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http://ssrn.com/abstract=227397
 
 

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Defined Benefit Versus Defined Contribution Pension Plans: What are the Real Tradeoffs?


Zvi Bodie


Boston University - Department of Finance & Economics

Alan J. Marcus


Boston College - Department of Finance

Robert C. Merton


MIT Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

October 1985

NBER Working Paper No. w1719

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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Date posted: April 27, 2000  

Suggested Citation

Bodie, Zvi and Marcus, Alan J. and Merton, Robert C., Defined Benefit Versus Defined Contribution Pension Plans: What are the Real Tradeoffs? (October 1985). NBER Working Paper No. w1719. Available at SSRN: http://ssrn.com/abstract=227397

Contact Information

Zvi Bodie (Contact Author)
Boston University - Department of Finance & Economics ( email )
595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-4160 (Phone)
617-353 6667 (Fax)
HOME PAGE: http://smgnet.bu.edu/mgmt/profiles/BodieZvi.html
Alan J. Marcus
Boston College - Department of Finance ( email )
Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)
Robert C. Merton
MIT Sloan School of Management ( email )
77 Massachusetts Avenue
E62-634
Cambridge, MA 02139-4307
United States
617 715 4866 (Phone)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Harvard Business School - Finance Unit ( email )
Boston, MA 02163
United States
617-495-6678 (Phone)
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