Government retirement systems have three sources of money: employee contributions, employer contributions and income earned on the investment of those contributions. Together, these three sources are used to pay annuities to retirees.
Employee contributions are collected the same way as payroll taxes, health insurance premiums and voluntary deductions. Necessary amounts are deducted from employees' earnings before employees are paid.
Employees never have a chance to hold this money, so they never even miss it. This process forces employees to save for retirement.
Employer contributions are paid at the same time as employee contributions. Government organizations send their contributions to retirement systems when they send employees' contributions. Organizations build this cost into their budgets. When organizations add new staff positions, these contributions are factored into how much each position will cost the organization.
Employees do not experience the benefit of employer contributions while they're working; however, they certainly realize it in retirement. It is one of the biggest reasons why people accept a government salary that is less than what they could earn in the private sector. Better than average health insurance and generous leave policies don't hurt either.
Employee and employer contributions come in every month. Retirement systems invest this money. Through skillful investment, the money grows.
Annuities are the defining feature of defined benefit plans.
Employees contribute regularly throughout their careers with an expected monthly income in retirement. This puts the onus on retirement systems to invest well. Unlike a defined contribution plan where employees assume investment risk, the retirement system assumes the investment risk in a defined benefit plan.
In addition to paying retirees, retirement systems build up cash reserves. Having a chunk of money saved back helps a retirement system overcome investment mistakes and sluggish economies. A rule of thumb for government retirement systems is to have in reserve an amount equal to 80% of current obligations. Meeting this threshold is an indicator of a financially sound system.
Even though this method of funding annuities forces employees to save for retirement, it does not mean employees will automatically have a balanced retirement. Employees need Social Security and personal savings to complete the three-legged stool of government retirement. The federal government's Thrift Savings Plan is a good tool for helping employees accumulate personal retirement savings. Up to a certain point, federal agencies even match employees' contributions to their Thrift Savings Plan accounts.