How do investment returns impact Defined Benefit Plan contributions? In this article, we will explore that question in depth.
At a high level, the impact of investment returns depends on several factors, including the Defined Benefit Plan’s funded status, the size of the investment deviation, and the value of Plan assets.
Additionally, investment returns impact the minimum and maximum contributions differently.
Lastly, although not related to the annual contribution requirement, investment return volatility may impact the final contribution needed to settle Defined Benefit Plan obligations at plan termination.
Before going further, we briefly need to describe how Defined Benefit contributions work. This will help explain the impact of investment returns on Plan contributions.
In general, employers must contribute to their Defined Benefit Plan each year. However, the contribution amount is not “fixed”. Rather, each year, a given Defined Benefit Plan will have a permissible contribution range. Specifically, employers must fund at least the minimum requirement but should not exceed the maximum deductible limit.
Note that the subject of this article is single-employer Defined Benefit Plans. We will not address the impact of investment returns on other types of Defined Benefit Plans, such as governmental or multiemployer (union) Plans.
As the name suggests, the minimum funding requirement is the least amount the employer may contribute to the Defined Benefit Plan without incurring excise taxes.
For Defined Benefit Plans, the minimum funding requirement equals:
Let start with an example of an underfunded Plan (the Plan liability exceeds Plan assets). For this illustration, assume the following:
In this situation, the Plan is underfunded because the liability exceeds Plan assets by $150,000 ($450,000 less $300,000).
Thus, the minimum requirement would be approximately $65,000 (the $50,000 value of expected benefit increases plus ($150,000 of underfunding divided by an estimated amortization factor of 10)).
The Plan’s actuary would adjust the requirement if the employer paid the contribution after the valuation date. The adjustment would be done using prescribed “bond” rates.
To understand how investment returns impact the Defined Benefit Plan contribution, let’s change the facts slightly. Specifically, let’s assume that Plan assets earned 10% less than the prior example.
In this situation, the Plan is underfunded because the liability exceeds Plan assets by $180,000 ($450,000 less $270,000).
Thus, the minimum requirement would be approximately $68,000 (the $50,000 value of expected benefit increases plus ($180,000 of underfunding divided by an estimated amortization factor of 10)).
In summary, a difference of 10% in investment return only changed the minimum contribution by $3,000 ($68,000 compared to $65,000). This is because the employer is able to amortize the $30,000 difference in assets by paying an additional $3,000 for 15 years rather than recognizing the difference all at once. Over the 15-year period, the employer would pay $45,000 ($3,000 times 15 years) rather than the $30,000 asset difference. This “premium” reflects an adjustment for interest (similar to a mortgage).
You may be thinking $3,000…that’s not very much! However, as we will show in the next example, the impact is larger as the Plan matures. For example, let’s assume all amounts in the previous example were 10-times higher. While that may seem like a drastic increase, it’s not. We would expect similar amounts for a 2-person business maxing out their contributions over a 10-year period.
Thus, the revised figures are as follows:
In this illustrative, mature Plan, the employer would amortize the $300,000 difference in investment returns ($3,000,000 less $2,700,000) over a 15-year period. Using an estimated amortization factor of 10, the difference in required contribution due to a 10% change in investment return would be $30,000 ($300,000 divided by 10). As expected, since we made all items 10-times higher, the contribution increase due to a 10% difference in investment returns also is 10-times the increase in the prior example ($30,000 vs $3,000).
However, that’s not the end of the story. Because of the way the math works, in some cases, there will be no difference in contributions due to investment return. In other instances, the difference will be recognized dollar-for-dollar rather than amortized over 15-years. That’s important because a $300,000 difference in the investment return, like in the previous example, could have no required contribution impact on one extreme but a $300,000 impact on the other extreme. More on that in subsequent examples.
What’s the bottom line? Given the potential volatility of contribution requirements, employers should choose competent investment advisors, ideally with Defined Benefit Plan experience, to manage Plan assets.
