A defined benefit pension plan sponsor tells its investment committee that the plan is "fully funded" using a 7.5% discount rate. The same liabilities discounted at a high-grade corporate bond yield would show a 30% shortfall. Both calculations are defensible under different regimes. The choice of discount rate is one of the most consequential decisions in institutional investing, and it shapes everything from asset allocation to benefit security.
Pension plans evolved to solve a workforce-retention problem and a longevity problem. Employers offered deferred compensation to encourage long careers and provide retirement income. Tax-favored treatment made pensions a major channel of retirement savings, since contributions and gains grow tax-deferred until withdrawal.
The curriculum names three basic types of pension plans:
- Defined benefit (DB) plans promise a formulaic benefit (typically years of service times final-salary average). The employer takes all investment risk.
- Governmental social security plans provide retirement income to previously employed citizens funded by required contributions.
- Defined contribution (DC) plans specify the contributions going in but leave the benefit dependent on investment outcomes.
Common mistakes
- Confusing DB and DC risk-bearing. DB sponsors bear investment and longevity risk for employees. DC participants bear both. Any scenario describing "participant-directed DB" or "sponsor-guaranteed DC" is a non-standard hybrid. Trap: answer choices labeling a traditional DC plan as "longevity-protected" are wrong.
- Misreading the progressive social-security system. Social security caps earnings, so low earners get a higher replacement ratio than high earners (roughly 82% lowest quintile versus 23% highest quintile in the CBO study). Trap: a choice claiming benefits rise proportionally with income misreads the progressive design and the system's portable service-credit mechanics.
- Assuming annuities are strictly inferior. A lifetime immediate annuity eliminates longevity risk but leaves no residual for heirs. A deferred annuity (longevity insurance) costs less and covers advanced age. Trap: the choice claiming "annuities always destroy value versus systematic withdrawals" ignores longevity, bequest motive, and the immediate-versus-deferred trade-off.
Bottom line
- Pension risk is measured three ways (asset-focused, asset-liability, integrated); allocation splits into a hedging bucket (duration matching, cash flow matching, or overlay) plus a growth bucket.
- Three basic plan types (DB, social security, DC) plus the cash balance hybrid: DB shifts investment and longevity risk to the sponsor, DC shifts both to the participant.
- Equity above surplus is a risk-return choice, not a fix for a funding gap.
- Government social security is progressive with earnings caps, giving low earners a higher replacement ratio (82% lowest quintile vs 23% highest); benefits are portable.
Exam shortcut
DB equals sponsor risk; DC equals participant risk. Identify the plan type first and most answers follow. If a sponsor claims "fully funded," audit the discount rate: corporate plans use a corporate bond yield, while public plans use the required return that flatters the balance sheet.
The full lesson (about 5,358 words, 36 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- institutional owners
- saa risk return
- aa objectives constraints
- ips purpose roles
- ips return risk spending
- ips aa manager selection
- defining endowments
- intergenerational equity
- endowment model
- large endowment performance
- endowment risks
- liquidity rebalancing taa
- tail risk
- pension development types
- pension risk tolerance aa
- defined benefit
- social security
- db vs dc
- annuities retirement
- sovereign wealth sources
- swf types
- swf establishment mgmt
- swf governance political
- swf analysis three
- identifying family offices
- fo goals benefits models
- fo generational goals
- fo macro exposures
- fo income taxes
- fo lifestyle assets
- fo governance
- charity philanthropy
- goals based investing
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