What Is an Underfunded Pension Plan?

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. Hence, 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.

An underfunded pensions should not be confused with an unfunded pension plan, which is a pay-as-you-go plan that uses the employer's current income to fund pension payments as they become necessary.

Understanding Underfunded Pension Plans

Defined-benefit pension plans have guarantees that employers make to employees in terms of income to be received during retirement. As such, a company's pension plan invests 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 liabilities stack up, where "underfunded" means that the liabilities, the obligations to pay pensions under defined-benefit retirement plans, exceed the assets (the investment portfolio) that have accumulated for the purpose of funding required payments. These comprise a combination of invested corporate contributions and the returns on those investments. 

Underfunded pension plans can become so in a variety of ways. Interest rate changes, a weak stock market, mergers and bankruptcies can all greatly affect company pensioners. During times of an economic slowdown, pension plans are most 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. 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. In such situations, a portfolio becomes overly dependent on the financial health of the employer, for both future contributions and good returns on the employer's stock.

If over three consecutive years, the value of the pension's assets is less than 90 percent funded, or if in any year the assets are less than 80 percent funded, the company must increase its contribution to the pension portfolio, which is usually in the form of cash. The need to make this cash payment could materially reduce EPS and equity. The reduction in equity could trigger defaults under corporate loan agreements, which generally have serious consequences, ranging from higher interest rates to bankruptcy.

Key Takeaways

  • Underfunded pensions describe a condition where assets do not cover current or future liabilities of a company's defined-benefit plan.
  • Underfunded plans can be risky for a company since pension guarantees to former and current employees are often binding.
  • The assumptions used to determine the funding status of a pension - for instance, the expected rates of return and inflation - can have a large impact.

Determining if a Pension Plan is Underfunded

Figuring out whether a company has an underfunded pension plan can be as simple as comparing the fair value of plan assets, which includes the current value of the plan assets that the company estimates it will have in the future, to the accumulated benefit obligation, which includes the current and future amounts owed to pensioners. 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 a company's 10-K annual financial statement. 

There's also the risk of companies using assumptions to reduce the need to add cash to their pension funds. Assumptions are necessary when estimating for long-term obligations and uncertainties. These assumptions can be made in good faith, or they can be used to minimize any adverse impact on corporate earnings. However, there is always a very real risk that companies will revise their assumptions as time goes on to minimize shortfalls or contributing additional money beyond what is needed to fund obligations 

For example, a company could assume a long-term rate of return of 9.5 percent, which would increase the funds expected to come from investments and thus reduce the need to add cash. This assumption, however, looks overly optimistic if you consider that the long-term return on stocks is about 7 percent and the return on bonds is even lower.

Underfunded vs. Overfunded Pensions

The opposite situation of an underfunded pensions is one that has more assets than liabilities, and so is overfunded. Actuaries calculates the amount of contributions a company must pay into a pension, based on the benefits the 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 that 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. Regrettably, overfunding is of no use while in the plan (beyond the sense of security it may provide beneficiaries). An overfunded pension plan will not result in increased participant benefits and cannot be used by the business or its owners.