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FRM Exam Part I · Insurance Companies and Pension Plans

Defined Benefit vs Defined Contribution Pension Plans

Updated 11 October 2026 · Fact-checked

A defined benefit (DB) plan promises a formula-based retirement income, usually from final salary and years of service, so the sponsor bears investment and longevity risk. A defined contribution (DC) plan fixes contributions, and the employee bears those risks. To solve questions, identify the plan type, then who carries each risk.

Understand Pension Plan Basics: Defined Benefit vs Defined Contribution

A pension plan is a way for an employer (the sponsor) and employees to set money aside for retirement. The two main designs differ in what is fixed: the benefit or the contribution.

In a defined benefit (DB) plan, the employer promises a retirement benefit set by a formula. The formula usually uses years of service and salary, often final salary or an average of the last few years. The sponsor pays contributions into a fund and must make sure enough assets exist to pay the promised benefits. If investments underperform or retirees live longer than expected, the sponsor must pay more. So the sponsor bears investment risk and longevity risk. The employee still faces some risk, such as the sponsor failing.

In a defined contribution (DC) plan, the contribution is fixed, often a percentage of salary, sometimes with an employer match. Each employee has an individual account. The retirement benefit is whatever the account is worth at retirement. Poor returns mean a smaller pot. Living longer than the money lasts is also the employee's problem. So the employee bears investment risk and longevity risk. In the US, 401(k) plans are a common DC example.

DC plans are simple, portable when you change jobs, and easy to fund for the sponsor, since there is no open-ended liability. Their weakness is that retirement income is uncertain, and employees may save too little or invest poorly. DB plans give predictable income and pool longevity risk, but create balance sheet liabilities, funding risk and sponsor risk for the employer.

For the exam, think in terms of liabilities. A DB plan creates a liability for the sponsor, equal to the present value of promised benefits. A DC plan creates none beyond the contributions made.

Key formulas to remember

DB annual pension (final salary)
Annual pension = accrual rate × years of service × final salary
Accrual rate is a percentage per year of service, for example 1.5% or 2%. Final salary may be an average of the last few years if the question says so.
DB replacement ratio
Replacement ratio = annual pension ÷ final salary
With a flat accrual rate this equals accrual rate × years of service.
DC account value at retirement
FV = Σ contribution_t × (1 + r)^(N − t)
For level end-of-year contributions C: FV = C × [(1 + r)^N − 1] ÷ r.
Risk allocation rule
DB: sponsor bears investment and longevity risk. DC: employee bears them.
Remember the exceptions: DB employees still face sponsor default risk, and DC sponsors face none of the funding risk.

How to solve Pension Plan Basics: Defined Benefit vs Defined Contribution questions

Use this method for any question on DB versus DC plans.

  1. 1Read what is fixed. If the benefit is promised by formula, it is DB. If the contribution is fixed and the benefit depends on the account, it is DC.
  2. 2Identify who bears investment risk and longevity risk. DB: sponsor. DC: employee.
  3. 3If a calculation is asked for a DB plan, find the accrual rate, years of service and the salary base (final or average).
  4. 4Multiply: accrual rate × years × salary base. Check whether the answer is annual or monthly.
  5. 5If a calculation is asked for a DC plan, compound each contribution at the stated return, or use the annuity formula for level contributions.
  6. 6Check the question for a twist, such as a salary growth rate, a cap on service years, or a sponsor default.
  7. 7Pick the option that matches the risk allocation and the number you computed.

Quickest way: Fix what is fixed, then follow the risk

When to use it: Use for conceptual multiple-choice questions on plan comparison and for fast DB benefit calculations.

  1. Ask: is the benefit or the contribution guaranteed? That decides DB or DC in seconds.
  2. Assign risk: whoever has the guarantee carries the risk. The DB sponsor guarantees the benefit, so it bears investment and longevity risk.
  3. For calculations, do accrual × years × salary and compare with the options.
  4. Eliminate options that swap the risk bearer or confuse annual and total figures.

Common mistakes in Pension Plan Basics: Defined Benefit vs Defined Contribution

  • Saying the employee bears investment risk in a DB plan.

    Students think the employee always owns the investment outcome.

    Fix: In DB, the promise is fixed. The sponsor must top up the fund if assets fall short, so the sponsor bears investment risk.

  • Forgetting longevity risk in DC plans.

    Candidates focus on market returns only.

    Fix: In DC, the employee may outlive the account balance. Longevity risk sits with the employee unless an annuity is bought.

  • Using starting salary instead of final salary in a DB calculation.

    Candidates rush and take the first salary figure in the question.

    Fix: Check the salary base the plan uses: final salary, or an average of the last years if stated.

  • Mixing up the accrual rate with a total percentage.

    A rate such as 2% is read as the full pension rather than the rate per year of service.

    Fix: Multiply the rate by years of service. 2% × 30 years = 60% of salary.

  • Assuming DB employees face no risk at all.

    The sponsor guarantee sounds absolute.

    Fix: Employees still face sponsor default risk if the plan is underfunded and the sponsor fails, though protections may exist depending on jurisdiction.

Worked examples

Example 1

A DB plan pays an annual pension of 1.5% of final salary for each year of service. An employee retires after 32 years with a final salary of $90,000. What is the annual pension, and what is the replacement ratio?

Show the solution
  1. Formula: pension = accrual rate × years × final salary.
  2. Replacement ratio = 1.5% × 32 = 48%.
  3. Pension = 0.48 × $90,000 = $43,200.

Answer: Annual pension is $43,200, a replacement ratio of 48%.

Example 2

An employee in a DC plan contributes $6,000 at the end of each year for 20 years. The account earns 5% a year. What is the balance at retirement, and who bears the risk that returns fall short?

Show the solution
  1. Formula: FV = C × [(1 + r)^N − 1] ÷ r.
  2. (1.05)^20 = 2.6533.
  3. (2.6533 − 1) ÷ 0.05 = 33.066.
  4. FV = 6,000 × 33.066 = $198,396 (approximately).
  5. In a DC plan the benefit equals the account value, so lower returns reduce the employee's pension.

Answer: The balance is about $198,400. The employee bears the investment shortfall risk.

Exam tips

  • Start every conceptual question by asking what is guaranteed. Risk follows the guarantee.
  • Read DB calculations for the salary base and whether the answer is annual or monthly.
  • Expect answer options that swap the sponsor and employee roles. Check each risk carefully.
  • For DC questions, a financial calculator helps: enter N, I/Y, PMT and compute FV.
  • Remember DB plans create a sponsor liability, which links to funding and sponsor risk questions.

Practice questions from Insurance Companies and Pension Plans

Pension Plan Basics: Defined Benefit vs Defined Contribution in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Pension Plan Basics: Defined Benefit vs Defined Contribution: frequently asked questions

What is the main difference between DB and DC plans?

A DB plan fixes the benefit by formula, so the sponsor funds it and bears the risk. A DC plan fixes the contribution, and the retirement benefit depends on the account value, so the employee bears the risk.

How is a defined benefit pension calculated from final salary?

Multiply the accrual rate by years of service and by final salary. For example, 2% × 25 years × final salary gives a pension equal to 50% of final salary. Some plans use an average of the last few years instead.

Who bears longevity risk in each plan?

In a DB plan the sponsor bears it, because the pension is paid for life. In a DC plan the employee bears it, because the account can run out if they live longer than expected.

What are the advantages and disadvantages of DC plans?

Advantages include portability, simple funding for the sponsor and no open-ended employer liability. Disadvantages are uncertain retirement income and employee exposure to poor returns, low saving and longevity.