What Is a Pension Shortfall?

A pension shortfall is a situation where a company offering employees a defined benefit (DB) plan does not have enough money to meet the obligations of the pension fund. A pension shortfall typically occurs because the investments selected by the pension manager did not live up to expectations. A pension with a shortfall is considered underfunded.

Key Takeaways

  • A pension shortfall is when a defined-benefit pension plans do not have enough money on hand to cover its current and future obligations.
  • This can be risky for a company as pension guarantees to former and current employees are often legally binding.
  • Shortfalls may be caused by investment loss, poor planning, demographic change, or low interest rate environments.

Understanding Pension Shortfalls

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. A pension shortfall 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.

A pension shortfall is a significant event that requires the company offering a defined benefit plan to take steps to rectify the situation. A company that starts the pension is responsible for paying its employees the money that they were guaranteed. In such a plan, the employee takes on none of the investment risk. Essentially, the company guaranteed eligible employees who worked for them for a set period of time that they would receive a specific amount of money upon retirement. If the money is not there when people are ready to retire, it can imperil both the company and employees alike.

Avoiding Shortfalls

Fund managers and companies can forecast whether there will be an issue with meeting their obligations well before retirees receive their allotted payments. Upon discovery of a shortfall, one option would be to increase the contributions they make to the plan. A well-known example of this course of action was automobile company General Motors, which discovered that they faced a pension shortfall in 2016 and subsequently allocated a significant portion of the company’s profits to ensure that the company’s obligations were met. While a reliable option, this course of action would dent the company’s net income

Another option for a company to make up a shortfall would be to simply improve their investment performance; however, that strategy is fraught with risk as greater returns are not guaranteed. 

The Role of Pension Insurance 

In some cases, a company that is unable to make up for its pension shortfall with its own money may be able to seek relief from pension insurance. A U.S. government-sponsored enterprise known as the Pension Benefit Guaranty Corporation (PBCG) exists to encourage the continuation and maintenance of private defined benefit plans, ensure payment of pension benefits, and keep pension insurance premiums in check. Created by the Employee Retirement Income Security Act of 1974 (ERISA), the PBCG may be able to step in and make sure that pension payments are made in full when a company faces a shortfall. In exchange for this protection, the company has to pay a premium for each worker that is included in the plan.