2. The amount needed to establish an annuity of $600 per year for 15
years (assuming payment at the end of each year) would be $4,564.
3. The ļ¬rm would have to put up $162 today to provide the required
annuity 35 years from now.8 The cost to the ļ¬rm would have been
$4,564 had the employee been 64 years old instead of 30; this helps
explain why older workers sometimes have a hard time landing jobs.
4. Given an inļ¬‚ation rate of 6 percent, the real (2004) value of the
income for the employee from this pension would be $78 in the ļ¬rst
year of retirement:
Real income $78.
If the person remained at Company DB until retirement, and if his or
her salary increased with inļ¬‚ation, then the ļ¬nal salary would be
$30,000(1.06)35 $230,583 per year, and his or her retirement
income would be 0.02(35)($230,583) $161,408, or 70 percent of
the $230,583 ļ¬nal salary. The real (2004 dollar) retirement income
would be $21,000, or 70 percent of the 2004 employment income,
Company DC: Defined Contribution
This ļ¬rm has a deļ¬ned contribution plan under which an amount equal to
6 percent of each employeeā™s salary is put into a pension fund account. The
We have assumed that inļ¬‚ation in wages is not built into the funding requirement. If a 6 percent wage inļ¬‚ation were
built in, then the cost would rise from $162 to $1,245 (as determined by a simple spreadsheet model).
29-16 Pension Plan Management
fund keeps track of the dollar amount of the contribution attributable to
each employee, just as if the company had put the money into a bank time
deposit or mutual fund for the employee. (Indeed, the money probably
would go into a mutual fund.) Here is the situation if the employee worked
for one year and then resigned:
1. The ļ¬rm would contribute 0.06($30,000) $1,800 to the employeeā™s
account in the pension fund. This is the ļ¬rmā™s cost, and it would be the
same irrespective of the employeeā™s age.
2. The fundā™s assets would earn 10 percent per year, so when the
employee retired, the value of his or her share of the fund would be
3. At a 10 percent rate of return, this $50,584 would provide an annuity
of $6,650 per year for 15 years. To get this result, enter N 15, I
10, PV $50,584, and FV 0, and press PMT to obtain $6,650.
4. The real (2004) retirement income for this person would be
$6,650/(1.06)35 $865. If the person remained at Company DC, his
or her retirement fund would accumulate to $1,024,444 over the 35-
year employment period (we used a spreadsheet model to obtain this
amount). This would provide a retirement income of $134,688, or 58
percent of the $230,583 ļ¬nal salary. The real (2004 dollar) retirement
income would be $17,524, or 58 percent of the 2004 employment
1. A young employee who has a high probability of moving would be
better off under a deļ¬ned contribution plan such as the one offered by
Company DC. Note too that a cash balance plan would be better for
a potentially mobile employee.
2. A worker who planned to spend his or her entire career at one ļ¬rm
would be better off at Company DB, with its deļ¬ned beneļ¬t plan.
3. The economic consequences of changing jobs are much worse under
the deļ¬ned beneļ¬t plan because beneļ¬ts are frozen rather than
increased with inļ¬‚ation. Therefore, deļ¬ned beneļ¬t plans contribute to
lower employee turnover, other factors held constant.
4. It is much more costly to a company to hire older workers if it oper-
ates under a deļ¬ned beneļ¬t plan than if it operates under a deļ¬ned
contribution plan. In our example, the 2004 cost to provide pension
beneļ¬ts to a 30-year-old employee under the deļ¬ned beneļ¬t plan
would be $162 versus $4,564 for a 64-year-old employee earning the
same salary. The average cost per employee to the ļ¬rm would depend
on the age distribution of employees. However, the cost would be
$1,800 per employee, irrespective of age, under the deļ¬ned contribu-
tion plan. Thus, deļ¬ned beneļ¬t plans carry with them an economic
incentive to discriminate against older workers in hiring, while deļ¬ned
contribution plans are neutral in this regard. Of course, it is illegal to
discriminate on the basis of age, but other reasons could be stated for
favoring younger workers.
5. If one were to vary the assumptions, it would be easy to show that
employees are generally exposed to more risks under the deļ¬ned contri-
bution plan, while employers face more risks under the deļ¬ned beneļ¬t
plan. In particular, the pension beneļ¬ts under the deļ¬ned contribution
Defined Benefit versus Defined Contribution Plans: The Employee Choice
plan are highly sensitive to changes in the rate of return earned on the
pension fundā™s investments. Likewise, the costs to Company DB would
vary greatly depending on investment performance, but Company DCā™s
costs would not vary with respect to changes in investment performance.
