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This paper employs a lifecycle model from the consumption-savings literature to examine
the tradeoffs between defined benefit and defined contribution pension plans. We
examine the effects of varying risk aversion, varying initial income and financial wealth,
and varying wage processes (that may be correlated with returns on the risky asset).
Results indicate that wage-indexed claims are not an optimal vehicle for retirement policy
if the decision to participate is made early in life, because individuals hold most of their
wealth in their human capital and would not wish to increase their exposure to income
shocks. Later in life, after most of a worker’s human capital has been converted to
financial assets, defined benefit pension plans help increase diversification by reducing
exposure to financial market risk. The access that defined benefit plans provide to
annuities markets and possible guaranteed rates of return over the risk-free rate increase
the value of defined benefit plans to workers. The model also predicts that wage-indexed
claims will be more valuable when equity markets provide low expected returns or are
highly variable and when annuity markets are inefficient.
The model illustrates two economic functions performed by defined benefit plans.
Firstly, DB plans pool individual wage risks. This allows older workers to buy a wagelinked
security that increases their exposure to wage risks. Secondly, they create a group
annuities market that reduces the cost of adverse selection.
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