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FRM Part I · FRM Exam Part I · Insurance Companies and Pension Plans

A company's pension plan promises each retiree an annual payment equal to 1.5% of final salary for every year of service. Investment returns on plan assets fall well below expectations. Who bears the shortfall risk, and what type of plan is this?

The plan is a defined benefit plan, because the benefit is fixed by a formula based on salary and service. The employer sponsor must make up any investment shortfall, so the sponsor bears the investment risk rather than the employee.

  1. AThe employee bears the risk; it is a defined contribution plan
  2. BThe employer (sponsor) bears the risk; it is a defined benefit planCorrect
  3. CThe employee bears the risk; it is a defined benefit plan
  4. DThe employer bears the risk; it is a defined contribution plan

Explanation

A formula-based promised benefit defines a defined benefit plan. The sponsor must fund the promised benefits, so investment shortfalls fall on the employer. In a defined contribution plan the employee carries investment risk, so the other options mismatch plan type and risk bearer.

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