6. We could have changed the facts of the example to deal with an āaver-
age manā with a life expectancy of 73.6 years and an āaverage womanā
with a 79.2-year life expectancy. Obviously, an average woman would
receive beneļ¬ts over a longer period and thus would need a larger accu-
mulated sum in the plan upon retirement, hence would have a higher
actuarial annual required cost to the ļ¬rm than an average man under
the deļ¬ned beneļ¬t plan. Thus, other factors held constant, there is an
economic incentive for employers to discriminate against women in their
hiring practices if they use deļ¬ned beneļ¬t plans. Deļ¬ned contribution
plans are again neutral in this regard.
Would a young worker with a high probability of changing jobs be better off
under a defined contribution or a defined benefit pension plan? Explain.
Would a company with a defined benefit plan or one with a defined contribu-
tion plan have more economic incentive to hire younger workers? Explain.
Would a company with a defined benefit plan or one with a defined contribution
plan have more economic incentive to hire men? Explain.
Defined Benefit versus Defined Contribution
Plans: The Employee Choice
Because some large employers offer both deļ¬ned beneļ¬t (or cash balance)
and deļ¬ned contribution plans, many employees have to choose between the
two types of plans. This is not an easy decision to make, because it depends
on both the speciļ¬cs of the plans and the situation of the individual. Each
individual must examine his or her expected cash ļ¬‚ows from wages and
investments and pick the plan that provides the incremental cash ļ¬‚ows (both
costs and beneļ¬ts) that maximize his or her expected utility. Clearly, an
employee must consider a vast array of economic variables such as expected
work life, potential job changes, vesting provisions, risk of inadequate fund-
ing, and inļ¬‚ation. These factors can vary so much among individuals and
employers that meaningful generalizations are impossible.
To illustrate the complexity of the decision, consider only one of the rele-
vant factors, inļ¬‚ation. Participants in a deļ¬ned beneļ¬t plan face substantial
inļ¬‚ation risk. For example, assume an individual retires at age 65 and
receives a ļ¬xed pension each year. (Most deļ¬ned beneļ¬t plans promise ļ¬xed
nominal payments, so there is no adjustment for inļ¬‚ation once the worker
retires.) If the annual inļ¬‚ation rate is 5 percent, each dollar would buy 78 cents
worth of goods and services after 5 years, and only 61 cents after 10 years.
If the inļ¬‚ation rate is 10 percent, purchasing power would fall to 62 cents
after 5 years and to only 39 cents after 10 years. For individuals who retire
before age 65 and hence face 20 or more years of retirement, inļ¬‚ation can
easily erode the purchasing power of their pensions to only a small fraction
of the original dollar amount.
The inļ¬‚ation factor also increases the complexity of decisions under a
deļ¬ned contribution plan. Here the participant must choose among a num-
ber of investment alternatives, including money market funds, ļ¬xed income
funds, balanced funds, company stock, and stock funds. The ability of the
29-18 Pension Plan Management
fund to withstand the ravages of inļ¬‚ation depends on the performance of the
investments chosen for the portfolio. Many studies have looked at the abil-
ity of various portfolio combinations to maintain a stable real return under
inļ¬‚ation.9 Although it is common āwisdomā that stocks are a good hedge
against inļ¬‚ation, studies show that stock returns and inļ¬‚ation are often neg-
atively correlatedā”when inļ¬‚ation heats up and the planā™s portfolio needs to
perform best, stocks do poorly. Some studies have suggested that a portfolio
consisting of T-bills and commodity futures can be a good hedge against
inļ¬‚ation, but very few deļ¬ned contribution plan participants would be will-
ing to place their assets in such a portfolio. In recent years, a few ļ¬nancial
institutions have offered, as a more realistic alternative, certiļ¬cates of
deposit with returns that are tied to the consumer price index. Better yet are
inļ¬‚ation-indexed U.S. Treasury bonds, whose interest rates are adjusted to
offset inļ¬‚ation. These securities can be used by investors in deļ¬ned contri-
bution plans to provide a constant real-dollar pension.
What factors should be considered by an employee when choosing between a
defined benefit and a defined contribution plan?
Explain how inflation affects payments from a defined benefit plan versus a
defined contribution plan.
Developing a Plan Strategy
When an employer establishes a pension plan, the plan type may be inļ¬‚u-
enced by competitive conditions in the labor market. For example, unions
generally seek deļ¬ned beneļ¬t plans to cushion beneļ¬ciaries from investment
risks inherent in deļ¬ned contribution and proļ¬t sharing plans. Even if a ļ¬rm
has the economic power to resist a deļ¬ned beneļ¬t plan, it may still agree to
one on the grounds that such a plan might reduce its turnover rate. Still,
there is no universal answer as to whether a deļ¬ned beneļ¬t or a deļ¬ned con-
tribution plan is better for a particular company.
