Investment Return Target for a Defined Benefit Plan. What’s the Right Answer?

This article has been updated for 2024.

Defined Benefit Plan Target Return Rate

What investment return should I target in a Defined Benefit Plan? Financial advisors ask us this question quite a bit. While we cannot give investment advice, we will provide you with the information needed to arrive at your own conclusion.

Specifically, we will discuss the theory behind the target investment return in a Defined Benefit Plan, why the real-world application is difficult, and how “embedded options” available to the employer may change the nature of Plan obligation.

In the end, we hope to convey the complexity of this question and show why there is not an easy answer. In fact, after reading this, financial advisors may conclude that the target investment return should be more of a rough guidepost, not a precise target.

Note that in this article we are focusing only on small Defined Benefit Plans. Many of the concepts discussed here will not apply to mid or large-sized Plans.

Context: How Do Actuaries Value Defined Benefit Plans?

Before discussing the appropriate investment return target, we need to explain how a Defined Benefit Plan is valued.

As the name suggests, a Defined Benefit Plan provides a predefined retirement benefit. This benefit is typically a formula based on a percentage of compensation or a flat dollar amount per year of service. For small Plans, that benefit usually is elected to be paid as a single sum distribution rather than in monthly installments. Additionally, when valuing a small Plan, it is common for Defined Benefit Plan actuaries to assume payment at the Plan’s retirement age. (Rather than assigning a probability of separation from employment at each age).

Thus, with small Plans, the actuary generally has only one expected cash flow per participant. This cash flow equals the single sum value of the benefit accrued at the measurement date with an expected payout at the participant’s retirement age.

To value such a Plan, the first step is for the actuary to calculate the expected cash flow and timing for each person. Next, he or she aggregates the expected cash flows by year of payment across the entire Defined Benefit Plan. Last, the actuary uses the appropriate spot rate to discount each year’s expected cash flow to the valuation date.

Example: How to Value a Defined Benefit Plan

For example, let’s assume you have a one-participant Plan where the value of the benefit on the valuation date is equal to a $2 million lump sum payable at age 62. Because there is only one participant, the actuary likely will assume that payment occurs at the specified retirement date. Thus, he or she would discount only one expected cash flow to the valuation date.

Assuming that the participant is 60 years old at the valuation date and the prescribed discount rate is 2.50%, the liability would be $1,903,629 ($2,000,000 / 1.025 ^ (62 – 60)). (Note, that we have made some simplifying assumptions in this calculation for illustration purposes).

Context: Understanding Plan Assets and Funding Requirements

Unlike 401(k) Plans, pension rules do not permit Defined Benefit accounts for each participant. Rather, the employer funds for the expected payouts of all Plan participants using a pooled account. Thus, the actuary calculates a total Plan liability, reflects existing Plan assets, then determines the amount needed to fund the obligation.

For example, if Plan assets exceed the Plan liability, then the Plan has a surplus. If that surplus is large, the employer may not need to contribute to the Plan that year. However, the employer may decide to make a discretionary contribution as a part of their funding strategy or to receive a tax deduction.

On the other hand, if the Plan liability is greater than Plan assets, then the Plan has a shortfall. When the Plan has a deficit, the employer generally will have a funding requirement. The actuary calculates this requirement by amortizing the Plan’s shortfall and reflecting the value of expected benefit increases in the current year.

Theory Behind the Defined Benefit Plan Investment Return Target

With that context behind us, let’s discuss the theory behind the investment return target for a Defined Benefit Plan.

Essentially, the theory says that if Plan assets equal the Plan liability and if they both increase at the same rate, then the Plan assets and liability will continue to be equal and the Plan will be fully funded. This, in turn, should reduce volatility in the Plan’s funding requirement and/or payout at termination.

For example, drawing from our prior illustration, assume Plan assets equal the Plan liability of $1,903,629 at the measurement date. Further, assume that for the next two years, until the participant retires, Plan assets exactly earn the liability discount rate of 2.50%. Last, assume that there is no change to the liability discount rate.

