Pension Basics

Defined Benefit vs. Defined Contribution

There are really two types of pension plans: defined benefit and defined contribution. Defined contribution plans set a fixed amount for how much the employer, and usually employee, contribute each year.  For example, the employer, and possibly the employee, could be required to contribute 5% of salary each year.  This money goes into an individual account for the employee, and at retirement he or she receives all that was contributed plus the fund's investment returns.  Therefore, the benefit received in retirement can vary greatly depending on stock market  and how much money the employee might have personally contributed to the fund.  All that is guaranteed is the annual contribution.  In recent decades, this type of plan has become much more popular in the private sector and has replaced most traditional defined benefit schemes. 

Defined benefit plans are the more traditional systems in which an employee has a guaranteed pension benefit in retirement.  The employer, and usually the employee, make annual contributions to a pension fund, and the level of contribution changes each year depending on investment returns and funding status.  However, it is important to note that the employee gets the same benefit in retirement regardless of the fund's investment returns and contributions made.  This type of benefit plan has remained common among public employees.

Pension Formula

In a public employees' defined benefit plan, the amount a retiree receives from their pension is typically based on the formula:

 (Years of Service) X (Accrual Rate) X (Final Average Compensation or FAC)

The years of service is simply the number of years the employee worked for the employer offering the plan.  The accrual rate is a multiplying variable that can vary greatly from one plan to another, but is typically somewhere between 1% and 3%.  Final average compensation is an individual's average salary, typically in their last two or three years of employment.

Let's say an Ann Arbor firefighter retired after 30 years of employment making $70,000 in each of his or her last three years of service.  The Ann Arbor firefighters use a multiplier of 2.75%, so the annual pension would be calculated using the following:

30 X 2.75% X $70,000

So in retirement, this firefighter would be guaranteed $57,750 each year, or about $4,800 per month.  As this is a defined benefit plan, the city guarantees this amount regardless of the fund's condition or investment returns.  If the investments perform poorly the city must put more money into the plan to sustain the pension. If ultimately the city fails to make the payments necessary to sustain the plan the State of Michigan is on the hook to fund the plan.

Funding Public Pensions

Determining what is required to fund a pension involved very complicated math that is performed by an actuary.  A few important variables used in these calculations are the number of member in the plan, the number of years members expected to work, members wages, and expected investment returns.  An actuary takes all of these factors into account and determines how much money needs to be put into the plan each year to fund future benefits.

A few important numbers when thinking about pension funding are the actuarial value of assets, the actuarial accrued liability (AAL), the unfunded actuarial accrued liability (UAAL), and the annual required contribution.  The actuarial value of assets is the estimated amount of money in the plan, and the actuarial accrued liability is what is the estimated amount of money needed to fund the plan at a given time.  The difference between these two numbers is the underfunded actuarial accrued liability.  When the actuarial value of assets is equal to the AAL, a plan is considered fully funded for that given year.  Annual required contribution is what is required to keep a plan fully funded based upon the actuary's assumptions.  As long as the annual required contribution is made each year, the actuarial value of assets and the actuarial accrued liability remain equal and the plan stays fully funded.

It is important to keep in mind that as investment markets rise and fall and the actuaries change there assumptions each year, so do these numbers.  For example, if the stock market has an unusually good year, the actuarial value of assets will likely rise more than usual, and, in turn, one could expect the annual required contribution to decrease.  In a bad market year, one should expect the opposite.

Subpages (1): Corporate Pension Plans