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An underfunded pension plan is a company-sponsored retirement plan that has more liabilities than assets. In other words, the money needed to cover current and future retirements is not readily available. This means there is no assurance that future retirees will receive the pensions they were promised or that current retirees will continue to get their previously established distribution amount. An underfunded pension may be contrasted with a fully-funded or overfunded pension.
A defined-benefit pension plan comes with a guarantee that the promised payments will be received during the employee's retirement years. The company invests its pension fund in various assets in order to generate enough income to service the liabilities posed by those guarantees for both current and future retirees.
The funded status of a pension plan describes how its assets versus its liabilities stack up. "Underfunded" means that the liabilities, or the obligations to pay pensions, exceed the assets that have accumulated to fund those payments.
Pensions can be underfunded for a number of reasons. Interest rate changes and stock market losses can greatly reduce the fund's assets. During an economic slowdown, pension plans are susceptible to becoming underfunded.
Under current IRS and accounting rules, pensions can be funded through cash contributions and by company stock, but the amount of stock that can be contributed is limited to a percentage of the total portfolio. No more than 5% of pension assets can be in any one company's stock.
Companies generally contribute as much stock as they can in order to minimize their cash contributions; however, this practice is not sound portfolio management because it results in an overinvestment in the employer's stock. The fund becomes overly dependent on the financial health of the employer. Even with the 5% limit, such an amount in one company can make its success have a significant impact on the pension's success.
An underfunded pension plan should not be confused with an unfunded pension plan. The latter is a pay-as-you-go plan that uses the employer's current income to fund pension payments.
A plan is considered at risk for a plan year if the "funding target attainment percentage for the preceding plan year is less than 80% and for the preceding year is 70%.
The need to make this cash payment could materially reduce the company's earnings per share, and therefore its stock price. The reduction in company equity could even trigger defaults on corporate loan agreements. This has serious consequences ranging from higher interest rate requirements to bankruptcy.
Figuring out whether a company has an underfunded pension plan can be as simple as comparing the fair value of plan assets to the accumulated benefit obligation, which includes the current and future amounts owed to retirees. If the fair value of the plan assets is less than the benefit obligation, there is a pension shortfall.
The company is required to disclose this information in a footnote in the company's 10-K annual financial statement.
There is a risk that companies will use overly-optimistic assumptions in estimating their future obligations. Assumptions are necessary when estimating long-term obligations. A company may revise its assumptions as time goes on to minimize a shortfall and avoid the need to contribute additional money to the fund.
For example, a company could assume a long-term rate of return of 13%, which would increase the funds expected to come from investments and reduce the need for a cash infusion. In real life, the long-term return on stocks is about 10% and the return on bonds is even lower, making the portfolio's overall return less than 10%.
The opposite of an underfunded pension is, of course, an overfunded pension. A fund that has more assets than liabilities is overfunded.
Actuaries calculate the amount of contributions a company must pay into a pension based on the benefits participants receive or are promised and the estimated growth of the plan’s investments. These contributions are tax-deductible to the employer.
How much money the plan ends up with at the end of the year depends on the amount they paid out to participants and the investment growth they earned on the money. As such, shifts in the market can cause a fund to be either underfunded or overfunded.
It is common for defined-benefit plans to become overfunded in the hundreds of thousands or even millions of dollars. An overfunded pension plan will not result in increased participant benefits and cannot be used by the business or its owners.
When a defined benefit plan is underfunded, it means that it does not have enough assets to meet its payout obligations to employees. If a plan is underfunded, then it must increase its contributions to be able to meet these obligations. A plan may allow for employees to increase their contributions or a plan may decide to reduce the payout for future employees. Benefits employees have already earned through working for the employer cannot be reduced. This is usually the case if a plan is significantly underfunded rather than slightly underfunded; the latter of which may be due to temporary adverse market movements.
When a defined benefit plan is overfunded, it means that the plan has more assets than it needs to meet its payout obligations to employees. This provides security for the future, and can help the plan be prepared for more difficult times. However, the money is often trapped in the plan. Companies cannot pay it out to shareholders without incurring huge penalties. They may be able to seek a balance sheet credit for it depending on the situation. However, pension funds are usually not considered a full asset.
Generally, no, you cannot withdraw money from a defined-benefit plan before the allowed legal age. Some types of plans may have hardship withdrawals, but the criteria is often extremely restrictive. Furthermore, this is not allowed if a plan is underfunded. People can, however, take loans against their defined-benefit plan.