What would be the result? In such a case, Plan assets and liabilities would both increase at a rate of 2.50%. After one year, they both would equal $1,951,220 ($1,903,629 x 1.025). After two years, at the participant’s assumed retirement age, both the Plan assets and liability would equal $2 million. ($1,951,220 x 1.025). Thus, at Plan termination, there would be no additional funding required. Plan assets exactly equal the retirement benefit.

That’s the theory behind the investment return target for a Defined Benefit Plan. Of course, as we’ll show later, it’s not quite that simple.

Accruals and the Defined Benefit Plan Investment Return Target

Let’s add one more wrinkle. We need to reflect that Defined Benefits generally grow with each year of additional service. For this simple example, assume that the single sum value of retirement benefit increases by $200,000 for each additional year of service. Thus, after the first year, the $2.0 million payment increases to $2.2 million. After the second year (the date of retirement), the payout increases to $2.4 million.

How does the theory work when we reflect benefit accruals? Assuming, as we did previously, that both Plan assets and liabilities are $1,903,629 at the valuation date, the employer simply would fund the $200,000 benefit accruals, adjusted for the discount rate. The result would be that Plan assets would exactly equal the $2.4 million payment in two years.

Specifically, at the end of the first year, the employer would fund $195,122, which is $200,000 adjusted for one year of interest at 2.50% ($200,000 / 1.025). At the end of the second year, which is the time of payout, the employer would fund exactly $200,000. (The employer would not adjust the last contribution for interest, because the date of deposit is the same date the Plan pays the participant).

Assuming both Plan assets and the liability increase at 2.50% per year, Plan assets will equal the $2.4 million needed to pay the participant at retirement. ($1,903,629 x 1.025 ^ 2 + $195,122 x 1.025 + $200,000 = $2,400,000).

Again, that’s the theory behind the investment return target for a Defined Benefit Plan. If Plan assets grow at the same rate as the liability discount rate and the employer deposits the value of benefit accruals, then the Plan has the exact amount needed to pay out retirement benefits.

The Investment Return Target for a Defined Benefit Plan Is Complicated

Before going into detail, let’s list at a high level why the real-world application of an investment return target for a Defined Benefit Plan is much more complicated than the described theory:

• It may be difficult to decide what the employer is hedging (e.g., required funding or the termination liability). Should the liability reflect vesting?
• Fixed income instruments may not be available to hedge the liability. For example, the required funding liability is smoothed but investments are marked-to-market. It may be difficult to match the Plan’s duration.
• Investment fees reduce Plan asset returns but not the Plan liability.
• For advisors to achieve the investment “target rate”, they may need to take equity risk; however, equity and business risk may be correlated, compounding employer exposure.
• The impact on the employer of target investment rate deviations varies significantly depending on the Plan’s funded status and size.
• It is difficult to incorporate the “exercise” of “embedded options” available to the employer (e.g., amending the Plan, reducing discretionary retirement contributions to fund required amounts, the ability to forgo owner benefits, manipulating salary to affect funding requirements, employing credit balances to reduce minimum funding).

As you can see, defining and calculating the investment return target for a Defined Benefit Plan is complex. Let’s discuss each of these items in more detail.

Which Liability Is the Employer Hedging?

To summarize, the theory behind the investment return target is that if Plan assets and the liability are equal and grow at the same rate, the advisor will dampen volatility in both the funding requirement and the amount required at Plan termination.

Simple enough, right? Not quite. Up until now, we have assumed that the liabilities for required funding and Plan termination are the same. However, actually, they are very different. Clearly, the advisor cannot hedge two targets at once. This leaves the employer a choice: “Which liability should I hedge?”.

For an advisor to know which liability to hedge and how to hedge it, we will explain the two liabilities in more detail. However, before doing that, let’s provide some additional context.

