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Pension plans come in two basic flavors: defined contribution and defined benefit plans.
Defined contribution plans
These plans have a combination of employer and employee contributions with a maximum amount that
is computed as a percentage of compensation. The contribution is what it is, and there is no guarantee
return on the invested funds. The money available for payment of benefits is the total of contributions
plus accumulated earnings.
Defined benefit plans
These are plans where the benefits are set by formula, usually as a percentage of average compensation
for a period of years before retirement. The contributions needed to pre fund the payment of benefits are
determined by discounting the future benefits to present value by an assumed investment rate of return.
This rate of return is one of the plan’s actuarial assumptions.
These plans can end up being underfunded if investment returns fall short of actuarial assumptions, and
contributions are lower than needed to fully fund the benefits. Government defined benefit pension
plans are notorious for underfunding benefits.