In a DB plan, the CIO and investment team pool assets and investment policy. They invest with an outcome in mind: not a pot of money, but the ability to pay each retiree a pre-determined pension, usually something like 60% of average pay over a period of years.
In a 401(k), however, participants are on their own, deciding asset allocation and rebalancing time frames. Managers must be selected from the platform the employer has selected. And when participants reach a certain age, they must begin depleting the savings whether or not it's needed.
The power of pooling longevity risk is simple: Those who die early subsidize those who live long.
When a chief investment officer invests the assets of a DB plan, she is using actuarial formulas to target a final payout. She can confidently estimate, through actuarial large numbers analysis, how long individuals in her plan will live.
This allows her to plan properly what her needs will be for liquid assets when payments are due, and for less liquid riskier assets that can be used to meet liabilities that are further away.
An individual in a DC plan is alone. If she takes time to look up actuarial tables and sees that the average age of death is 85, she might make a rational plan to spend down her funds until she dies at 85. But what if she gets to 85 and is in good health. She took the time to plan actuarially but she wasn't in an actuarial situation. She was in an individual situation. She has to plan to live to be 100! And if she does get to 100 she'll have to plan for 110!
DC plan participants face another risk, the sequence of payments risk.
This is the risk that every individual in a DC system faces: What if the markets crash right before she retires? Many individuals faced this very question at the end of 2008 and the beginning of 2009. According to the Employee Benefit Research Institute, the average 401(k) account balance of those age 55-64 with more than 20 years in their plan decreased by 25% in 2008. Someone who retired then would have 25% less to live on in retirement.
But in a collective DC plan, a professional CIO and staff would have stayed focused on the long term, so they could pay benefits to the 2008 retiree and to the thousands of participants who were still decades away from retirement.
The plan would pay the 2008 retiree the pension he was due. Just like the "risk" of living too long can be pooled for everyone, the risk of retiring at the "wrong" time can be pooled and shared equally. The pooled plan is not going to pay more to person who is lucky enough to retire when markets are up, or less to the person who retires when markets are down.