Types of investors, and DB vs DC pension plans

How do investors differ?

Every investor can be described by four things: the time horizon, the risk tolerance, the income needs and the liquidity needs. These feed the planning step of the process, and they are set mainly by what the money has to pay for. Investors split into two broad groups.

Investorssorted by who owns the money

• Individual investors Know the idea life stage sets every need; often saving through a DC plan
• Institutional investors Memorize pooled money with its own liabilities or purpose
  • Defined benefit pension plans Memorize long horizon; pay retirees
  • Endowments and foundations Memorize perpetual; fund a mission
  • Banks Memorize short horizon; deposits can leave any day
  • Insurance companies Memorize invest premiums to pay claims
    • Life insurerslong horizon
    • Property and casualty insurersshort horizon
  • Investment companies Know the idea run funds; must meet redemptions
  • Sovereign wealth funds Know the idea state-owned; no specific liabilities

What do individual investors need?

Individual investors (also called retail investors) invest for many reasons. Short-term goals include a child’s education, a car or a house. The big long-term goal for most is retirement income. A young saver may seek growth and capital gains; a retiree may need income and so hold more fixed income and dividend-paying shares. Because circumstances differ so much, their horizon, risk tolerance and needs all vary by individual.

Many employees save for retirement through a defined contribution plan, covered below. Wealthier individuals often want more customized solutions together with tax and estate planning.

What do institutional investors need?

Institutional investors pool money for a defined purpose. The main kinds are below. Learn the needs table in the memorize card, because the exam asks “which investor most likely has…”.

• Defined benefit pension plans are company-sponsored plans that pay a predefined benefit on retirement. Their horizon is long (indefinite if new members join, finite if the plan is closed) and risk tolerance is quite high. A mature plan with many retirees needs high income, while a young plan has low income needs. Liquidity needs vary with the plan’s maturity. Some plans match assets to liabilities, for example with bonds whose cash flows meet the expected pension payments.
• An endowment is a fund held by a non-profit institution, such as a university, to support its services. A foundation is a grant-making entity. Both usually have perpetual lives, a very long horizon and high risk tolerance. Their goal is typically to keep the real (inflation-adjusted) capital value of the fund while paying out income for the mission. Liquidity needs are low, which is why they hold large amounts of alternative investments.
• A bank accepts deposits and lends. Excess reserves go into conservative, very short-duration fixed income. The horizon is short, risk tolerance is low, and liquidity is paramount because depositors can ask for their money back.
• An insurance company invests premiums to pay claims. Life insurers have long-term liabilities and long horizons; property and casualty (P&C) insurers have short horizons. Risk tolerance and income needs are low and liquidity needs are high, because claims must be met. The general account is invested conservatively in diversified fixed income, while the surplus account (assets minus liabilities) targets a higher return and can hold equities, real estate and alternatives.
• An investment company runs pooled funds such as mutual funds. Horizon and risk tolerance depend on the fund, but liquidity needs are high because investors can redeem.
• A sovereign wealth fund (SWF) is a state-owned investment fund, often funded by commodity revenue or reserves. It does not typically manage specific liabilities such as pensions. Horizon and objectives vary with the government’s goals.

Go deeper Today versus tomorrow in endowment spending

A high payout helps today’s students and researchers but leaves less for later generations, and a low payout does the reverse. A spending rule settles that tug of war: the institution gets a budget it can plan around, and the fund keeps its value after inflation. The long-run payout rate is the target, and smoothing lets actual spending catch up with market swings slowly.

Sort each investor by horizon and liquidity need. Then flip to the DB versus DC tab to see who absorbs a market fall.

How do defined benefit and defined contribution plans differ?

Memorize

In a defined benefit pension plan (DB plan) the sponsoring company specifies the benefit owed to its employees, usually through a formula: years of service × final salary × an accrual rate. The employer pays the contributions and bears the risk of funding the benefit, so poor investment returns are the employer’s problem. The plan manager invests so that enough assets will be there when pensions fall due.

In a defined contribution pension plan (DC plan) the account is in the employee’s name, usually funded by both employee and employer. Only the contributions are defined. The employee accepts the investment and inflation risk and is responsible for building enough assets for retirement. Examples are 401(k) plans in the United States, group personal pension schemes in the United Kingdom and superannuation in Australia.

Pension planswho carries the investment risk?

• Defined benefit (DB) Memorize the employer promises the benefit
  • Sponsor bears the investment and funding risk
  • Benefit set by a formula years of service × salary × accrual rate
• Defined contribution (DC) Memorize only the contributions are defined
  • Employee bears the investment and inflation risk
  • Pot belongs to the employee usually chosen from a menu of funds

$$P = a \times Y \times S$$

Here $a$ is the accrual rate per year of service, $Y$ the years of service and $S$ the final salary.

Exam tip DB: the employer carries the risk. DC: the employee carries it.

Go deeper Why sponsors are moving from DB to DC

Plan sponsors increasingly prefer DC plans because they cost the company less and carry less risk: a DB plan leaves the sponsor with the funding risk, while a DC plan moves it to employees. As a result DB plans have been losing market share of pension assets to DC plans, although they remain big sources of money for asset managers. The mix differs by country: some markets are heavily DC, others still mostly DB. Hybrid plans mix features of the two.