As mentioned, let’s illustrate next how the minimum requirement works for an overfunded Plan. Assume:
For this example, the Plan is overfunded by $35,000 because Plan assets exceed the liability by that amount. Thus, to calculate the requirement, we simply would subtract the value of the Plan’s overfunded amount from the value of benefit increases.
Specifically, we would subtract the overfunded amount of $35,000 from the value of benefit increases for the current year of $50,000. The result would be a funding requirement of $15,000. Note that there is no unfunded amortization because the Plan is overfunded.
Similar to the calculation for the underfunded Plan, the actuary would increase the contribution if the employer paid the amount after the valuation date.
The impact that investment returns have on overfunded Defined Benefit Plans is nuanced.
We will show this by illustrating three situations. First, the investment return has no impact on the required contribution. Second, the investment return has a dollar-for-dollar impact. Third, the investment return has a “combination” effect.
Let’s take the first instance: the investment returns have no impact on the Defined Benefit contribution requirement. For this example, we are assuming that Plan assets significantly exceed the sum of the Plan liability and the value of current year benefit increases.
In such an instance, the funding requirement will be zero. This makes sense because if Plan assets are sufficient to pay for both the liability accrued plus the value of benefits earned during the year, the employer should not have to make a contribution.
Let’s use a numeric example:
For this example, the Plan is overfunded by $250,000 because Plan assets exceed the liability by that amount. Thus, to calculate the requirement, we simply would subtract the value of the Plan’s overfunded amount from the value of benefit increases.
Specifically, we would subtract the overfunded amount of $250,000 from the value of benefit increases for the current year of $50,000. The result would be a funding requirement of $0 (the requirement cannot be less than zero). Note that there is no unfunded amortization because the Plan is overfunded.
Now, what would happen if Plan assets were $630,000, which is 10% lower, because of investment return? In that case, the Plan would be overfunded by only $180,000 rather than $250,000. However, the overfunded amount still exceeds the value of benefit increases, so the requirement is still zero. Thus, in this example, the investment return had no impact on the Defined Benefit contribution requirement!
In summary, if the Plan is significantly overfunded, the investment return may not have an impact on the contribution requirement. It depends on how overfunded the Plan is and the size of investment deviation. Put another way, if Plan assets exceed the liability and the value of benefits earned during the current year under either investment return scenario, the investment return will have no required contribution impact for that year. In either case, the requirement will be zero.
Next, we will address the second instance, which is investment returns have a dollar-for-dollar impact on the Defined Benefit Plan contribution. This situation occurs when the Plan assets exceed the liability but are less than or equal to the sum of the liability and value of benefit increases during the current year.
In such a situation, there is no unfunded amortization because the Plan is overfunded (Plan assets exceed the liability). However, the required contribution is not zero because the sum of the liability and value of benefits accrued during the coming year exceed Plan assets. Being in this “corridor” means that as assets change, the offset against the value of benefits accrued changes dollar-for-dollar.
Here is an example to illustrate:
For this example, the Plan is overfunded by $50,000 because Plan assets exceed the liability by that amount. Thus, to calculate the requirement, we simply would subtract the value of the Plan’s overfunded amount from the value of benefit increases.
Specifically, we would subtract the overfunded amount of $50,000 from the value of benefit increases for the current year of $50,000. The result would be a funding requirement of $0 (the overfunded amount exactly equals the value of benefit increases). Note that there is no unfunded amortization because the Plan is overfunded.
Now, assume Plan assets were $450,000, which is 10% lower than $500,000, because of investment return. If that were the case, the Plan would be neither underfunded nor overfunded. The Plan assets and liability both equal $450,000. Therefore, there would be no unfunded amortization nor would there be an offset against the value of benefit increases. The requirement simply would equal $50,000 or the value of benefit increases for the current year. So, what’s the impact of a 10% change in investment returns in this example? It would be a $50,000 increase in the funding requirement (from $0 to $50,000) due to a $50,000 change in the Plan assets. That’s a dollar-for-dollar change!
