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.

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.

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.

Understanding Underfunded Pension Plans

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.

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.

If the pension fund is less than 90 percent funded over three consecutive years, or if it is less than 80 percent funded for a single year, the company must increase its contribution to the pension portfolio, usually in the form of cash.

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.

Key Takeaways

  • Underfunded pension plans do not have enough money on hand to cover its current and future commitments.
  • This is risky for a company as pension guarantees to former and current employees are often binding.
  • Underfunding is often caused by investment losses.

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 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 a 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 their 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 9.5 percent, 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 7 percent and the return on bonds is even lower.

Underfunded vs. Overfunded Pensions

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 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. An overfunded pension plan will not result in increased participant benefits and cannot be used by the business or its owners.