Defined Benefit Pension Plans: Cost of Living Adjustments and Membership Heterogeneity

Abstract

In this paper we explore different structures for cost of living adjustments (COLA), based on Hardy et al. (2020)’s five significant criteria: affordability, sustainability, efficiency, adequacy, and fairness. Full COLA protects plan members’ real income after retirement but leads to high costs and solvency risks. A two-tier COLA method, as an alternative, moderates the risks and protects low-paid members’ benefits. We provide a new insight using a heterogeneous pension plan model, consisting of equal populations of blue-collar (lower-paid) and white-collar (higher-paid) members. We further modify the existing benefit structure of the heterogeneous plan to achieve a DB pension plan conforming to the five criteria.