Explain how defined benefit and defined contribution pension plans work
The idea
Pension plans come in two broad forms. In a defined benefit plan the employer promises a specified retirement benefit, usually based on salary and years of service, and must fund it; the sponsor therefore bears the investment risk and the risk that retirees live longer than expected. The plan's funded status compares its assets with the present value of its obligations, and a shortfall is the sponsor's problem. In a defined contribution plan the employer's obligation ends with making the agreed contributions: the employee usually chooses how the account is invested, and the retirement benefit depends on contributions and investment returns, so the employee bears investment and longevity risk. DC accounts are portable when an employee changes jobs. A DB plan's investment policy depends on its liabilities: a plan with many retirees has shorter-duration obligations, greater liquidity needs and usually a lower ability to take risk.
A practice question
In a defined benefit pension plan, who bears the investment risk?
- The sponsoring employer - correct
- The individual employeeWhy not: That is the defined contribution arrangement, where benefits depend on the account's returns.
- The plan's asset managerWhy not: Managers are paid to invest but do not guarantee the promised benefit.
The employer has promised a specified benefit, so if investment returns fall short the sponsor must contribute more to meet it.
A harder one
An employee expects to change employers several times. Which plan feature is most likely to suit her?
- The guaranteed benefit of a DB planWhy not: DB benefits usually accrue on service with one employer, so frequent moves reduce them.
- The sponsor funding of a DB deficitWhy not: Deficit funding protects benefits already promised; it does not make them portable.
- The portability of a DC account - correct
A DC account belongs to the employee and can be taken from job to job, while DB benefits typically reward long service with a single sponsor.
The hardest tier
A company closes its DB plan and offers a DC plan instead. Which risks move from the company to its employees?
- Investment risk, while longevity risk stays with the companyWhy not: Longevity risk also moves. In a DC plan, an employee who lives longer must make the pot last.
- Longevity risk, while investment risk stays with the companyWhy not: Investment risk is the main one that moves. In a DC plan, the employee's benefit depends on the returns earned.
- Investment risk and longevity risk - correct
Under DC, poor returns reduce the employee's account, and outliving the savings is the employee's problem: both risks the DB sponsor used to carry.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →