Why Does It Matter? Allocating Risk and Reward Between Employer and Employee

Abstract

It is useful to divide retirement-related risks into three broad categories: investment risk, funding risk, and longevity risk. Investment risk is the risk that retirement resources will earn an inadequate rate of return. Funding risk is the danger that the funds necessary to finance adequate retirement benefits will not be contributed to the plan. For both these categories, defined benefit arrangements place responsibility upon the employer for financing the benefits promised by the plan. Defined contribution arrangements shift the investment and funding risks to the employee. Longevity risk is the danger that a retiree will outlive his retirement resources. The traditional, annuity-paying defined benefit plan provides partial protection against this since such a pension disburses retirement payments periodically and continues such annuity-type payments until the participant's death, often with payments continuing to the participant's surviving spouse. While the defined contribution participant can eliminate his longevity risk by annuitizing his account balance, such individually-purchased annuities typically suffer from the cost-related problem of adverse selection.