Before moving to the third overfunded instance, we want to return to an earlier point. Namely, the larger the Plan assets, the more the impact of the investment return is magnified. This is an extremely important concept, especially, in a dollar-for-dollar impact situation, as we will illustrate.
To illustrate this point, let’s assume that all the figures in the prior example were 10-times higher. Again, this situation is not unrealistic, it could occur in a Plan for only two owners. Under this assumption, as one would expect, the impact would be 10-times greater. Specifically, rather than a $50,000 increase in the contribution requirement, due to a 10% change in investment experience, there would be a $500,000 increase in the contribution requirement!
Now imagine that Plan assets experience an even greater loss. What would be the effect? Fortunately, the impact likely would be a combination of the previous examples. Namely, no impact for the first portion of the loss, a dollar-for-dollar impact for the next portion of the asset loss, and an amortized impact for the remaining portion of the loss. Let’s explore this in our final scenario.
For our last overfunded example, we will show a more dramatic decline in investment experience. This will demonstrate how the impact of investment returns on a Defined Benefit may have a “combination effect”. As just described, the investment experience may have no impact for the first part of the loss, a dollar-for-dollar impact for the next part of the loss, and, finally, an amortized impact for the remaining loss.
Assume the following:
We showed this example previously and calculated a contribution requirement of $0 (a $50,000 value of benefit increases less the overfunded amount of $250,000; since the requirement cannot be less than zero, the minimum contribution is zero).
Now, assume the employer invests the Plan assets aggressively and loses significantly. As a result, the assets are 40% lower than the original value shown above. If that occurred, Plan assets would be $420,000 rather than $700,000. Because assets are significantly lower, the Plan goes from being very overfunded to being underfunded by $30,000 ($450,000 in liability less $420,000 in Plan assets).
Since the Plan is now underfunded, to calculate the funding requirement, we would add the value of the benefit increases to the amortization of the unfunded amount. Using an estimated amortization factor of 10, the unfunded amortization would be $3,000 ($30,000 underfunding divided by 10). The required contribution would be $53,000 ($50,000 in the value of benefit increases during the year plus the $3,000 unfunded amortization payment).
So, what is the impact of the 40% loss? Surprisingly, in this instance, a loss of $280,000 in assets only increased the contribution requirement by $53,000.
Note that this illustration is a combination of the scenarios we discussed. For the first $200,000 loss (until assets reach $500,000 and equal the sum of the liability plus benefit increases), there was no impact. For the next $50,000 loss, while the Plan assets exceeded the liability but were less than the sum of the liability plus the value of benefit increases, there was a dollar-for-dollar impact. Lastly, once Plan assets were less than the liability, the employer was able to amortize the remaining $30,000 loss.
Before discussing how investment returns affect the Defined Benefit maximum contribution, let’s consider the correlation between investment experience and business income.
For many businesses, lagging investment returns will occur during or near years when business income also is lagging. That’s important because if Plan assets are volatile, you likely will need to fund the Plan more, potentially much more, in years when you may have business cash constraints. Additionally, as shown, the larger the Plan, the more impactful the investment experience.
Knowing this, how can you minimize your exposure? There are three “levers” to consider.
First, strongly consider overfunding the Plan in good years. As shown in the first overfunded example, investment losses for significantly overfunded Plans may have no impact!
Second, hire a competent investment advisor who has experience with Defined Benefit Plans. Typically, they will recommend a portfolio based on your appetite for risk, the size of your Plan, expected time to termination, and business correlation with the market. In general, the lower the volatility of Plan investments, the lower the volatility of required contributions.
Third, consider adopting and funding the Plan earlier in the year. This provides time to amend the Plan for the coming year before it’s too late. This also puts you on an earlier funding schedule, which buys you more time when needed.
Now that we’ve covered the impact of investment experience on the Defined Benefit minimum funding requirement, let’s turn to the maximum deductible amount.
