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
Compared with a DB plan whose members are mostly young employees, a DB plan whose members are mostly retirees most likely has:
- a longer horizon and higher risk abilityWhy not: Describes the young plan; retirees' benefits are being paid now, shortening the horizon.
- higher liquidity needs and lower risk ability — correct
- identical needs, as the sponsor bears riskWhy not: Sponsor risk-bearing does not change the timing of the plan's payments.
A mature plan pays benefits now, so its liabilities have shorter duration, it needs cash for payments, and it has less time to recover from losses.
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