What Is an Underfunded Pension Plan?

What Is an Underfunded Pension Plan?

Let me explain what an underfunded pension plan really is. It's a company-sponsored retirement plan where the liabilities outweigh the assets. Simply put, the funds needed for current and future retirements aren't there. You can't be sure that future retirees will get what was promised, or that current ones will keep receiving their set amounts. Compare this to a fully funded or overfunded pension, which has enough or more than enough.

Key Takeaways

Underfunded plans lack the cash to cover commitments now and later. This creates risks for companies since pension promises to employees are usually binding. Often, it's due to investment losses or bad planning. On the flip side, an overfunded plan has extra assets beyond what's needed.

Understanding an Underfunded Pension Plan

A defined-benefit pension guarantees payments during retirement. The company invests the fund in assets to generate income for those guarantees, covering both current and future retirees. The funded status shows how assets stack up against liabilities. If liabilities exceed assets, it's underfunded—obligations to pay pensions outpace the accumulated funds.

This can happen from interest rate shifts, stock market drops, or economic slowdowns, which hit pension plans hard.

Funding a Pension

Under IRS and accounting rules, pensions get funded via cash or company stock, but stock is capped at a percentage of the portfolio—no more than 5% in any one company's stock. Companies often max out stock contributions to cut cash outlays, but this isn't smart management. It leads to over-reliance on the employer's stock, tying the fund's health to the company's fortunes. Even at 5%, that's enough to sway the pension's performance significantly.

Important Distinction

Don't mix up underfunded with unfunded pensions. Unfunded ones are pay-as-you-go, using current employer income for payments. A plan is at risk if its funding target attainment is under 80% for the prior year and 70% for the year before that. Needing to inject cash can slash earnings per share and stock price, possibly triggering loan defaults with outcomes from higher interest to bankruptcy.

Determining If a Pension Plan Is Underfunded

To check if a plan is underfunded, compare the fair value of assets to the accumulated benefit obligation, which covers current and future retiree amounts. If assets fall short, there's a shortfall. Companies must disclose this in their 10-K footnotes. Be aware, companies might use overly optimistic assumptions to downplay obligations, revising them to avoid extra contributions. For instance, assuming a 13% return boosts expected investment income, but real stock returns are around 10%, and bonds less, so overall returns dip below that.

Underfunded vs. Overfunded Pensions

An overfunded pension has more assets than liabilities. Actuaries figure contributions based on promised benefits and expected investment growth—these are tax-deductible. Year-end funds depend on payouts and investment returns, so market shifts can tip a plan under or over. Overfunded plans can run surpluses in the millions, but that doesn't increase benefits or let the business or owners use the money.

What Happens When a Defined-Benefit Plan Is Underfunded?

If underfunded, the plan can't meet employee payouts. It must boost contributions, perhaps by employees chipping in more or cutting future payouts—earned benefits stay intact. This applies more to significant underfunding, not minor market dips.

What Happens When a Defined-Benefit Plan Is Overfunded?

Overfunding means excess assets for obligations, offering future security against tough times. But the money is stuck—companies can't distribute to shareholders without penalties. They might get a balance sheet credit, though pensions aren't full assets.

Can I Withdraw Money From a Defined-Benefit Plan?

Generally, you can't withdraw before the legal age. Some plans allow hardship withdrawals under strict rules, but not if underfunded. You can take loans against the plan, though.