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Pension plans are complicated -- how do they work?

In general, there are three types of retirement plans.

Defined Contribution Plan In a DC plan, the employer and the employee contribute a percentage of each employee’s earnings to the employee’s separate account.  The contributed money and investment earnings are available to the employee during retirement.

Examples of DC plans are IRAs, 401(k)s, and 403(b)s.

Defined Benefit Plan Kentucky’s Tier 1 and Tier 2 employees are covered by a defined benefit (DB) plan.

Unlike a DC plan, in a DB plan the future retirement payment are defined using a formula based on the employee’s compensation at the time of retirement. Then, based on economic and demographic assumptions, actuaries compute the amount of money that the employer and/or employee should contribute annually.  Those amounts are invested and, theoretically, will be sufficient to pay retirement benefits far into the future.

If the investments do not produce as anticipated or if the actuarial assumptions do not work out, there will not be enough money to pay all of the pension benefits.  In the case of the Commonwealth’s plans, all eight plans are severely underfunded and that puts future pension benefits at risk of not being paid.

Obviously, DB plans are complex and, monitoring their status from year-to-year is difficult.  For this reason, actuarial and funding adjustments should be considered every year.

“Hybrid Cash Balance Plan”  Employees, other than teachers, hired after January 1, 2014 are “Tier 3” employees covered by the “Hybrid Cash Balance Plan.”  This plan is similar to a DC plan, except that covered individuals are guaranteed at least a 4% annual investment return.  Plus, if actual investment returns are higher, the annual investment return can be higher.

Source: PFM Group Consulting report, May 22, 2017.  For more information about this topic, click here to see relevant portions of that report.