A deļ¬ned beneļ¬t plan provides tax-planning ļ¬‚exibility, because ļ¬rms can
vary the fund contribution from year to year. Thus, in highly proļ¬table years
ļ¬rms can make large contributions, which decrease taxable income, hence
taxes. Deļ¬ned contribution plans do not afford such ļ¬‚exibility, because the
speciļ¬ed contributions must be made each year regardless of the ļ¬rmā™s prof-
itability. However, deļ¬ned contribution plans do not require ļ¬rms to
increase contributions if the fundā™s investment performance is poor.10
Deļ¬ned beneļ¬t plans also have higher administrative costs, plus the burden
to make promised pension payments regardless of the fundā™s investment per-
formance. In recent years there has been a tendency for new ļ¬rms to adopt
deļ¬ned contribution or proļ¬t sharing plans. Also, the high administrative
costs and the regulatory burdens of ERISA have driven a large number of
older ļ¬rms to replace deļ¬ned beneļ¬t with deļ¬ned contribution plans.
Assuming a ļ¬rm has a deļ¬ned beneļ¬t plan, proper strategic planning
requires integrating the planā™s funding and investment policies into the
For example, see Zvi Bodie, āAn Innovation for Stable Real Retirement Income,ā Journal of Portfolio Management,
Fall 1980, 5ā“13.
The distinction between a pension plan and a pension fund should be noted. A pension plan is a contract between
the participants and the ļ¬rm that spells out the rights and obligations of each party. A pension fund is the investment
portfolio that provides the collateral that secures the planā™s contractual beneļ¬ts.
Developing a Plan Strategy
companyā™s general corporate operations. Funding strategy involves two deci-
sions: (1) How fast should any unfunded liability be reduced, and (2) what
rate of return should be assumed in the actuarial calculations? Investment
strategy deals with this question: Given the assumed actuarial rate of
return, how should the portfolio be structured?
Pension fund managers use asset allocation models when making funding
and investment decisions. These models use computer simulation to exam-
ine the risk/return characteristics of portfolios with various mixes of stocks,
bonds, T-bills, real estate, international assets, and so on, under different
economic scenarios. Note ļ¬rst that the very nature of pension funds suggests
that safety of principal is a paramount consideration, so pension fund man-
agers ought not to āreachā for the highest possible returns. Also, as we dis-
cussed in Chapter 2, for a given level of return, the inclusion of more types
of assets generally reduces the portfolioā™s risk, because returns on different
asset types are not perfectly correlated. Choices among the possible portfo-
lios may be limited by the introduction of managerial constraints, such as (1)
that the portfolio value should not drop more than 30 percent if a 1930s-
level depression occurs, or (2) that the portfolio should earn at least 10 percent
if a 1970s level of inļ¬‚ation occurs.
Pension fund managers must also consider the effects of the portfolio mix
and actuarial assumptions on required contributions. First, note that the
most commonly used measure of a pension planā™s cost is the ratio of pension
contributions to payroll. Now suppose a young company has no retirees,
and salary inļ¬‚ation heats up to 15 percent, causing the companyā™s projected
beneļ¬t payments under a ļ¬nal pay plan to grow by 15 percent per year for
active participants. Here inļ¬‚ation would not affect the percentage of pension
costs to payroll costs, because payroll and contributions would rise at the
same rate. However, if an older company has a large number of retirees rel-
ative to actives, and if the payments to retirees are ļ¬xed while the reinvest-
ment rate rises on assets held for retirees (because inļ¬‚ation pushes up inter-
est rates), then pension costs as a percentage of payroll might even decline.
On the other hand, in a 1930s-style depression a company with a lot of
retirees on deļ¬ned beneļ¬ts might be in substantial trouble. For example,
suppose production cutbacks caused employees to be laid off, and many of
them elected to take early retirement. This would reduce payroll expenses
but increase retirement expenses. At the same time, the pension fund, if it
had invested heavily in stocks, would decline substantially in value, which,
in turn, would lead to higher required contributions. For such a company,
pension expenses could lead to bankruptcy.
Asset allocation models generally indicate that portfolios consisting of 25
to 50 percent bonds and 50 to 75 percent stocks provide adequate diversiļ¬-
cation for safety along with a satisfactory expected return. Additionally, it is
now recognized that further beneļ¬ts can be gained by investing in assets
other than stocks and bonds. Indeed, many pension funds invest in at least
four asset categories, including international securities and such āhard
assetsā as real estate, timberland, oil and gas reserves, and precious metals,
mainly as inļ¬‚ation hedges.
To illustrate one companyā™s approach to asset allocation, consider Table
29-1, which contains the recent asset allocation of General Electricā™s pension
fund. GEā™s pension fund is diversiļ¬ed along three lines. First, the fund con-
tains numerous types of securities, including stocks, bonds, real estate,
options, and venture capital. Second, the portfolio contains both domestic
and international securities. Finally, although it is not apparent from the
29-20 Pension Plan Management
Table 29-1 General Electric Company: Pension Fund Assets (Millions of Dollars)
Asset Category Value Portfolio
Cash/short-term equivalents $ 1,703 5.9%
GE $ 184 0.6%
Actively managed domestic portfolios 5,704 19.8
Passive (indexed) domestic portfolios 5,337 18.5