What Is an Advance Funded Pension Plan?

An advance funded pension plan is funded concurrently with the benefits accrued by employees. These funds are set aside and accounted for well before employees retire. Advance funded pension plans are generally defined-contribution plans and are fully funded.

There are several ways these plans can be funded. In one scenario, the employer alone bears the burden of funding the plan. In another, the plan can be funded by both the employer and the employee, similar to a 401(k) or 403(b) retirement option.

Key Takeaways

  • Unfunded pension plans are often set up by governments or businesses to offer a pay-as-you-go situation for employees.
  • Advance funded pension plans do not carry as much financial risk as unfunded pension plans.
  • Advance funded pension plans are similar to traditional 403(b) or 401(k) retirement plans, and they are considered defined-contribution plans.

How an Advance Funded Pension Plan Works

An advance funded pension plan has sufficient liquid assets to cover all of its liabilities, including all future payments to beneficiaries. This type of pension plan not only benefits employees who expect to receive the full allotment of their retirement benefits but also helps companies eliminate many of the costs and risks that accompany more traditional pension plans. 

This type of pension plan designates precisely what the benefits will be upon retirement, and employers make defined contributions along the way. This means that companies can effectively add to the plan as they go, meaning that employees who depart the company before meeting the predetermined amount of time for them to retire can still reap some of the benefits of the pension plan.

When companies fully fund their pension plans in advance, it means that employees can count on sufficient assets being available to cover their accrued benefits.

An advance funded pension plan allows employers to reap the rewards of their pensions without worry that the pension plans will not be available upon retirement.

Advance Funded Pension Plan vs. an Unfunded Pension Plan

When employers offer a pension plan, they can plan for the anticipated financial requirements of the pension plan, set aside a certain amount of money on a regular basis, and invest the money to, ideally, grow the fund.

Conversely, certain employers elect to fund the pension plan out of current earnings. In contrast, the unfunded pension plan is an employer-managed retirement plan that uses the employer's current income to fund pension payments as they become necessary. This type of plan uses actuarial assumptions to determine the periodic contributions it makes to the plan. 

An unfunded pension plan carries much more financial risk, as well as operational risk, for the pensioner and the employer than the advance funded pension plan. Both may be subject to investment risks should the company go through a difficult period financially. In certain situations, either due to operational issues on the company's part or because of broader market dynamics, the pensioner may not have the ability to sustain the appropriate contribution rate to ensure that the pension liabilities are met.