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Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-offs?

In: Pensions in the U.S. Economy

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  • Zvi Bodie
  • Alan J. Marcus
  • Robert C. Merton

Abstract

Defined Benefit and Defined Contribution plans have significantly different characteristics with respect to the risks faced by employers and employees, the sensitivity of benefits to inflation, the flexibility of funding, and the importance of governmental supervision. In this paper, we examine some of the main tradeoffs involved in the choice between DB and DC plans. Our most general conclusion is that neither plan type can be said to wholly dominate the other from the perspective of employee welfare.The major advantage of DB plans is the potential they offer to provide a stable replacement rate of final income to workers. If the replacement rate is the relevant variable for worker retirement utility, then DB plans offer some degree of insurance against real wage risk. Of course, protection offered to workers is risk borne by the firm. As real wages change, funding rates must correspondingly adjust. However, to the extent that real wage risk is largely diversifiable to employers, and nondiversifiable to employees, the replacement rate stability should be viewed as an advantage of DB plans. The advantages of DC plans are most apparent during periods of inflation uncertainty. These are: the predictability of the value of pension wealth, the ability to invest in inflation-hedged portfolios rather than nominal DB annuities,and the fully-funded nature of the DC plan. Finally, the DC plan has the advantage that workers can more easily determine the true present value of the pension benefit they earn in any year, although they may have more incertainty about future pension-benefit flows at retirement. Measuring the present value of accruing defined benefits is difficult at best and imposes severe informational requirements on workers. Such difficulties could lead workers to misvalue their total compensation, and result in misinformed behavior.

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This chapter was published in:

  • Zvi Bodie & John B. Shoven & David A. Wise, 1988. "Pensions in the U.S. Economy," NBER Books, National Bureau of Economic Research, Inc, number bodi88-1, July.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 6047.

    Handle: RePEc:nbr:nberch:6047

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    1. Robert C. Merton, 1981. "On the Role of Social Security as a Means for Efficient Risk-Bearing in an Economy Where Human Capital Is Not Tradeable," NBER Working Papers 0743, National Bureau of Economic Research, Inc.
    2. Alan J. Marcus, 1983. "Corporate Pension Policy and the Value of PBGC Insurance," NBER Working Papers 1217, National Bureau of Economic Research, Inc.
    3. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1979. "Duration and the Measurement of Basis Risk," The Journal of Business, University of Chicago Press, vol. 52(1), pages 51-61, January.
    4. Bierwag, G O & Kaufman, George G, 1977. "Coping with the Risk of Interest-Rate Fluctuations: A Note," The Journal of Business, University of Chicago Press, vol. 50(3), pages 364-70, July.
    5. Peter A. Diamond & James Mirrlees, 1985. "Insurance Aspects of Pensions," NBER Chapters, in: Pensions, Labor, and Individual Choice, pages 317-356 National Bureau of Economic Research, Inc.
    6. Robert C. Merton & Zvi Bodie & Alan J. Marcus, 1984. "Pension Plan Integration as Insurance Against Social Security Risk," NBER Working Papers 1370, National Bureau of Economic Research, Inc.
    7. Bulow, Jeremy I, 1982. "What Are Corporate Pension Liabilities?," The Quarterly Journal of Economics, MIT Press, vol. 97(3), pages 435-52, August.
    8. Bierwag, G. O., 1977. "Immunization, Duration, and the Term Structure of Interest Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(05), pages 725-742, December.
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