Key Takeaways
- Unfunded plans lack dedicated assets for future benefits.
- Employers pay normal costs plus unfunded liability amortization.
- Deficits create financial risks for employers and participants.
What is The Basics of Unfunded Pension Plans: Definition and Operation?
An unfunded pension plan is a retirement plan where the employer has not set aside dedicated assets to fully cover future pension obligations. Instead, these plans rely on future revenues or contributions to pay benefits as they come due, contrasting with fully funded plans that hold specific investments matching liabilities.
This type of plan often overlaps with underfunded defined benefit plans, where shortfalls arise due to factors like investment losses or actuarial changes, requiring employers to manage deficits carefully.
Key Characteristics
Unfunded pension plans share distinct features that impact both employers and participants:
- No dedicated assets: The plan lacks a dedicated fund, relying on general revenues or future contributions to meet payments.
- Unfunded liability: The shortfall between promised benefits and current assets is called an unfunded actuarial accrued liability (UAAL).
- Ongoing contributions: Employers must make special amortization payments to cover the UAAL over time.
- Regulatory oversight: Plans often undergo actuarial valuations using methods like going concern and solvency assumptions.
- Risk exposure: Deficits can strain budgets, especially during economic downturns or market volatility.
How It Works
Employers fund unfunded pension plans by paying the normal cost, which covers benefits accruing each year, plus additional payments to amortize existing unfunded liabilities over periods typically ranging from 15 to 20 years. These payments help reduce the plan's deficit gradually.
Valuations assess the plan’s financial status under different scenarios. The going concern valuation assumes the plan continues indefinitely, while the solvency valuation considers immediate plan termination, requiring faster funding of shortfalls. Some plans may use back-to-back letters of credit to partially secure their solvency liabilities, adding flexibility in managing funding requirements.
Examples and Use Cases
Unfunded pension plans are common in various industries, especially where large legacy benefit promises exist:
- Airlines: Companies like Delta and American Airlines have historically managed unfunded pension liabilities due to their extensive employee benefit commitments.
- Public sector: Many state and local government plans carry unfunded liabilities resulting from past market losses or benefit increases.
- Investment management: Understanding unfunded pension risks is crucial when analyzing stocks or bond portfolios, especially for companies with significant pension trust obligations.
Important Considerations
When evaluating or managing an unfunded pension plan, consider the potential impact on your company’s financial health and future cash flows. Persistent underfunding can lead to increased contributions, affecting budgets and investment decisions.
Employers should also monitor actuarial assumptions and economic conditions closely, as changes can significantly alter unfunded liabilities. Incorporating strategies from guides like best bond ETFs or best low-cost index funds may help optimize pension fund investments when assets are held to address funding gaps.
Final Words
Unfunded pension plans rely on future contributions and general revenues to meet obligations, creating potential funding risks. Review your plan’s funding status regularly and consult a financial advisor to assess its long-term sustainability.
Frequently Asked Questions
An unfunded pension plan is a retirement plan where the employer has not set aside dedicated assets to fully cover future pension obligations, relying instead on future general revenues or contributions to pay benefits as they come due.
A fully funded pension plan has assets equal to or exceeding its liabilities, meaning it has enough investments to cover promised benefits. In contrast, an unfunded plan's liabilities exceed its assets, creating a shortfall known as an unfunded liability.
Pension plans become unfunded due to factors like investment losses, changes in actuarial assumptions, low interest rates, or increases in promised benefits, which can create deficits where liabilities exceed plan assets.
Employers pay the normal cost, which covers benefits accruing that year, plus amortization payments spread over 15 to 20 years to gradually eliminate the unfunded liability, adjusting these payments annually based on plan performance and changes.
Two main valuation methods are used: the going concern valuation, which assumes the plan will continue indefinitely, and the solvency valuation, which assumes immediate plan termination and requires faster funding of shortfalls.
Yes, unfunded pension plans remain operational as long as employers make required normal cost contributions and amortization payments to address the deficits over time.
For employers, large unfunded liabilities can strain budgets, especially during economic downturns. Participants generally continue receiving benefits, but the long-term security of payments depends on the employer’s ability to address funding gaps.
An unfunded liability is calculated by subtracting plan assets from the present value of all future pension benefits owed; for example, if benefits total $1 billion but assets are $900 million, the unfunded liability is $100 million.
