Types of Retirement Plans

Defined Benefit Plan
  • A defined benefit plan, also referred to as a “pension,” is one option for an employer-sponsored retirement plan. 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 pensions 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 pension 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. An example would be 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. Employee participation in a defined benefit plan is often mandatory.

Defined Contribution Plan

  • A defined contribution plan is one where the retirement benefit is not known ahead of time. Rather, the employee and possibly the employer make contributions into an account for the employee. This account is invested in the markets with the individual employees choosing their preferred investment strategy. The employees are responsible for ensuring they save enough and make good choices with their investments. The amount of retirement income provided by these plans depends on the amount of assets the employee is able to accumulate in their account before retirement. These plans are preferred in the private sector where the 401(k) plan has gained popularity over the past three decades. While public sector employers cannot implement 401(K) plans, they may provide a 401(a), 457(b), or possibly a 403(b).
  • Defined contribution plans typically require the employee to work a specific number of years in order to be able to gain access to the funds the employer has contributed. This is called “vesting.” The employer can determine the vesting period. The employee is always 100% vested in their own contributions, however, there are federal regulations that place restrictions on when the employee can access their funds. Employee participation in a defined contribution plan is often optional to the employee.

Funding a Retirement Plan

Defined Benefit Plan

Defined benefit pensions 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.
  • Employee Contributions
    • Employee contributions to the plan are often a specific dollar amount or a specific percentage of the employee’s salary. These contributions are used to help fund the future retirement benefit and normally do not impact the amount the employee will draw in the future. The employees’ accounts typically 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 employer 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, often are the plan’s 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, public pension funds typically smooth gains and losses over a three to five year period in order to add stability and decrease volatility.

Defined Contribution Plan

The retirement benefits from a defined contribution plan may have three sources of funding: Contributions from the employee, investment returns, and, possibly, contributions from the employer.

  • Employee Contributions
    • Employees typically make their contributions to a defined contribution plan through a payroll deduction. The employee may choose, subject to limits defined by federal regulations, how much money to put into their plan. The employee is allowed to increase, decrease, or terminate their contributions to the plan as they see fit.
  • Investment Returns
    • Investment returns on the individual employees’ accounts will help fund their future retirement benefit from a defined contribution plan. The amount of returns the employee is able to achieve depends on the amount of risk the employee is willing to take, the asset allocation the employee chooses, how the employee adjusts that allocation throughout their career, and how the markets perform while the employee’s funds are invested. The employee receives the risk and reward for their own investment decisions.
  • Employer Contributions
    • The amount of money the employer contributes to the defined contribution plan is determined by the employer. The employer may adjust the amount of its contribution as they see fit. An employer may contribute money into an employee’s account automatically, regardless of whether the employee is contributing or, the employer may provide a “matching” contribution. This means that the employer will only make contributions to an employee’s account if that employee is also contributing. Employers also have the option to provide both an automatic contribution and a matching contribution in order to encourage stronger employee participation in the plan.

