Underwhelmed with the performance of your one person defined benefit pension plan?

If you have a defined benefit pension retirement plan or are thinking about starting one for your small business, this article may be able to help you. Defined benefit pension retirement plans can be an incredibly useful vehicle to reduce taxes and save for retirement for small business owners. I’ve written about the merits of using a defined benefit pension retirement plan for closely-held businesses on Forbes, but in the last couple of months, I’ve noticed something that deserves further investigation.

The benefits of having a defined benefit pension retirement plan for owners of a small business cannot be overstated. Depending on your age and if you have employees, you may be able to contribute hundreds of thousands of dollars per year into a plan and significantly reduce your taxes. When I wrote about the merits of having a defined benefit pension retirement plan, I also noted a few drawbacks, like setup costs and annual expenses. However, I failed to mention another potential issue. At the time, I wasn’t aware of it, but after recently reviewing several plans, it is something you should be aware of as well.

When you hear “pension plan,” you probably think of a large corporation or government organization with hundreds of thousands of employees. What is the purpose of a pension plan? It’s a savings vehicle that allows corporations to take some of its profits and invest it for the retirement of their employees. Large companies, school systems, and government organizations have pension plans that cover millions of employees in the United States. From an investment perspective, it is challenging to invest the retirement accounts of 200,000 employees with varying ages – some just starting their careers, others just days away from retiring, and still others deep into retirement. The pension plan would need to be invested in a way to be able to pay the benefit amount to each of their retired employees until they died – and in many cases – until their spouses died. The portfolio would need to be allocated to produce income now (remember, they may have thousands of retired employees who are counting on their monthly pension check). As a result, the asset allocation would need to be less aggressive and more conservative – the pension plan couldn’t afford to take too much investment risk because they are pulling money out each month. Instead, pension plans tend to be invested conservatively. A 2016 study by Towers Watson and Willis shows pension plans invest less than half of their portfolio in stocks.

What does this have to do with you and your pension plan? If what I’ve seen in the last few months is representative, this has potentially significant ramifications for you. I don’t have verifiable data to cite, but I’ve reviewed several one person and husband/wife pension plans recently and what I’ve seen is that they have, in almost every case, been invested conservatively. In fact, I would argue too conservatively. Most of the actuaries, administration firms, and investment advisors who specialize in defined benefit pension plans are used to serving these large plans with hundreds or thousands of employees. There may be many reasons for this, but my working theory is that most are not focused on the small business owner who is the sole employee and participant in the pension plan. In other words, even if the pension plan is for the benefit of just a single owner/employee, they treat the plan as if it had 1,000 or 10,000+ employees. If you are 64 years old and about to start pulling money from your pension plan, this may not be an issue for you. It may make sense for your plan behave less than 50% in stocks (although there is a good argument that you may need a higher stock allocation even after you are retired). However, if you are younger and/or plan on working longer, your defined pension plan may be invested too conservatively. Over 10 or 20 years, this could mean the difference of hundreds of thousands or even millions of dollars of lost investment gains for you. The long-term investment return of a portfolio with 45% in stocks versus another with 65% in stocks is significant.

If you have a defined benefit pension retirement plan, what should you do? I recommend you determine your asset allocation. Look at your most recent investment statement. It may show you how you are invested, but most statements do not do an adequate job reporting this. Instead, you may need to calculate this yourself. There are websites such as Morningstar and Yahoo where you can create a portfolio that may do a better job showing how you are allocated. How much do you have in stocks versus bonds, real estate, and cash? Is this level appropriate given your age, risk tolerance, and anticipated retirement date? Also look at investment fees. There are investment expenses for the holdings you purchase as well as management fees. I often see portfolios with investment expenses exceeding 1%. This should be closer to 0.50% or even 0.25%. Investment management fees shouldn’t exceed 1%. Also, consider working with a team of defined benefit pension retirement plan experts who specialize in serving the small business space. I recently recorded a podcast episode about this potential investment problem with defined benefit pension plans to give you additional insight.

Your defined benefit pension retirement plan may be the single largest investment account when you retire. It may be the account that provides the majority of your retirement income. It’s critical that it is invested based on your goals, age, and needs, and not invested based on a cookie-cutter approach that may work for Ford or the California Public Employee’s Retirement System, but may leave you under-allocated and coming up short when you retire.

 

This article was written by Robert Pagliarini from Forbes and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.