Beware of These Pitfalls When Managing Investments Within Defined Benefit Plans

Introduction

Defined benefit plans, promising specific retirement benefits to business owners and employees, require a delicate balance in funding. The penalties for overfunding or underfunding can be substantial, making the management of these investments a critical task. This article discusses why aiming for a 3-4% return balance is essential and the specific penalties associated with straying from this target.

Understanding Defined Benefit Plans

A defined benefit plan guarantees specific retirement benefits but demands precise management to avoid severe penalties.

The Balance of Growth: Why 3-4%?

Striving for a 3-4% return balance in defined benefit plans ensures a growth path that aligns with regulatory requirements and long-term goals. 

Here's why:

1. Why Too High Growth Can Be Problematic
a. Overfunding Penalties:

• Reversion Tax: A 50% excise tax on the excess funding reverting to the employer, minus any amount used for plan expenses or benefits.

• Federal Income Tax: The reversion is also subject to federal income tax.

• State Income Tax: Some states may impose additional income tax on the reversion.

b. Increased Volatility: High growth may lead to riskier investments, increasing exposure to market fluctuations.

2. Why Too Low Growth Can Also Be Troubling
a. Underfunding Penalties:

• Minimum Funding Requirement (MFR) Excise Tax: A 5% excise tax on the unfunded liability at the end of the plan year, minus any contributions made during the year.

• Additional Penalties: Other penalties may include a 10% or 100% excise tax on the shortfall, a lien on the employer's assets, and a prohibition on deducting contributions to the plan. 

b. Opportunity Costs: A too-conservative approach may miss market gains, affecting the plan's stability.

Maximizing Benefits Through Stacking Plans

Stacking retirement plans requires expert management to maximize benefits and avoid compromising tax advantages.

A Practical Example: The Impact of Fluctuating Growth

Consider a small business owner who faces the following issues due to a 10% return:

• Short-term Complications: Overfunding leads to reversion tax, federal and state income taxes, and challenges in short-term tax planning.

• Long-term Challenges: Regulatory limitations affect the entire stacked retirement strategy, requiring a recalibration of her approach.

• The Resolution: Specialized guidance helps navigate the penalties and realign her retirement strategy.

Conclusion: The Crucial Role of Expert Guidance

The management of defined benefit plans is intricate, and the importance of maintaining a 3-4% return balance is vital. Specific penalties for overfunding and underfunding can be significant, and expert guidance is essential to leverage these benefits to their fullest extent.

Note: The information provided is for educational purposes only. The specific penalties may vary depending on the plan's circumstances. Employers should consult a qualified actuary or tax advisor to understand the specific penalties that apply to their plan.