Employees ultimately bear the risk in DB pension plans: new study

"Employees ultimately bear the cost of DB (and DC plans), even if the employer and the employee ostensibly share these costs."

 

Toronto (13 June 2008) – The common assumption that employers bear all the risk in defined-benefit (DB) pension plans is overly simplistic and questionable, according to a newly released study by the C.D. Howe Institute.

In Risky Assumptions: A Closer Look at the Bearing of Investment Risk in defined-Benefit Pension Plans, James E. Pesando, an economist at the University of Toronto, examines whether employees, employers or both, ultimately share the risk for poor investment performance in DB plans – a question that has important implications for who can lay claim to any surpluses in plans.

Pesando notes that with the relative decline of DB pension plans in Canada, pension experts have increased their focus on the relative advantages of DB plans compared to defined-contribution (DC) plans, and whether steps should be taken to shore up the popularity of DB plans.

Common perception has it that in DB plans, the sponsors (firms) bear the investment risk, and in DC plans, members bear the risk. But Pesando finds such common assumptions overly simplistic. He explores the question of how the bearing of investment risk is distributed in DB plans, first by taking a closer look at the proposition that employer sponsored pension plans represent deferred wages and, second, by re-examining how employers and their employees trade off pension benefits for other components in the total compensation package.

The key findings of the paper include:

  • The defined-benefit formula notwithstanding, members of DB plans may bear substantial investment risk. The key issue is the extent to which members of DB plans grant wage or other concessions based on the contributions made by the plan sponsor, including any additional contributions required as a result of investment shortfalls.
  • While there is a strong case for clarifying the ownership rights to investment surpluses that may emerge in DB plans, the argument that sponsors are entitled to plan surpluses because they bear all of the downside risk of investment performance may not withstand closer scrutiny.
  • Yet, DB plans are not just DC plans in disguise. Even if members of DB plans bear substantial investment risk, there is a fundamental difference between risk bearing in DB and in DC plans. In DB plans, unlike DC plans, there exists the possibility of intergenerational risk sharing.
  • In a DB plan, but not in a DC plan, the financial consequences of the adverse investment outcome would be shared by all members of the plan. The potential for intergenerational risk sharing in DB plans is an important and an attractive feature of these plans.

The paper focuses attention on the uncertain state of our knowledge regarding the manner in which wages or other forms of compensation are traded off for pensions in DB plans. The author also reminds the reader that based on economic analysis, employees ultimately bear the cost of DB (and DC plans), even if the employer and the employee ostensibly share these costs.