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.
(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.
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.