Infographic: Defined Benefit Plans Explained

Infographic: Defined Benefit Plans Explained

Public pensions systems across the country are struggling with lower than expected investment returns. Just this morning, AL.com reported that investments supporting Alabama’s Teachers’ Retirement System earned a 1.04% rate of return. As currently structured, the expected annual cost of the system’s defined benefit pension plans assumes an 8% rate of return. State retirees are guaranteed their predetermined benefit, regardless of investment returns. When the returns fall short, Alabama taxpayers are the safety net.

Many state pension systems are facing the same challenges as we are in Alabama. The common denominator is the structure of the defined benefit plan. Defined benefit plans are inherently risky for the employer because it is the employer who makes up the difference when investment returns don’t meet projections. Other variables—like employee growth, life expectancy, and hiring trends—also add to the difficulty of estimating the amount needed to cover future pension liabilities.

Because of the risks associated with defined benefit plans, the private sector has largely moved away from this benefit structure. Out of 85 public pension plans that the Alabama Policy Institute analyzed, 27 of them now offer an alternative to the traditional defined benefit plan. These alternatives are typically in the form of either a defined contribution plan, similar to a 401(k), or a risk-managed defined benefit plan (also known as a cash balance plan) in which a specific benefit is promised, but plan funding is more predictable for the employer.