What is a Defined Benefit Retirement Plan?

LAGERS is a defined benefit retirement plan. Defined benefit plans are also referred to as pensions. The benefits from these plans are “defined” because they pay a pre-determined amount for a person’s remaining life after work. Individuals participating in the plan do not direct their own investments; rather, the funds in the plan are pooled together and invested in one portfolio that is managed by professionals. Returns from the investments are used to help pay for the benefits. Defined benefit plans are the preferred retirement plan in the public sector where 75% of state and local government workers in the U.S. participate in these plans.

Participants in defined benefit plans must meet certain criteria in terms of their age and how long they have worked to gain access to their benefit. The criteria varies from plan-to-plan, as each plan will designate the amount of work required to be eligible for a benefit (called “vesting”) and a retirement age. For example, a participant who has reached age 60 and has participated in the plan for at least five years would be eligible to start receiving a retirement benefit. Most plans also offer a reduced retirement benefit available at an early retirement age, and some even provide disability and death benefits.

How Defined Benefit Plans Work

Defined benefit plans pay a retiree an amount, usually for their lifetime, based on the person’s working career. The amount of the benefit is known ahead of retirement because it is either a specific amount (e.g. $500 per month), or it is determined using a formula. LAGERS’ benefits are determined using a formula. Formulas vary from plan-to-plan, but LAGERS’ formula includes the months a person works and the person’s working salary. Because retirement benefits increase the longer a person works, defined benefit pensions help build a loyal workforce and decrease employee turnover.

Here is an example of LAGERS’ defined benefit pension formula:

0.015 x $3,000 (monthly salary) x 25 years of work = $1,125 per month

Formulas for pension benefits can be much more complex than the LAGERS’ example shown here. Some formula components change with the number of years of participation, the date the employee was hired, or the age the employee retires. Because of the hazards associated with public safety jobs (police, fire, EMS), retirement plans for these workers typically offer lower retirement ages and/or increased benefits. In LAGERS, police and fire employees may retire at age 55 rather than age 60.

How Defined Benefit Plans Are Funded

Defined benefit plans typically have three sources of funding: contributions from the employer, contributions from the employees, and the investment returns of the pension fund’s portfolio. The investment returns of the portfolio are normally the largest source of funding for the plan.

Employer Contributions

The employer’s contribution is determined by an actuary and will vary from year-to-year based upon economic and demographic factors. An actuary is a business professional who is highly trained in the measurement of risk and uncertainty. It is imperative that the full contribution recommended by the actuary is put into the plan each year. Plans that receive the full annual contribution are in the best position to meet all of their obligations now and into the future. Missouri state law requires that all employers participating in LAGERS make their full contributions each month. This is the primary reason LAGERS continually ranks in the top 10% of U.S. public pension plans in terms of funding.



Employee Contributions

Employers participating in LAGERS may choose whether their employees will contribute toward their LAGERS benefits. Employee contributions to LAGERS are a specific percentage of the employees’ salary. These contributions are used to help fund the future retirement benefit and do not impact the amount the employee will receive in the future. The employees’ accounts earn a set amount of interest annually. Though the employees’ money is invested in the same portfolio as the employer’s money, the employee does not take on the risk of losing their money in the markets and does not receive the same rewards for strong market performance. Instead, the employer sponsoring the plan receives the risks and rewards of investing in the markets.



Investment Returns

The contributions received from the employers and employees are invested in the markets in order to help fund the retirement benefits of the participants. Investment returns, though they vary from year to year, are LAGERS’ largest funding source. The investment returns of the pension fund will vary based upon the asset allocation of the portfolio, market performance, and the talent of the professionals managing the funds. Because market returns are unpredictable, LAGERS smooths annual gains and losses over a five year period in order to add stability and decrease volatility.

Defined Benefit Plans Promote Retirement Security

Retirement planning is difficult for the average American. Financial products are confusing; investing in the markets is risky; and education is lacking. Investing for retirement is not easy, and low-to-middle income workers are affected the most because they may not have the means to set aside enough to support themselves during retirement. In fact, 87% of Americans say retirees don’t know enough about managing investments to make their savings last.

Defined benefit plans help take some of the guesswork out of retirement planning by providing a stable lifetime income base. Retirees don’t have to worry about running out of money because benefits from a defined benefit plan are paid for life, and studies show that defined benefit plans help keep older Americans out of poverty and off of public assistance programs.

That’s not to say defined benefit plans are a silver bullet for retirement. Workers participating in these plans still must plan appropriately for the future in order to ensure they will be able to maintain their standard of living during retirement. LAGERS’ defined benefit plan provides a modest monthly benefit that must be combined with other sources of income to safeguard participants’ financial independence.

Defined Benefit Plans are Good for Everyone

Defined benefit plans are a tool for government employers to attract good workers who provide valuable services to the taxpayers, keep those workers during their most productive years, then provide a dignified exit from the workforce. The amount of a benefit is tied to longevity, so defined benefit plans discourage turnover. Defined benefit plans also help employees retire when they should. This is good for the employer so they can avoid the additional costs incurred when employees stay on the job too long.

All of these advantages of a defined benefit retirement plan are good for the taxpayers as well. Taxpayers want well maintained streets, good parks, healthy businesses, and great public safety. These things are a product of well-trained, experienced, and motivated public workers. Plus, nine in ten retired Missouri local government workers remain living in the towns they served while working and reinvest in their communities by spending their pension payments on local goods and services.

Facts About Defined Benefit (DB) Plans:

How are benefits determined?

Retirement benefit amounts are not based on a participant’s account balance, investment decisions, or market performance. Benefits are based on a formula that provides a monthly benefit that is a direct reflection of the participant’s actual career. Key components of the formula are length of service and salary.

How is a DB plan funded?

Defined benefit plans like LAGERS are funded through three sources: Employer contributions, employee contributions (if employer requires), and the investment return of the system. Investment return of the LAGERS system is the largest source of funding. LAGERS used the “level contribution method” which equalizes contributions between the generations. This way, retirement benefits are paid for by the time the member retires.

Who is responsible for investment decisions?

Who bears the investment risk?

What protections do employers have from rising contribution rates?

What about plan fees and administrative costs?