Context: Minimum Funding Requirements

To ensure the employer adequately funds future defined retirement benefits, pension rules generally require annual contributions.

This minimum contribution requirement is a function of both benefit increases during the year and the Plan’s funded status. That’s important to understand, because if the employer contributes the value of benefit increases and Plan assets grow at the same rate as the liabilities, then the annual funding requirements should be stable.

But what rate does the actuary use to discount expected cash flows for minimum funding? Actually, the IRS publishes three rates: a short-term, a mid-term, and a long-term rate. For cash flows expected to occur in the next 5 years, the actuary uses the short-term rate. For cash flows expected to occur after 5 years but within 20 years, the actuary discounts the cash flow at the mid-term rate. And, for cash flows expected to occur more than 20 years from the valuation date, the long-term rate is used.

Each of these three rates is based on high-quality bond yields (A, AA, and AAA-rated bonds) and reflect smoothing. Specifically, the IRS smooths each of these three rates using 24-months of bond yield data for the appropriate, corresponding maturities. Additionally, for each of the three rates, the IRS applies a 25-year average interest rate “overlay”, as well as a fixed-rate floor, to artificially increase rates (and decrease contributions) for minimum funding.

The Minimum Funding Target Interest Rate for Defined Benefits

Now that we’ve explained how required contributions and their corresponding discount rates are calculated, let’s further discuss the hedging of this liability.

First, you may be asking what are the current discount rates for minimum funding. For 2024, the IRS has published the short, mid, and long-term rates of 4.75%, 4.87%, and 5.59%, respectively.

It’s important to note, as mentioned earlier, that these rates are smoothed and artificially adjusted to reflect historical yields, as well as have a fixed-rate floor. As a result, they may not reflect the current yields of high-quality bonds.

The fact that minimum funding rates differ from current yields poses an issue. As you can imagine, it is difficult for an investment manager to hedge smoothed rates. He or she cannot simply hedge the liability using currently available high-quality bonds. Rather, for Plan assets to grow at the same rate as the liability, the advisor may need to use return-generating assets, such as equities, to keep pace with liability growth. The issue is that these investments also tend to be more volatile, creating fluctuations in the Plan’s annual funded requirement.

Does It Make Sense to Hedge the Minimum Required Liability?

Now that we’ve explored how the Plan actuary calculates the minimum required liability, we need to ask the question: does it even make sense to hedge this liability?

For small Plans, probably not. In our experience, small employers prefer to maximize, not minimize, their annual contributions. Of course, there may be exceptions during periods of economic challenges, but, in general, the employer is not simply contributing the minimum amount each year.

This fact is important for two reasons. First, by the employer funding more than the required amount, the Plan likely has a surplus to absorb market fluctuations and dampen the year-to-year volatility of minimum funding. Second, if the employer is not focused on minimum funding, should the investment manager hedge the underlying liability?

Again, for most small Plans, it probably does not make sense to hedge the liability associated with minimum funding requirements. Instead, the termination liability, which we will discuss next, may be a better target. What’s more, by funding to and hedging the termination liability, we would expect the required contribution to be at least partially hedged.

Hedging the Plan Termination Liability

As mentioned, because many small employers overfund their Defined Benefit Plans, their required contribution will tend to be manageable and relatively stable. On the other hand, the Plan termination liability generally will be higher than the liability for required funding liability and fluctuate more from year to year.

Thus, we believe that for most small employers hedging the termination liability may be more appropriate than hedging the liability for required funding.

But what is the target investment rate for a Defined Benefit Plan when hedging the Plan termination liability? The answer, it turns out, is somewhat complex and depends on the type of Defined Benefit, the Plan’s actuarial equivalence rate, and whether the value of the benefit exceeds the maximum payout limit. Let’s discuss each of these factors in this next section.

