Defined Benefit Plans & Defined Contribution Plans (CFA III) – 2

In our previous blog on pensions, we discussed defined benefit plans, defined contribution plans, cash balance plans, and profit sharing plans. We discussed funded status, ABO, PBO, future liability, retired lives, and active lives.

It is vital for the CFA III curriculum to understand the difference between defined contribution plans and defined benefit plans in more detail:

In a defined benefit plan:

  • The employee receives periodic payments beginning at retirement based on an eligibility date formula
  • Does not bear the risk of portfolio performance or market movements
  • Receives stable retirement income
  • Usually faces a vesting period and faces a restricted withdrawal of funds
  • There is an adverse effect on diversification because both job and pension are linked to employer health
  • Employee is subject to early termination risk if employee is terminated prior to retirement
  • The employer is responsible for managing the plan assets to meet pension liabilities
  • The employer thus takes investment risk
  • Benefits are determined by stated criteria usually associated with years of service and salary at retirement
  • Pension benefits are a liability
  • Regulated by ERISA and state governments

In a defined contribution plan:

  • The employee bears all the investment risk
  • Legally owns all personal contributions, and owns all sponsor contributions once vested
  • DC plan lowers taxable income
  • Employee must make all investment decisions for his/her retirement
  • Employee must decide on asset allocation and risk tolerance
  • There is restricted withdrawal of funds
  • Employee owns plans assets and can move assets to other plans
  • The employer must offer employees a sufficient variety of investment vehicles
  • The only financial liability is making contributions to the employee account
  • Has lower liquidity requirements
  • Has fewer regulations to deal with, but is usually required to have an IPS that addresses how plan will help employees meet objectives and constraints
  • Defined contribution plans also come in 2 forms, participant-directed and sponsor-directed (profit sharing)
  • In a profit sharing plan, the employer decides the investments

A plan is considered qualified in the U.S. if it meets federal and state tax laws for retirement funds.

Defined benefit plan objectives include:

  • Returns: To have pension assets generate returns sufficient to cover liabilities
  • Return requirement depends on funded status and contributions based on accrued benefits
  • Also determined by future pension contributions: return levels can be calculated to eliminate the need for contributions to plan assets, contribution minimization goal more realistic
  • Pension income should be recognized in the income statement
  • Plan Surplus: Indicates cushion provided by plan assets to meet liabilities
  • Greater the surplus, greater ability to take risk
  • Underfunded means decreased ability to take risk
  • Risk: Common risk exposure measured by correlation between firm’s operating characteristics and pension asset returns
  • Lower the correlation, higher the risk tolerance
  • Higher the correlation, lower the risk tolerance
  • Financial Condition: Can be measured by debt-to-asset or other leverage ratios (debt-to-cap, debt-to-EBITDA), using sponsor’s balance sheet
  • Lower debt ratios imply better ability to tolerate risk
  • Higher debt ratios imply lower ability to tolerate risk
  • Profitability: Can be represented by current or pro former financials
  • Workforce: Age of the workforce and ratio of active to retired lives is a strong indicator of performance
  • Usually the younger the workforce, the greater the ratio of active to retired, increased ability to tolerate risk
  • When older, lower rate of active to retired and higher risk
  • Plan Features: Some offer option of either retiring early or receiving lump-sum payments instead of a retirement annuity

Defined benefit plan constraints include:

  • Liquidity: Pension plans receives contributions and payments to beneficiaries…any outflow represents liquidity constraint.
  • Liquidity is affected by the number of retired lives; greater the #, the more liquidity is needed
  • The amount of sponsor contributions; smaller the contributions, the greater the liquidity need
  • Plan features; early retirement features would increase liquidity need
  • Time horizon: mainly determined by whether the plan is a going concern and workforce age and ratio of active to retired lives
  • Legal & regulatory: ERISA, the Employee Retirement Income Security Act regulates defined benefit plans, above state and local pension law
  • Pension fund assets should be invested for the sole benefit of the participant, not the sponsor
  • Pension funds have to exercise diligence before alternative asset classes can be added to asset base
  • Pension plans may prohibit investment in traditional asset choices like investments in defense industry, firms that produce alcoholic beverages, or firms that have a reputation for being destructive to environment

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