Definition and Examples of Unfunded Retirement Plans
What Affects Retirement Plan Funding
How Do Unfunded Retirement Plans Work?
Definition and Examples of Unfunded Retirement Plans
An unfunded retirement plan is an employee benefit plan that provides retirement income that has assets less than its liabilities, or what it owes in benefits.
For example, a retirement plan may have $10 billion in employee benefit obligations but only $5 billion in current assets. This means it has a funding ratio of only 50%.
Both public and private retirement plans can be unfunded, and these shortfalls can affect more than just retirees. For example, unfunded public retirement plans can lead to changes in taxes and/or public spending that affects the general population. At the same time, those belonging to the retirement system may face changes such as increased contributions and/or altered benefit payments.
Note: An unfunded retirement plan does not necessarily mean that it is in perpetual debt. Even if the plan is unfunded, it may not be on track to pay the full amount promised to participants, but it may return primarily to meet its obligations.
What Affects Retirement Plan Funding
Retirement plans are funded in three main ways: employee contributions, employer contributions, and investment returns. A significant portion of retirement plan revenue comes from the latter – investment returns. These returns can fluctuate for several reasons, from changes in interest rates to stock market trends.
It is possible for a retirement plan to move from an unfunded status one year to a funded status the next year, such as if rising interest rates allow the plan to lower its liability assumptions.
In recent decades, the United States has operated in a generally low-interest-rate environment, leading many retirement plans to become unfunded. For the fiscal year 2021, it was expected that the major public retirement plans in the U.S. would have a combined funding ratio of 74.7%, according to the Retirement Research Center.
For private retirement plans, the average funded ratio of the largest 100 corporate defined benefit plans in the U.S. was 95.8% as of July 31, 2021, according to the Milliman Pension Funding Index (PFI).
How Do Unfunded Retirement Plans Work?
Determining whether a retirement plan is unfunded or funded can often involve complex calculations and can be relatively subjective. This is because determining liabilities, for example, requires assumptions made by professionals, such as actuaries, who take into account factors like retirees’ life expectancy and expected future returns on investments related to retirement benefits.
Note: Different types of retirement plans may follow different procedures for calculating assets against their liabilities to determine their funded status. Some may make more aggressive assumptions about how much they can expect in investment returns, while others may be more conservative.
While many retirement plans are unfunded, this does not necessarily mean that they have not received adequate funding from employees and/or employers. A retirement plan may be unfunded for several reasons. For example, public funds allocated to the retirement plan could be used elsewhere, or expected investment returns could decline if the stock market crashes.
Addressing an unfunded retirement plan may involve multiple solutions and may depend on the cause of the issue. If the retirement plan is closer to being funded at 100%, for example, and is only slightly affected by stock market changes, the company may decide to stay the course and rely on long-term trends to compensate for short-term losses.
For
For pension plans that experience larger funding gaps, solutions may include increasing employee contributions or reducing employee benefits.
Publicly funded pension plans may also benefit from tax increases or reallocating public spending to address the funding shortfall.
Source: https://www.thebalancemoney.com/what-is-an-underfunded-pension-plan-5210634
Leave a Reply