How the Plan Termination Liability Increases

What is the target investment rate for a Defined Benefit Plan when hedging the Plan’s termination liability? It depends:

• If the value of the benefit exceeds the lump sum payout limit, then the termination liability will increase by just over 5%. However, if the Plan’s actuarial equivalence exceeds 5%, then the liabilities will increase roughly at that rate, all else being equal.
• If the Plan is a traditional Defined Benefit Plan (but the value does not exceed the lump sum payout limit), then the termination liability generally will increase somewhere around the long-term discount rate for calculating lump sum payouts under IRC 417(e). For 2024, this rate is about 5.40% assuming a five-month lookback and a one-year stability period for a calendar year Plan. Note that at some ages when the retirement horizon changes from long-term to mid-term or from mid-term to short-term, there may be a “spike” in the liability rate of increase. Additionally, if the Plan’s actuarial equivalence rate is lower than current rates, the liability will increase at that rate.
• If the Plan is a Cash Balance Plan (but the balance does not exceed the lump sum payout limit), then the termination liability will increase at the interest crediting rate defined by the Plan.

In summary, in the current environment, you may decide that an investment rate target of 4% to 6% is reasonable when hedging the termination liability. Note that some Cash Balance Plans credit interest rates using an index (e.g., Treasury bonds) or the actual return on Plan assets and may not fall within this range.

Should Vesting Be Reflected in the Target Liability?

Before moving on from the appropriate liability to hedge, we need to discuss one other topic. Namely, whether the asset manager should hedge the vested or accrued liability.

In a Defined Benefit Plan, vesting refers to the amount of benefit available to the employee when he or she separates from service. For example, in a Cash Balance Plan, an employer may require employees to work at least 1,000 hours for three years to be fully vested. If they leave before that time, they may forfeit their entire accrued benefit. Additionally, when counting the three years, the employer may exclude employment before the Plan started.

Thus, for many Plans there likely will be a portion of the termination liability that will never be vested. A portion of that liability will, in fact, be forfeited. Hence the question, should the asset manager hedge the vested liability or the total liability (vested and non-vested)?

For small Plans, we generally believe it’s more appropriate to hedge the full termination liability, whether vested or not. That’s because, in most cases, the liability will be heavily concentrated towards the owners/partners of the employer who likely will become fully vested even if they aren’t initially. This is even true should an unexpected event occur, such as the death or disability of an owner/partner, because Defined Benefit Plan TPAs typically write their Plans to fully vest benefits upon death/disability.

Where We Go from Here

To summarize the article thus far, we’ve discussed how actuaries value Defined Benefit Plans, the theory behind an investment return benchmark, some of the issues in application, and the appropriate liability to hedge.

In the next portion of the article, we will discuss in more detail the real-world issues associated with hedging the Plan liability. We will start by discussing investment-related issues. Next, we will explain how deviations from the benchmark become more impactful as the Plan becomes larger and/or is closer to the termination. Last, we will discuss how various options available to the employer may materially change the Plan liability.

Investment-Related Issues

As mentioned, even after the investment manager decides which liability to hedge, the execution of the hedging strategy is difficult.

First, the investment manager may find it challenging to create an asset portfolio that keeps pace with the Plan’s liability while hedging changes in interest rates. Second, investment management fees will decrease Plan assets, but the liability is not reduced for fees. This may create an asset/liability mismatch. Last, the investment manager may need to take equity risk to keep pace with liability growth, but market and business risk may be correlated, compounding the risk to the employer.

We will address each of these topics in turn, starting with an introduction to the concept of duration, why it’s important for Defined Benefit Plans, and why it may be difficult for an investment manager to create a portfolio that coordinates with the liability when interest rates change, where applicable.

What Is Duration?

Before explaining why it may be difficult for an investment manager to match the duration of the liability in a small Plan, we first need to define duration.

