financial strategy. Business owners should consider an advisor experienced not only in Defined Benefit Plans but in creating a holistic financial roadmap.

In Summary

As you can see, hiring a financial advisor for a Defined Benefit Plan requires additional consideration. The more your advisor understands and has experience with managing Defined Benefit assets, the more likely they will help you achieve a good outcome.