Comparing Retirement Plans


  • Advantages of Defined Benefit Plans for the Employer
    • Recruiting and Retaining Employees Since defined benefit plans are preferred in the public sector, a government employer that sponsors a defined benefit plan will be in a better position to attract quality workers. Defined benefit plans also encourage employees to remain with the same employer since the benefits are based upon the employee’s length of service.
    • Employer Can More Easily Set Retirement Income Objectives An employer with a defined benefit plan can more easily decide on what they believe is an appropriate amount of retirement income and design their plan to achieve the desired outcome since the retirement benefits are defined by a formula. This is more difficult with a defined contribution plan because of all the variables associated with the individual investment accounts.
    • Reduces The Risk of Employees Staying on the Job Too Long Employers suffer financially when employees continue to work into older ages. The costs of insurance, salary, and other benefits increase with age. Plus, productivity and morale can be negatively impacted when employees stay on the job because they cannot afford to retire. Many public sector jobs are also physically demanding. Offering an employee a plan that allows them to exit the workforce with dignity is a win-win for the employer and the employees.
    • Disability and Death Benefits Defined benefit plans typically provide disability and death benefits in addition to retirement benefits. This provides and extra layer of protection for employees should something happen to them prior to retirement. It also may prevent the employer from having to seek these types of benefits from other vendors at a higher cost.
  • Advantages of Defined Benefit Plans for the Employee
    • More Easily Plan for Retirement An employee with a defined benefit plan can more easily prepare for retirement since the amount of retirement income can be known ahead of time. This allows the employee to plan other sources of income around their pension benefit so they may create the retirement they desire.
    • Retirement Benefits Are Paid for Life Defined benefit plans pay a retiree a monthly benefit for their remaining lifetime so they need not worry about running out of money before they die. Most defined benefit plans also allow the retiree to choose from multiple payment options where benefits may be paid to a beneficiary after the retiree passes away.
    • Disability and Death Benefits Many defined benefit plans also provide disability and death benefits. This adds an additional layer of protection for the employee and the employee’s loved ones should they become disabled or pass away prior to retirement.
    • The Employer Assumes the Investment Risk for the Employees Employees with a defined benefit plan need not worry about losing money to swings in the markets because their benefits are defined by a formula and their employer is receiving the risks and rewards of market performance.
  • Advantages of Defined Contribution Plans for the Employer
    • The Employer Contributions are Flexible An employer offering a defined contribution plan determines the amount, if any, it will pay into employee accounts. The employer may change the amount of contributions as they see fit. However, in order for a retirement plan to be successful, the plan must provide adequate income in retirement for the employees. A minimal employer contribution will place employees at risk of longer working careers and inadequate retirement income.
    • The Employer Assumes Less Investment Risk The investment risk is completely owned by the employees participating in a defined contribution plan since each individual is directing their own investments. But, a defined contribution plan is not risk-free for the employer. The employer will have the risk of employees not adequately preparing for their own retirement and thus not being able to exit the workforce with dignity.
  • Advantages of Defined Contribution Plans for the Employee
    • More Portability Assets in a defined contribution are more easily transferred from plan-to-plan when employees change jobs.
    • More Control Employees direct their own investments in a defined contribution plan, which may be preferable for some. Those at higher income levels and with more education are typically better equipped to save appropriately and make sound investment decisions. Other employees may struggle to achieve success with their defined contribution plan because they have less money to save, may be less financial savvy, or because they are apathetic toward retirement saving.
DC v. DB

Combining Defined Benefit & Defined Contribution Plans

IMG_1775.jpg

Combining a defined benefit plan with a defined contribution plan may be the best approach to promote successful retirement outcomes for employees and employers.

  • Three-Legged Stool
    • The traditional retirement approach has been based on the three-legged stool concept where the legs of the stool are a defined benefit plan, Social Security, and personal savings. With three strong legs and proper planning, an individual can expect an adequate retirement.
3-legged-stool-2
  • Defined Benefit Base with Defined Contribution Supplement
    • One way an employer can create a three-legged stool is to provide a defined benefit plan as the foundation of the employee retirement benefit with a defined contribution plan to supplement retirement income. The defined contribution plan would act as the “personal savings” leg of the three-legged stool. An employer may provide an automatic or matching contribution to the defined contribution plan or the employer could simply offer the plan for the employees to divert money into with no employer contribution.

Switching from a Defined Contribution Plan to LAGERS’ Defined Benefit Plan

IMG_3315-1.png

If an employer already has a defined contribution plan in place and is considering adding or switching to LAGERS, there are some things they should know.

  • Is your current plan similar in purpose to LAGERS?
    • Missouri state law prohibits an employer from providing LAGERS benefits during the same time period that same employer had a retirement plan that is similar to LAGERS. A defined benefit plan would be considered similar in purpose and a defined contribution plan may be considered similar depending upon the plan’s characteristics and the amount of contributions to the plan. LAGERS staff will review an employer’s retirement plan document to determine if it is similar.
    • An employer may still join LAGERS even if its plan is considered similar in purpose so long as the coverages of the plans do not overlap and create a duplication of benefits.
  • Options for Employers with Similar Plans
    • Prior Service. Employers joining LAGERS typically have the option to retroactively cover employees under LAGERS from their hire dates forward. This is called 100% prior service coverage. Employers with similar plans may not have this option if it would create a duplication of benefits.
    • Vesting Only Service. If an employer could not cover any prior service for its employees because of a similar retirement plan, LAGERS would still count the employees’ service prior to the LAGERS joining date toward their vesting in LAGERS.
    • Employee Purchase Options. Employees that become vested in LAGERS would have the individual option to purchase their previous service if their employer could not provide prior service coverage. Purchasing would add service credits to the employee’s LAGERS’ record, therefore increasing their future retirement benefits. An employee could directly roll funds from an eligible retirement account to LAGERS for the purpose of purchasing service and/or use personal funds.

Want to Learn More?

Contact us to learn how to switch to a LAGERS defined benefit plan

Learn More