Duration is a weighted average of the times when the Plan’s cash flows are expected to be paid. For example, using our prior illustration, if the Plan is only expected to pay out one cash flow in two years, the weighted average of the times the cash flows are expected to be paid is 2 years. That’s easy because there is only one cash flow to be paid and that’s in two years! If the Plan had several cash flows expected to occur at different times, we would need to take the weighted average of the timing of several cash flows.

Duration Measures How Liabilities React to Changes in Discount Rates

Duration is an important concept because it also measures how changes in discount rates are expected to change the Plan’s liability. Specifically, if the duration of the liability were 2 years, then we would expect a 2% change in the liability for every 1% change in the discount rate. Let’s illustrate this by running through the figures in our prior example.

Assume that the Plan is expected to pay out a $2 million lump sum in two years. If the discount rate were 2.50%, then the present value would be $1,903,629 ($2,000,000 / 1.025 ^ -2). Again, because there is only one expected cash flow, and it is assumed to be paid in two years, we expect a duration of 2 years. This means that the liability should change by 2% for every 1% change in the discount rate.

Let’s test this. For example, rather than using a discount rate of 2.50%, assume the discount rate was 3.50%. Using this discount rate, the present value would be $1,867,021 ($2,000,000 / 1.035 ^ -2).

As expected, the change in the liability would be 1.92% or roughly 2% ((1,867,021 – $1,903,629) / $1,903,629). Note that, for simplicity, we are using the Macaulay duration. Other measures of duration may better approximate the change in liability.

Why Is Duration Important for Defined Benefit Plans?

Why is duration important? Remember, the theory of having an investment return target in a Defined Benefit Plan is that if Plan assets equal the Plan liability and increase at the same rate, then the Plan remains fully funded. We demonstrated this using a simple example and assumed that the discount rate of 2.50% was constant over a 2-year period.

However, in reality, discount rates don’t stay constant. They fluctuate, and when they change, so may the value of the Plan’s obligation. What’s more, if Plan assets don’t change at the same rate, then the funded status of the Plan will be impacted. On the other hand, for interest-sensitive obligations, if the duration of the fixed income portfolio equals the duration of the Plan’s liability, then Plan assets and the liability move together as interest rates change, preserving the funded status of the Plan.

Note that the concept of duration only is important for hedging the required contribution liability (which, as discussed, may not make sense) and for hedging the termination liability for traditional Defined Benefit plans that are not at the maximum lump sum limit.

On the other hand, the termination liability is not interest-rate sensitive for all fixed-interest rate Cash Balance Plans and traditional or Cash Balance Plans at the maximum lump sum payout.

Thus, although we have spent some time on duration, because it applies in some cases, its application for small Defined Benefit Plans may be somewhat limited.

Why Hedging the Plan’s Liability May Be Difficult

Before proceeding with this section, we want to make it clear that we are not investment managers. Our expertise is in calculating Defined Benefit Plan liabilities, not in selecting investments.

However, based on our understanding, it seems difficult for managers to hedge the liability of small Plans. Here is a list of potential reasons why:

• If the business owner is funding to the maximum benefit payout, the termination liability will increase at roughly 5% per year. This may be higher than current high-quality bond yields. Thus, a portfolio containing only fixed-income investments may not keep pace with the growth of the liability. As a result, the advisor likely will take equity risk, introducing volatility into the funded status. The risk of this volatility increases with the Plan size and the horizon to Plan termination. Additionally, equity losses may occur when the employer’s business income has dropped, potentially creating large contributions when the employer is short on cash.
• As the business owner approaches retirement (and Plan termination), the duration becomes increasingly short but the rate at which liabilities grow may be higher than short-term bond yields. Thus, to immunize the Plan’s funded status against changes in interest rates, the portfolio’s duration should be short, but the yield for these short-term bonds may be too low to keep pace with the growth of the Plan liability. Having a surplus may help with this, but there are risks associated with having a surplus as well (see the section below “Risk Changes with the Plan’s Funded Status”).
• Because small Plans tend to allocate most of the benefits to business owners, who are more likely to stay until Plan termination, the Plan’s duration may decrease each year by roughly one year. It may be difficult to find diversified investments that decrease at the same rate.

