Preface: "Pension plan," as used in this chapter, will refer only to defined-benefit pension plans, not defined-contribution pension plans.
A defined-benefit plan is a traditional pension plan, where the benefit is defined as an annuity—$X a month for the rest of our life—or a cash balance pension plan, where the benefit is defined as a lump sum. In either case, the plan sponsor bears the entire risk or opportunity of investment results. The employee is entirely unaffected.
A defined contribution plan, such as a 401 (k) plan, is one where the employee bears the entire risk or opportunity of investment results. Within the investment options provided by the plan, the employee decides how his particular account will be invested.
First, what's similar about pension funds and endowments? Most things.
They both want the highest long-term return they can achieve within an acceptable level of risk. The process of developing their investment policy and asset allocation, and hiring and monitoring managers, is essentially the same, and so are the principles of governance. In fact, almost everything written in the first eight chapters of this book applies to pension funds as well as endowment funds.
So what's different (besides the fact that private pension plans are governed by ERISA)? A pension plan's definition of risk should be different. For the endowment fund, risk is the volatility in the market value of its portfolio. For pension funds, risk is the possibility that the plan won't be able to pay all promised pension benefits to retirees. As long as the plan sponsor remains solvent, that's not much of a risk, because if pension assets fall short of pension liabilities, the plan sponsor must make higher contributions to the pension fund. So risk for the plan sponsor is just that—the possibility of the sponsor having to make greater contributions to the pension fund, perhaps suddenly much higher.1
A measure of risk for the pension plan therefore is its funding ratio— the ratio of the market value of plan assets to the present value of the plan's liabilities, and both change from year to year. That's because a declining funding ratio means the plan sponsor will have to come up with higher contributions to the plan.
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