Who bears the investment risk in 401(k) plans?

By Matt Lee AAA
A:

Who actually bears the investment risk in a pension plan depends on the type of pension plan that is employed. In a broad sense, there are two benefit formulas that will calculate the pension benefits the plan member will receive. In the case of a defined-contribution pension plan, the plan member (i.e. the employee) bears all of the investment risk.

The formula for calculating how much an employee under this type of plan will receive is simple, as it only calculates the amount that the plan member and the member's employer will contribute to the pension plan. The amount of cash that is in the fund when the plan member retires is what that person will receive as a pension. There is no guarantee that the plan member will get anything from this defined-contribution plan, as the fund may lose all of its value in the equities markets.

The other type of pension plan is called a defined-benefit pension plan. In this type of plan, the contribution amounts are determined by how much the plan member desires, or is eligible to receive upon retirement and how long the worker has until retirement. Once these figures are known, the contributions that are required to achieve that ending total are determined. In this type of pension plan, the benefits are guaranteed by the employer and, therefore, the company must also bear the investment risk. This investing strategy is called a liability driven investment strategy, and is a key feature of any defined benefit pension plan.

For more insight, see The Demise Of The Defined-Benefit Plan.

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