Now that we’ve explained why hedging the Plan’s liability may be difficult, let’s discuss the issue of management fees.

Making Up Investment Management Fees

As mentioned, investment management fees create another issue with regards to asset/liability management. More specifically, management fees reduce Plan assets but not the Plan liability. This creates a mismatch between the growth of Plan assets and the liability.

Thus, even if the manager invests in assets with the same “return”, and if applicable, the same duration, as the Plan liability, the assets still will not keep pace with the liability because they are reduced by management fees.

To “make up” for management fees, so that the Plan’s funded status is hedged, the advisor will need to earn alpha equal to their management fees. However, it may be difficult to earn alpha of 1.00% to 1.25%, which is a typical management fee, on a portfolio that is heavily invested in fixed-income.

Thus, to achieve a higher expected return, the advisor may take additional portfolio risk by investing in return-generating assets. The downside is that these asset classes tend to be more volatile, potentially creating additional asset/liability mismatch.

Another option to close the asset/liability gap created by management fees is for the employer to simply deposit additional Plan contributions to pay the management costs. Of course, the advisor and employer could use all these options in combination to offset the cost of management fees.

After reading this section, you may think we encourage employers to invest their own Plan assets. Quite the contrary! We believe competent investment managers are integral to managing Defined Benefit assets. We simply are stating that investment management fees add another layer of complexity when targeting a return equal to the liability.

Market and Business Risk Are Likely Correlated

Before proceeding, Let’s pull together the concepts we’ve discussed.

First, for small Plans, liabilities may increase at a higher rate than current bond yields. Second, given the nature and limitations of small Plans, matching a Plan’s duration to immunize against interest rate changes may be difficult. Third, investment management fees reduce Plan assets, but the Plan liability is unaffected, further making liability hedging difficult.

What conclusion can we draw from these three concepts? Essentially, for Plan assets to keep up with the growth in the Plan liability, it seems that either the Plan will need to invest a portion in “riskier” assets or the employer will need to make additional contributions to fund the shortfall between the liability and asset growth.

However, as you know, investing in “riskier’ assets may present other issues. Most notably, for many small businesses, market risk and business risk are correlated. Put another way, when the stock market declines, business income, and hence the employer’s ability to fund asset losses, also will be diminished. Thus, when the employer may be required to fund large contributions, he or she likely will have difficulty doing so.

So, what’s the solution then? Financial advisors will need to determine, for a given client, the appropriate balance between lowering contributions (by taking more investment risk) and minimizing the volatility of the annual funding requirement and/or the contribution required at Plan termination.

Risk Changes with the Plan’s Funded Status

As advisors discuss balancing the risk of asset volatility with the cost of funding the Plan, it may not be apparent that the level of risk varies depending on the Plan’s funded status.

For example, if the Plan is very well-funded, asset losses may not impact minimum funding requirements at all. The requirement may be zero whether the assets increase or moderately decrease. However, and perhaps not intuitively, if the Plan is slightly overfunded, investment losses may have a dollar-for-dollar impact on minimum funding. We have discussed this concept thoroughly in a previous article.

However, a significant surplus may not be the answer. In fact, having too much money in the Plan can be a significant, albeit a different type of, risk. In this case, the risk isn’t funding volatility, but of “forfeiting” surplus assets at Plan termination. With some exceptions, excess assets are subject to significant excise taxes, which may essentially “wipe out” most of the Plan’s surplus. This is especially true if the owner(s) already are funding to the maximum payout, such that an amendment at termination to increase benefits and “use up” Plan assets is not possible.

