Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches 10th Edition by Allen, Joseph Melone, Jerry Rosenbloom, Dennis Mahoney

Exercise 3

The text suggests that a private pension plan allows the burden of retirement security to be spread out over a long period of time. Discuss how this specifically applies in the case of investment risk. Assume that there are only two forms of investments for retirement: a risk-free asset with a known rate of return, and a risky asset with a higher expected rate of return. Unfortunately, the risky asset may experience large decreases as well as increases in any particular year. If employees were to invest for their retirement on an individual basis, why might they be willing to choose the risk-free asset, knowing their expected accumulation at retirement will be smaller? In contrast, if employees allowed the employer to invest for their retirement through a defined benefit pension plan (in which the employee's retirement benefit is guaranteed regardless of the level of the pension assets), would the employer be as likely to choose the lower yielding, risk-free asset for the pension plan? (Hint: What is the relevant investment horizon for a pension plan if it is assumed to be an ongoing operation?)