Replicating Default Risk in a Defined-Benefit Plan

Abstract

A stock-bonus plan with a provision to permit diversification can come close to replicating the classic default risks in defined-benefit pension plans. The diversification formula is a function of a worker's service in the company and the particular features of the defined-benefit (DB) plan that are being reproduced. The diversifiable stock-bonus (DSB) plan still gives workers a stake in the financial performance of the company, but the diversification formula eliminates the extreme downside of a traditional stock-bonus plan, namely, the possibility that workers could lose up to all of their retirement accounts after long years of service. Because the DSB plan imposes about the same default risks on workers as a DB plan, workers' compensation levels with a DSB plan need not be any higher than in a traditional pension plan.