An Underfunded Pension Plan: What Is It?

A company-sponsored retirement plan with more obligations than assets is an underfunded pension plan. In other words, the funds required to support current and future retirements are not easily accessible. This implies that there is no guarantee that present pensioners will continue to receive their predetermined distribution amount or that future retirees will get the pensions they were promised. Compare a pension that is underfunded to one that is fully funded or overfunded.

Recognizing an Underfunded Pension Scheme

A guarantee is associated with defined-benefit pension plans that the promised payments will be made to employees throughout their retirement. The organization allocates its pension fund among diverse assets to provide sufficient revenue to meet the obligations imposed by those assurances for both present and prospective retirees.

A pension plan’s funded state explains how its assets and liabilities balance out. “Underfunded” refers to a situation in which the assets amassed to finance pension payments are less than the liabilities or responsibilities to pay pensions.

Underfunding of pensions may occur for many reasons. Changes in interest rates and stock market losses may significantly deplete the fund’s assets. Plans for pension funds are vulnerable to underfunding during a recession.

Paying for a Pension

According to current IRS and accounting laws, business stock and cash contributions are acceptable funding sources for pensions. Still, the amount of stock that can be donated is restricted to a proportion of the whole portfolio.

Companies often donate as much stock as possible to reduce their cash payments. However, this strategy could be more effective in portfolio management since it leads to an overinvestment in the employer’s stock. The fund becomes too reliant on the employer’s financial stability.

It is essential to distinguish between an underfunded and an unfunded pension plan. In the latter, pension payments are paid on a pay-as-you-go basis using the employer’s current revenue.

If the “funding target attainment percentage for the preceding plan year is less than 80% and for the preceding year is 70%,” the plan is said to be at risk for that plan year.

The need to make this cash payment might significantly lower the stock price and, therefore, the profits per share of the firm. Even defaults on corporate credit arrangements might result from decreased business equity. This has severe repercussions, such as increased interest rate needs and bankruptcy.

How to Assess Whether a Pension Plan Is Underfunded

Comparing the fair value of plan assets to the cumulative benefit obligation, including the present and future sums owing to retirees, can help determine if a corporation has an underfunded pension plan. There is a pension deficit if the benefit requirement exceeds the fair value of the plan assets.

The corporation must disclose this information in a footnote to its 10-K annual financial statement.

Businesses risk calculating their future commitments using assumptions that are too optimistic. Estimating long-term commitments requires making assumptions. To reduce a deficit and prevent having to provide more funds to the fund, a corporation may update its assumptions over time.

A business may project a long-term rate of return of 9.5%, which would raise the amount of money anticipated to flow from investments and lessen the need for a capital injection. Bonds have an even lower long-term return than equities, around 7%.

Pensions: Overfunded vs. Underfunded

Naturally, an overfunded pension is the reverse of an underfunded pension. An overfunded fund has more assets than liabilities.

Actuaries use projections of the plan’s assets’ growth and the benefits members will get or are promised to determine how much an employer needs to contribute to a pension. The employer can deduct these donations from taxes.

The amount the plan pays out to members and the investment growth they get on the money determine how much it has at the end of the year. Therefore, changes in the market may result in an underfunding or an overfunding of a fund.

Definable-benefit plans often need more funding than hundreds or even millions of dollars. The company or its owners do not use an overfunded pension plan, which will not lead to higher member benefits.

What Takes Place If a Defined-Benefit Plan Is Insufficiently Funded?

A defined benefit plan is said to be underfunded if it lacks the resources necessary to pay its workers as promised. An underfunded plan will need to make more contributions to fulfill its responsibilities. The plan may increase employee payments or choose to lower employee benefits. This is often the situation when a plan is severely underfunded instead of marginally underfunded, the latter of which might result from transiently unfavorable market fluctuations.

When a defined-benefit plan is overfunded, what takes place?

A defined benefit plan is said to be overfunded if it has more assets than are required to fulfill its employee payment commitments. Although it cannot be distributed to shareholders, the excess may be considered net income.

Is it possible to take money out of a defined-benefit plan?

In general, no, even hardship withdrawals, you are not permitted to take money out of a defined-benefit plan before you reach the legal age. Moreover, if a plan is underfunded, this is prohibited. Nonetheless, borrowers may use their defined-benefit plan as collateral.

Conclusion

• Underfunded pension plans need more funds to meet their present and future obligations.
• This is problematic for a business since pension promises made to current and past workers are often enforceable.
• Losses on investments or inadequate planning are common causes of underfunding.
• An overfunded pension plan is the reverse of an underfunded one; it has enough assets to cover its liabilities.