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1. The annual bene¬t at age 65 would be 0.02($30,000) $600.
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 ¬rm would have to put up $162 today to provide the required
annuity 35 years from now.8 The cost to the ¬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 in¬‚ation rate of 6 percent, the real (2004) value of the
income for the employee from this pension would be $78 in the ¬rst
year of retirement:

Real income $78.
If the person remained at Company DB until retirement, and if his or
her salary increased with in¬‚ation, then the ¬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 ¬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 ¬rm has a de¬ned contribution plan under which an amount equal to
6 percent of each employee™s salary is put into a pension fund account. The
We have assumed that in¬‚ation in wages is not built into the funding requirement. If a 6 percent wage in¬‚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
Chapter 29

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 ¬rm would contribute 0.06($30,000) $1,800 to the employee™s
account in the pension fund. This is the ¬rm™s cost, and it would be the
same irrespective of the employee™s age.
2. The fund™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
$1,800(1.10)35 $50,584.
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 ¬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 de¬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 ¬rm
would be better off at Company DB, with its de¬ned bene¬t plan.
3. The economic consequences of changing jobs are much worse under
the de¬ned bene¬t plan because bene¬ts are frozen rather than
increased with in¬‚ation. Therefore, de¬ned bene¬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 de¬ned bene¬t plan than if it operates under a de¬ned
contribution plan. In our example, the 2004 cost to provide pension
bene¬ts to a 30-year-old employee under the de¬ned bene¬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 ¬rm would depend
on the age distribution of employees. However, the cost would be
$1,800 per employee, irrespective of age, under the de¬ned contribu-
tion plan. Thus, de¬ned bene¬t plans carry with them an economic
incentive to discriminate against older workers in hiring, while de¬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 de¬ned contri-
bution plan, while employers face more risks under the de¬ned bene¬t
plan. In particular, the pension bene¬ts under the de¬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 fund™s investments. Likewise, the costs to Company DB would
vary greatly depending on investment performance, but Company DC™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 “aver-
age man” with a life expectancy of 73.6 years and an “average woman”
with a 79.2-year life expectancy. Obviously, an average woman would
receive bene¬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 ¬rm than an average man under
the de¬ned bene¬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 de¬ned bene¬t plans. De¬ned contribution
plans are again neutral in this regard.

Would a young worker with a high probability of changing jobs be better off
Self-Test Questions
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 de¬ned bene¬t (or cash balance)
and de¬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 speci¬cs of the plans and the situation of the individual. Each
individual must examine his or her expected cash ¬‚ows from wages and
investments and pick the plan that provides the incremental cash ¬‚ows (both
costs and bene¬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 in¬‚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, in¬‚ation. Participants in a de¬ned bene¬t plan face substantial
in¬‚ation risk. For example, assume an individual retires at age 65 and
receives a ¬xed pension each year. (Most de¬ned bene¬t plans promise ¬xed
nominal payments, so there is no adjustment for in¬‚ation once the worker
retires.) If the annual in¬‚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 in¬‚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, in¬‚ation can
easily erode the purchasing power of their pensions to only a small fraction
of the original dollar amount.
The in¬‚ation factor also increases the complexity of decisions under a
de¬ned contribution plan. Here the participant must choose among a num-
ber of investment alternatives, including money market funds, ¬xed income
funds, balanced funds, company stock, and stock funds. The ability of the
29-18 Pension Plan Management
Chapter 29

fund to withstand the ravages of in¬‚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
in¬‚ation.9 Although it is common “wisdom” that stocks are a good hedge
against in¬‚ation, studies show that stock returns and in¬‚ation are often neg-
atively correlated”when in¬‚ation heats up and the plan™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
in¬‚ation, but very few de¬ned contribution plan participants would be will-
ing to place their assets in such a portfolio. In recent years, a few ¬nancial
institutions have offered, as a more realistic alternative, certi¬cates of
deposit with returns that are tied to the consumer price index. Better yet are
in¬‚ation-indexed U.S. Treasury bonds, whose interest rates are adjusted to
offset in¬‚ation. These securities can be used by investors in de¬ned contri-
bution plans to provide a constant real-dollar pension.

What factors should be considered by an employee when choosing between a
Self-Test Questions
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 in¬‚u-
enced by competitive conditions in the labor market. For example, unions
generally seek de¬ned bene¬t plans to cushion bene¬ciaries from investment
risks inherent in de¬ned contribution and pro¬t sharing plans. Even if a ¬rm
has the economic power to resist a de¬ned bene¬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 de¬ned bene¬t or a de¬ned con-
tribution plan is better for a particular company.
A de¬ned bene¬t plan provides tax-planning ¬‚exibility, because ¬rms can
vary the fund contribution from year to year. Thus, in highly pro¬table years
¬rms can make large contributions, which decrease taxable income, hence
taxes. De¬ned contribution plans do not afford such ¬‚exibility, because the
speci¬ed contributions must be made each year regardless of the ¬rm™s prof-
itability. However, de¬ned contribution plans do not require ¬rms to
increase contributions if the fund™s investment performance is poor.10
De¬ned bene¬t plans also have higher administrative costs, plus the burden
to make promised pension payments regardless of the fund™s investment per-
formance. In recent years there has been a tendency for new ¬rms to adopt
de¬ned contribution or pro¬t sharing plans. Also, the high administrative
costs and the regulatory burdens of ERISA have driven a large number of
older ¬rms to replace de¬ned bene¬t with de¬ned contribution plans.
Assuming a ¬rm has a de¬ned bene¬t plan, proper strategic planning
requires integrating the plan™s funding and investment policies into the

For example, see Zvi Bodie, “An Innovation for Stable Real Retirement Income,” Journal of Portfolio Management,
Fall 1980, 5“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 ¬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 plan™s contractual bene¬ts.
Developing a Plan Strategy

company™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 ¬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 “reach” 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 portfolio™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 in¬‚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 plan™s cost is the ratio of pension
contributions to payroll. Now suppose a young company has no retirees,
and salary in¬‚ation heats up to 15 percent, causing the company™s projected
bene¬t payments under a ¬nal pay plan to grow by 15 percent per year for
active participants. Here in¬‚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 ¬xed while the reinvest-
ment rate rises on assets held for retirees (because in¬‚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 de¬ned bene¬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 diversi¬-
cation for safety along with a satisfactory expected return. Additionally, it is
now recognized that further bene¬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 “hard
assets” as real estate, timberland, oil and gas reserves, and precious metals,
mainly as in¬‚ation hedges.
To illustrate one company™s approach to asset allocation, consider Table
29-1, which contains the recent asset allocation of General Electric™s pension
fund. GE™s pension fund is diversi¬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
Chapter 29

Table 29-1 General Electric Company: Pension Fund Assets (Millions of Dollars)
Percent of
Asset Category Value Portfolio

Cash/short-term equivalents $ 1,703 5.9%
Common stock:
GE $ 184 0.6%
Actively managed domestic portfolios 5,704 19.8
Passive (indexed) domestic portfolios 5,337 18.5


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( 7 .)