Thus, the investment manager has the difficult task of balancing a number of items. On one hand, he or she must both minimize potential spikes in funding requirements and manage the relationship between Plan assets and the termination liability. At the same time, for Plan assets to keep pace with liabilities, it seems that a portion of the portfolio must be invested in return-generating investments, likely introducing volatility into the metrics the advisor was managing (i.e., the funding requirements and the management of the termination liability). Additionally, should the manager think that an asset surplus is the solution, having a small surplus may create additional funding volatility, as stated above, while having a large surplus may result in the “forfeiture” of excess assets at termination.

Impact Depends on Plan Size

In addition to the funded status impacting Plan and employer risk, the size of the Plan also influences the risk level to which the employer is exposed.

It’s obvious, for instance, that the dollar impact of investment losses is commensurate with the size of the Plan. For example, if Plan A has $5,000,000 in assets but Plan B only has $500,000 in assets, an investment loss of say 20% will be 10-times greater in Plan A than in Plan B, simply because assets are 10-times greater. This also means that the employer sponsoring Plan A may have to fund 10-times more in losses than the employer sponsoring Plan B.

What may not be obvious is that the horizon to Plan termination often is correlated with Plan size. That’s because most small Plans often only exist for 5 to 10 years. At inception, there are no assets, but the employer makes large contributions each year until they reach their maximum limit and terminate the Plan.

Thus, the Plan size increases as the horizon to Plan termination shortens. That’s significant because the larger the Plan, the larger the expected dollar impact, but the shorter the time that the employer has for Plan assets to “self-correct” or to make up losses via cash contributions. In fact, a large investment loss close to the time of Plan termination may create an employer hardship, because they may need to fund a significant amount in a short period of time.

Interestingly, strong asset returns when the horizon to Plan termination is short also may create issues, because, as mentioned, excess assets could be “forfeited” via excise tax.

Thus, the investment advisor must understand how Plan size affects the employer’s risk, and how it is correlated with the horizon to Plan termination. The advisor may conclude that more investment risk can be taken when the Plan is small and/or the horizon to termination is longer and less risk should be taken as the size of the Plan increases and/or the horizon to termination is shorter.

The Exercise of Employer Options

In the previous sections, we discussed hedging the Plan liability, including some of the challenges faced by the investment manager. We also explained how the risk of deviations from the benchmark varies based on the Plan’s funded status, size and time until Plan termination.

In the next portion of this article, we will explain how various options available to the employer may change the nature of the Plan liability and/or the ability of the employer to fund the Plan. These options are important because they are difficult for advisors to incorporate their impact when building the Plan’s portfolio but are potential “game changers” when exercised by the employer.

Specifically, we will discuss the options to amend the Plan, redirect discretionary retirement dollars to the Defined Benefit Plan, forgo owner benefits, use owner salaries to influence the Plan liability, and apply credit balances against contribution requirements.

Plan Amendments

The first option that an employer may exercise to change the nature of Plan obligations is to amend the Defined Benefit Plan. This is done by drafting and signing a formal change to the Plan document.

An amendment to the Plan may increase or decrease benefits, with some restrictions, which we will cover.

The first type of amendment we will explain is an amendment to increase the Plan’s liability. This could be done, for example, by increasing owner benefits or employing a spouse so that they are a participant in the Plan. This option may be exercised, for instance, to allocate a surplus that exists at Plan termination to the owners or the owners’ spouses. Of course, if there are non-owner employees, the amendment will need to satisfy nondiscrimination testing. Additionally, if the owner already is at their maximum payout limit, they will not be able to increase their benefit.

The second type of amendment we’ll describe is an amendment to decrease benefits. Note, however, that with this type of amendment, the employer only is able to decrease benefits on a prospective basis. Benefits already earned in the past generally cannot be cutback. Because benefits already accrued cannot be reduced, this type of amendment does not impact the current Plan liability like an amendment to increase benefits might. However, it will reduce future contribution requirements, which, in turn, will free up employer dollars that would have been used to pay for future benefit accruals to close any funding gap.

