The defined benefit plan is probably the most underrated small business retirement plan. One of the reasons it is so underrated is because of its design complexities and actuarial requirement. However, if you do decide on this plan, what about the Self-Directed Defined Benefit Plan?
- A defined benefit plan guarantees a specific benefit at retirement
- Generally, DB plans are invested in more conservative asset classes
- Once the plan is fully funded, it can be rolled over and invest in alternative assets
What is a Defined Benefit Plan?
Unlike a defined contribution plan, such as a 401(k) plan, where the employee is essentially responsible for making contributions to the plan and the plan does not have a specified retirement benefit, a defined benefit plan guarantees a specific benefit at retirement to each eligible employee. The benefits in a defined benefit plan are generally based on age, wages, and in some cases length of service. Defined benefit plan contributions are not discretionary but are determined by an actuary and create an annual funding obligation to the plan. Once the retirement benefit objective is established, the employer contributions required to meet the benefit objective is determined actuarially on an annual basis. The primary benefit of establishing a defined benefit plan is the high annual contributions limits, which are based on numerous factors including age and income. A cash balance plan is the most popular type of defined benefit plan.
In general, defined benefit plan benefits are funded over the working life of the participating employee with annual tax-deductible contributions from the employer. The employee does not make any contributions to the plan. Instead, the employer makes all contributions based on predetermined retirement benefit as outlined in the pension plan document. The assets of the defined benefit plan are held in a pool, rather than individual accounts for each employee, and as a result, the employees have generally no say in investment decisions. Once established, the employer must continue to fund the defined benefit plan, even if the company has insufficient income or profits in a given year.
The Cash Balance Plan
For a cash balance plan, the key indicator of how much you can generate in the plan annually is called the cash balance credit. The cash balance credit is basically how much you are able to accumulate in the plan each year. It does not mean the actual annual contribution you are required to make each year, but actually the amount you can get credit for saving in the plan on an annual basis. Annual plan contributions have a range and are somewhat flexible. An actuary will calculate the annual plan contribution range based on IRS guideline. In essence, the older you are and the higher the compensation amount, the higher the cash balance credit will be under the plan since you have less years to get to retirement age. Most actuaries use a 4% interest rate to get to an interest credit for cash balance credit calculation purposes.
Actuaries typically use a conservative annual interest rate to offer business owners more flexibility in order to best protect against lower plan returns as a result of a down market. For example, if a business owner makes an annual contribution on the low end of the actuarial range and the equity markets have a bad year that generates less than a 4% annual rate of return, the business owner would have to make higher contributions the following year to make up the difference in order to satisfy the plan’s funding requirement.
Hence, when it comes to making investments in a defined benefit plan, most financial advisors will suggest a conservative investment approach. The idea is to keep the plan investments in annual return range of 4%-6% so that the business owner will not have to make up any plan funding shortfalls.
The Self-Directed Defined Benefit Plan
A defined benefit plan is permitted to make alternative asset investments, such as real estate. A defined benefit plan is subject to the same IRS prohibited transaction rules under Internal Revenue Code Section 4975 as an IRA or 401(k) plan. In other words, one is permitted to have a Self-Directed Defined Benefit Plan and make alternative asset investments under the plan, however, that investment approach is not common for a number of reasons. The primary reason is that valuing alternative assets is often difficult and valuing a defined benefit asset at its true fair market value is crucial with respect to meeting the plan’s annual funding requirements. In addition, some alternative asset investments can be volatile, which could potentially force the business owner to make up a plan asset shortfall
In sum, it is far more common for defined benefit plans to invest in conservative investments with the guidance of a seasoned financial advisor. Accordingly, most defined benefit plans will not have their defined benefit plan assets invested in alternative asset investments. However, after the defined benefit plan has been fully funded, typically after three to five years, many defined benefits plan investors will rollover their defined benefit plan investments to a Self-Directed IRA to gain more investment diversification opportunities.
To learn more about the self-directed defined benefit plan, please contact a self-directed retirement specialist at 800-472-0646.