A guaranteed return plan builds retirement income for participants by creating notionally personal accounts for each employee and blending investments that are managed by a retirement system.
The retirement system invests the money for members and guarantees that they’ll earn a minimum return, usually with a share of returns above that minimum amount. Upon retirement, the accumulated balance for each employee is converted into guaranteed income. If an employee leaves for another job, they can take the entire vested balance of their account with them.
What is a Guaranteed Return Plan?
In a guaranteed return plan (GR), you and your employer both make contributions to a fund managed on your behalf. The retirement system invests the money for you and guarantees you’ll earn at least a certain amount on your investment. During your working years, you accumulate contributions and the minimum investment return on those contributions, plus some share of investment returns above that minimum. When you reach retirement, you can choose to convert the accumulated savings into guaranteed income for life, which essentially turns your GR plan into a traditional pension.
Guaranteed return plans are sometimes called “money purchase” or “cash balance” plans. Technically, they are “defined benefit” plans like traditional pensions. However, the benefit being “defined” is the guaranteed rate of return rather than a fixed amount of income.
Just like traditional pensions, the retirement system in a GR plan holds all of the money and manages the investments. The professionals running the system keep track of exactly how much has been contributed in your name. They then track how much of the fund’s overall investment return should be added to those contributions at regular intervals. So, while individual teachers don’t have to make any decisions about their investment strategy, they also don’t have any control over that strategy.
Typical GR plans promise a minimum of around 4% on accumulated retirement savings (i.e., contributions from you and your employer). Usually, any investment returns above the minimum amount are shared between employers and employees. Some of the additional investments are added to your account, and the remainder go to a reserve fund for the system to use in case it needs funds to provide the minimum investment guarantee down the road if investments underperform.
Lump Sum vs. Annuitization
Guaranteed return plans usually provide some options for how you use your savings when you retire. All guaranteed return plans give you the option to take your money as a lump sum. You can also convert this savings, or part of it, into a monthly check you receive throughout retirement. This process is known formally as “annuitization.” Some guaranteed return systems will administer this themselves, so you’d get a pension check just like if you were in a pension plan. Others use a third-party provider to distribute the annuity.
Example: Guaranteed Return Plan
- Employees and employers each contribute 5% to 7.5% of pay (for a total of 10% to 15%).
- The state guarantees (through the retirement system) a 4% annualized return is credited to the employee account.
- The GR plan also provides a share of upside returns:
- Three-fourths (75%) of any investment returns above 4% are also credited to the employee account.
- One-fourth (25%) of investment returns above 4% are reserved to the state retirement fund (to cover management costs and create a pool of funds for years where investment returns are low).
- Employees vest in their employer contributions over a period of two to five years.
- Employees can leave at any time and take with them the full balance of their account, including investment returns and vested employer contributions along with their own contributions.
- Upon applying for retirement, employees can have the accumulated total of their account converted into guaranteed monthly income (just like a traditional pension).
The Pros and Cons of Guaranteed Return Plans
Compared to other plan types, like defined contribution plans, hybrid plans, and defined benefit plans, GR plans have several main pros and cons.
Pros
- May provide adequate retirement income security if plan design includes sufficient minimum guaranteed and shared returns, access to lifetime income options and adequate contributions
- Funding and budgetary predictability
- Can support retention goals if plan designs elements increase guaranteed returns over increasing years of service
- Moderate to full portability, depending on how quickly employer contributions vest
- No direct employee investment risk
Cons
- May not provide adequate retirement income security if total contributions are less than 10% to 15% of salary
- Possible that budgetary costs increase if investments consistently underperform guaranteed rate
- Plans typically designed for either full-career workers or more mobile workers
- Limited funding risk (if state does not build a backstop to the guaranteed returns)