The Pros and Cons of Defined Contribution vs. Defined Benefit Pension Plans
In Study Session 4 of the CFA Level 3 curriculum, pension plans are the most exhaustive section. And that’s not an accident. Pension plans are the most tested institutional investor type on the exam.
This post, part of a four part series of posts on pension plans, covers the difference between defined contribution and defined benefit plans.
Four Part Pension Series
- Defined contribution vs. Defined benefit pension plans (this post)
- The Risk and Return Objectives of DB Plans
- Asset-Liability Management and mimicking pension liabilities
- Pension Plan Constraints
Pension Plan 101 for the CFA Exam
There are two (main) types of pension plans.
In a defined benefit plan the employer/company is responsible for providing retirement benefits to its workers.
In a defined contribution plan the company might match employee contributions in the beginning but they have no further obligations from a benefits perspective.
Defined benefit plans are much more important from the level three perspective. What matters from a DC vs. DB perspective is just the high level overview of the pros and cons of each from both a company and individual point of view.
Let’s go a little deeper into these advantages and disadvantages.
Defined Benefit Plan Pros and Cons
Again, a DB plan is one in which the firm is responsible for providing fixed benefits to the employee. That's the defined benefit in the name, right…it's a promise to the employee.
This employee benefit is a future financial commitment for the firm. In other words it’s a liability which the firm is entirely responsible for.
From the perspective of the employee a DB plan is awesome. You know that you've got this pension that has a guaranteed future value. From the firm's perspective, however, it creates a lot of risk because the future liability is unknown. That said, there are potential benefits to the company. For example, if the plan generates a significant surplus these additional assets can support its stock price etc.
Defined Contribution Plan Pros and Cons
A DC plan is a bit more simple. Again this is a plan in which the firm's sole liability is in the beginning when they're obligated to match a certain dollar contribution of their employees into a retirement account. There's a few legal obligations at this stage (like presenting three plus investment options for the employee) but those are pretty limited and not likely to be tested.
Anyway, once the firm has matched that dollar contribution in the beginning, there is no investment risk for the company anymore and there's none of the costs associated with running a defined benefit pension plan either.
100% of risk gets shifted to the individual. Each person is now responsible for their investment results. You have to make sure that you have enough assets in retirement or like this guy from the Wild West you might be stuck trying to go rob a bank, right?
That's not to say it's all bad though, because the assets are really truly yours. Meaning you have much more discretion and flexibility over how you invest. Your assets are also now more portable (you can take them with you when you leave the company) and more transferable. The last benefit to mention is that when you contribute to your retirement portfolio you are usually doing this with pre-tax dollars so you are able to lower your total taxable income as well.
Employee vs. Employer - Pension Plans
Know both of these tables well. This material has shown up on past CFA Level 3 exams more than once.
If you know the information presented in these tables you're good to go in terms of comparing DC and DB plans. The rest of the pension material on the level three exam is really focused on defined benefit pension plans, and circles back to ALM vs. AO, and the core risk/return and constraints material common to any investment policy statement (IPS) question.