DC versus DB pensions

This article attempts to contrast the differences between defined contribution pension plans (DC) and defined benefit pension plans (DB).

The type of pension plan most people are familiar with is called a defined benefit pension plan or DB plan. The most common example is the Canada Pension Plan (CPP), to which contributions are made with the expectation of a known future payout. Many employers, however, now offer a defined contribution pension plan or DC plan, to which moneys are contributed and which is invested on behalf of the contributor. The final sum available to fund retirement then depends on the investment returns obtained.

Background
Traditional defined benefit pension plans have been in prolonged crisis, one whose roots were first exposed in the two recessions of 1980-82 and revealed more fully in the downturn of 1991. Those recessions most affected manufacturing companies with large workforces, first the steel industry, then companies such as IBM, extending now into the auto sector and the airline industry.

Such industries faced two challenges. The first was that, with restructuring, there was no longer a growing workforce to match the increasing number of retirees, whether long-timers or those who had taken early pensions. The solution would have been to raise contribution rates for new workers in what was treated much like a pay-as-you-go pension scheme (as, for many years, the Canada Pension Plan was). That structural problem was avoided, to some extent, by better rates of return offered by shifting the asset mix from bonds to equities. But that gravy train came to halt with the 2000-2002 bear market.

As pension burdens become increasingly problematic, companies are shifting to defined contribution pension plan. While DC plans provided startups in such industries as high-tech the flexibility to grow into mature companies without heavy upfront costs for pensions, they also exposed plan members to investment risk as well as longevity risk: inadequate retirement savings.

Increasingly, pension experts are examining a hybrid DC-DB plan with compulsory contributions.

How pension income is determined
Defined benefit pension plans provide a payment of a pre-determined amount based on factors such as years of service and salary.

Defined contribution pension plans payments are based on the contributions made and the investment return on the contributions.

Who carries the risk?
In a traditional DB pension plan, the plan sponsor bears the risk that the plan may not be sufficiently funded, and must top up any shortfall. The primary difference between a DB and DC pension plan is that, in the latter, the subscriber, not the sponsor, carries the risk. Thus, DC plan contributors who invested heavily in equities during a market crash, may have suffered a substantial drop in the value of their pensions. Because of the potential for a large drop, some DC plan sponsors may limit the equity percentage that subscriber can hold.

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