Employees of both private and public companies often save and invest for retirement via defined contribution (DC) pension plans in which they assume the investment risk. In the case of a defined benefit (DB) pension plan, the responsibility and investment risk fall on the employer and they must ensure they can provide the defined benefits to employees on retirement.
Defined Contribution Pension Plan
A DC pension plan is an investment vehicle in which the amounts invested, or the contributions that the employee makes to the plan are defined or specified but the benefits are not. The objective of the pension plan is to accumulate wealth by investing a portion of wages while working in order to provide income during retirement. As the benefits of a DC plan are not defined, the employee assumes the investment risk and needs to ensure the contributions and investment growth are sufficient to provide the required income on retirement.
Defined Benefit Pension Plan
In a DB pension plan, the employer has an obligation to provide certain benefits to employees when they retire. The future benefit is specified or defined. The investment management of DB plans has to take into consideration the timing of its future liabilities or cash flows by assessing the age of its plan members. If a DB pension plan has a lot of young members, the investment time horizon of the plan may be quite long. The plan investment manager may try to match the cash flow requirements of the plan with cash-flow producing assets like bonds so that the portfolio assets offset the portfolio liabilities.
Which of the following best describes the investment risk of a DB pension plan?
A. The employer assumes the investment risk
B. The employee assumes the investment risk
C. The employer and the employee share the investment risk
The correct answer is A.
In a DB pension plan, the employer must ensure there are sufficient assets to match the future defined benefits paid to employees on retirement.
Reading 51 LOS 51c:
Describe defined contribution and defined benefit pension plans