Employers wholly or significantly fund traditional pension plans. These defined pension plans pay a specific amount when an employee reaches retirement which the employer commits to fund. Unfunded retirement benefits arise when an employer does not inject enough funds to cover its pension commitments.
Defined Benefit Plan
A defined benefit plan is an employer-sponsored retirement plan that guarantees an employee a specific “defined benefit when he or she retires. If an employee leaves well in advance of retirement — for example, after working there for ten years then leaving, the plan will pay her when she reaches retirement age. The amount a defined benefit plan pays in retirement depends on the employee’s age when she files for benefits, the salary she made while working and the number of years she worked there.
Unfunded Pension Plan Described
In many corporate pension plans the employer contributes all the funds necessary to fund employee pensions. In most state and local government pensions the government contributes the bulk of a plan’s funding but the employer also deducts a percentage of the employee’s salary. An unfunded pension plan is also called an unfunded retirement benefit or unfunded pension liability. It is the difference between the amount an employer owes its employees based on the services they have already provided and the actual funds an employer has available to pay what it owes.
Current Income and Set-Asides
Federal and state laws require employers to put some money aside for their pension plans. The minimum funded amount depends on the state, organization type, number of employees and actuarial tables which calculate average life spans. However, organizations are typically not required to place money aside regularly to finance the retirement fund payments. Instead, they are also allowed to make pension payments out of both current income and funds previously set aside. This works fine as long as the company is profitable. However, as a company grows and hires more employees who reach retirement age, the company may encounter difficulty paying pensions out of current income, especially if it encounters financial difficulties.
With funds set aside an employer can either purchase insurance products that guarantee pension payments or invest. During years when the stock market is rising, the original funds set aside can increase dramatically. Employers often decrease their contribution amounts during this time, relying more heavily on the growth in pension assets due to investment returns. When investment returns flatten or turn negative, an employer must adjust its contributions upward but may take a few years to make this change.
Due to the risk of current income disappearing and stock market downturns, an unfunded pension plan carries a higher risk. An employer’s risk is that it will not be able to pay the pensions it owes. The employee’s risk is that she will not have some of the pension she expects to have when she retires. However, the Pension Protection Act of 2006 reduces that risk by requiring all pension plans to be fully funded by 2015. If an employer files for bankruptcy, the Act also treats unfunded liabilities as unsecured financing by the parent. This means that only the parent company’s secured debt and any debt the parent guaranteed supersede unfunded liabilities. This increases the likelihood that an employee will receive her pension even if the employer enters bankruptcy.
- AXA Equitable: Understanding Defined Benefit Plans [http://www.axa-equitable.com/retirement/understanding-defined-benefit-plans.html]
- City of Chicago: Just the Facts: Answers to Frequent City Pension Questions [http://www.cityofchicago.org/city/en/depts/mayor/iframe/just_the_facts.html]
- Governing: State Pension Plans: Liabilities, Funded Ratios http://www.governing.com/gov-data/state-pension-funds-retirement-systems-unfunded-liabilities-obligations-data.html
- Fried Frank: Underfunded Pension Liability: Lenders and Buyers Beware http://friedfrank.com/siteFiles/Publications/E568BF31B044A22529CBFAADE80C1635.pdf