As the name suggests, the maximum deductible contribution is the most the employer may contribute and deduct for a given tax year.
We calculate the maximum contribution as follow:
Note that, unlike the minimum requirement, the Plan’s actuary would not adjust the maximum amount for interest if the employer funds it after the valuation date.
So, what does the calculation mean? Essentially, the employer may fund the value of benefit increases over the coming year plus 150% of the Plan liability (reduced by Plan assets). Additionally, the employer may fund the entire amount of expected future salaries increases.
The maximum contribution generally provides a lot of room for the employer to overfund their Plan. As suggested, it’s important that employers take advantage of this during good years to minimize contribution requirements in downturns.
Before discussing how investment experience affects the Defined Benefit maximum deductible contribution, let’s run through an example.
Here is an illustration of how the maximum deductible contribution works. Let’s assume the following facts:
In this case, the employer could fund the value of benefit increases plus 150% of the liability. Thus, the maximum contribution would be $240,000 ($50,000 plus $450,000 times 150% less $485,000). For simplicity, we will ignore the impact of expected future salaries in this example.
The impact of investment returns on the maximum contribution is more straightforward than with regard to the minimum requirement. Put simply, it’s a dollar-for-dollar impact.
That’s because investment returns don’t affect the value of benefit increases or the Plan liability. Only the offsetting Plan asset changes.
For example, let’s use the facts from the prior illustration but with assets that are $100,000 lower.
In this case, the employer could fund the value of benefit increases plus 150% of the liability. Thus, the maximum contribution would be $340,000 ($50,000 plus $450,000 times 150% less $385,000). Again, for simplicity, we will ignore the impact of expected future salaries in this example.
As expected, a $100,000 decrease in Plan assets increased the maximum deductible contribution by $100,000, which is a dollar-for-dollar impact.
Before summarizing, let’s look at one other important consideration: the Plan termination.
Outside of the annual contribution range, the employer also must consider the impact of investment returns on the Defined Benefit Plan termination. This becomes increasingly important as the Plan termination date nears.
By way of context, at Plan termination, the employer must settle the Plan liability. Essentially, the employer uses Plan assets to pay out participant benefits.
If the termination liability exceeds Plan assets, with few exceptions, the employer must make the Plan whole by contributing an amount such that the Plan assets equal the liability. On the other hand, if Plan assets exceed the liability, the employer may enhance benefits such that the liability increases to the level of the Plan assets. The issue is that generally the owners already are at their benefit limits, so most or all of the surplus goes to the staff. Alternatively, the surplus may revert to the employer, but it would be subject to a significant excise tax.
Therefore, at termination, a Plan ideally, would not have a significant deficit nor a substantial surplus. A large deficit will generally require the employer to make a significant cash contribution (with no amortization), while a large surplus would essentially be forfeited.
With that as context, it’s easy to see why asset volatility within a couple of years of Plan termination could be problematic. For example, if assets drop significantly right before termination, the employer may have to make the Plan whole over a short period of time (again, no amortization). If, on the other hand, assets substantially increase such that the Plan is significantly overfunded, most of that surplus is lost.
What’s the problem with a significant asset gain that creates a large surplus (even if most of it is lost)? The issue is with risk. In such a situation, the employer has taken an asymmetric risk. That’s because they are not benefitting from the upside (most of the surplus is forfeited) but are responsible for the entire downside (fully required to fund shortfalls with no amortization).
Again, hiring a competent financial advisor and communicating to them the termination horizon is key.
In summary, Defined Benefit Plans generally require annual contributions. Additionally, the employer must contribute an amount within the permissible contribution range. As discussed, the contribution range can vary significantly based on the Plan’s asset experience.
To minimize their exposure, Plan sponsors should consider overfunding their Plan in “good years”, hiring a competent advisor with Defined Benefit Plan experience, and adopting and funding the Plan earlier in the year to provide more flexibility. Additionally, as Plan termination nears, employers should consult with their financial advisor to minimize asset volatility.