Using Discretionary Buckets

The second option available to employers is to redirect discretionary retirement dollars to fund the Defined Benefit Plan instead. This doesn’t change the Plan’s liability, but it does increase the employer’s capacity to fund the obligation.

For example, it is common for employers with Defined Benefit Plans to also sponsor a Defined Contribution Plan, like a 401(k) or Profit Sharing Plan. In general, Defined Contribution Plans do not require employer contributions like Defined Benefit Plans. Funding Defined Contribution Plans usually is discretionary.

Thus, should the employer need access to additional funds to contribute to the Defined Benefit Plan, such as to meet a required contribution “spike”, the employer may be able to stop contributing to the Defined Contribution Plan, freeing up funds to close a Defined Benefit Plan gap.

Ability to Forgo Benefits

A third option an employer may exercise is for majority owners to forgo all or a portion of their benefit.

This option typically would be exercised if, at Plan termination, Plan assets were insufficient to pay benefits and the majority owners did not want to fund the shortfall. If that were the case, majority owners could reduce the Plan liability, by forgoing all or a portion of their benefit, such that Plan assets are sufficient to benefits at Plan termination.

Although they would forgo a portion of their benefit, majority owners may prefer this option to funding the Plan shortfall.

Salary May Be a Lever

Additionally, for corporations or entities taxed as corporations, the owner may use the option of setting his or her salary to impact the required contribution or the Plan termination payout. This option could be exercised as a way to either increase the current liability or decrease the accrual of future liability.

In general, as long as the owner is not at the maximum payout limit or at the compensation limit, he or she could create an immediate impact to the Plan liability by increasing salary. This may be useful if the employer would like to decrease taxable income by making a larger contribution or defer additional dollars into an IRA at Plan termination.

Using the salary to decrease future benefit accruals and contributions, as a way to change the Plan’s funding requirement, works best if the Plan formula uses a Cash Balance pay credit that is a percentage of salary (e.g., 75% of owner salary) or for a fairly new traditional Defined Benefit Plan. For certain designs or historical pay scenarios, adjusting the current year’s salary would not have an impact on funding requirements.

Accounting for Credit Balances

The last option available to employers that we will discuss is the use of credit balances.

Credit balances are the accumulated amounts of excess contributions made in prior years. Credit balances can be applied against funding requirements and reduce them dollar-for-dollar. For example, if an employer had a credit balance of $100,000, representing accumulated contributions in excess of requirements for prior years, and a funding requirement of $125,000, the employer could apply the credit balance for a net funding requirement of only $25,000.

As you can imagine, credit balances may be useful as a “safety net” should the employer have cash constraints and a required contribution. However, to apply a credit balance, the Plan has to have been at least 80% funded in the prior year. Additionally, credit balances may require the employer to jump through additional hoops and may create other unintended consequences. Lastly, small Plans tend to be well-funded so that credit balances often are not needed. For these reasons, small Plans typically do not maintain credit balances to be used against future contribution requirements.

Conclusion: Defined Benefit Plan Investment Return Target

In this article, we have discussed a number of concepts, including how a Defined Benefit Plan is valued and funded, the theory behind a target investment return, and the complications of its application. We also have explained a number of options an employer may exercise to increase or decrease the Plan’s liability or even free up funding for the Defined Benefit Plan.

As mentioned, the purpose of this article was not to recommend a specific asset allocation or even an investment return target for Defined Benefit Plans. We are not asset managers. Rather, our purpose was to provide information, not typically available to advisors and employers, to help them arrive at their own investment conclusions.

Given the complications of hedging Plan risk and the difficulty of incorporating employer “options”, you may have concluded that an investment return target “range” may be more appropriate than a precise target.

Outside of investment strategies, we believe there are a number of design options that Defined Benefit Plan actuaries can utilize to reduce the risk to Plan sponsors. We hope to explore these strategies in future articles.