Risk Allocation in Retirement Plans: A Better Solution

Donald E. Fuerst

Journal of Applied Corporate Finance, 2006, vol. 18, issue 1, 95-103

Abstract: The corporate world is reconsidering the cost‐effectiveness of defined benefit pension plans while contemplating a change to defined contribution plans. This article begins by examining the three primary risks faced by sponsors of most DB pension plans—investment risk, interest rate risk, and longevity risk—and shows how shifting these risks to employees through a DC plan would affect both the corporation and the individual. Although DC plans clearly help companies manage risks, they provide at best an incomplete solution for individual participants. This article describes an innovation in pension design—the Retirement Shares Plan (RSP)—that combines many of the best features of DB and DC plans. An RSP provides: • predictable and stable cost to the plan sponsor, with little chance of unfunded liabilities; • lifetime income, guaranteeing that retirees will never outlive their benefits; • a benefit accrual pattern comparable to that of traditional pension plans that preserves value for older, long‐service employees; and • potential inflation protection for retirees. The RSP accomplishes this by allocating risk to sponsors and individuals differently than either a traditional DB plan or a DC plan. Unlike most DB plans, the RSP shifts investment and interest rate risks from plan sponsors to participants. Unlike DC plans, the RSP keeps longevity risk with the sponsor.

Date: 2006
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Journal of Applied Corporate Finance is currently edited by Donald H. Chew Jr.

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