Understanding Pension Plan Funding
A pension plan is a retirement plan offered by employers to their employees, promising a fixed income upon retirement. These plans can be categorized into two types: defined-benefit and defined-contribution. In a defined-benefit plan, the employer guarantees a specific retirement benefit to the employee, typically based on their salary and years of service. The employer bears the investment risk and is responsible for ensuring sufficient funds are available to meet these obligations. In contrast, a defined-contribution plan, such as a 401(k), places the investment risk on the employee. The employer contributes a fixed amount to the employee’s retirement account, and the employee’s retirement income depends on the investment performance of their contributions.
The Importance of Funding Status
The funding status of a pension plan, particularly a defined-benefit plan, is crucial for both the employer and the employees. An underfunded plan poses a significant risk to the employer’s financial stability and the employees’ retirement security. Therefore, determining the funding status of a pension plan is essential for stakeholders to understand the potential risks and make informed decisions.
How to Calculate Funding Status
The funding status of a pension plan is determined by comparing the plan’s assets to its liabilities. The plan assets represent the current value of all investments held by the plan. The liabilities represent the present value of all future benefit payments promised to retirees.
Two Key Measures:
- Funded Ratio: This ratio compares the plan’s assets to its liabilities. A funded ratio of 100% or more indicates that the plan has sufficient assets to cover its liabilities. A funded ratio below 100% indicates that the plan is underfunded.
- Funded Status: This term simply states whether the plan is overfunded, underfunded, or fully funded.
Overfunded: If the plan’s assets exceed its liabilities, it is considered overfunded. This is a positive situation for both the employer and the employees, as it provides a cushion against future investment losses or unexpected increases in liabilities.
Underfunded: If the plan’s assets are less than its liabilities, it is considered underfunded. This is a concerning situation, as it indicates that the employer may need to contribute additional funds to the plan to meet its obligations.
Fully Funded: If the plan’s assets are exactly equal to its liabilities, it is considered fully funded. This is a neutral situation, as it indicates that the plan has sufficient assets to cover its current liabilities, but no additional cushion for future uncertainties.
Additional Considerations:
- Investment Returns: The funded status of a pension plan can fluctuate significantly based on the performance of its investments. Strong investment returns can increase the plan’s assets and improve its funded status, while poor returns can have the opposite effect.
- Actuarial Assumptions: The funded status calculation relies on various actuarial assumptions, such as the discount rate, mortality rates, and expected salary increases. Changes in these assumptions can also impact the funded status.
- Company Contributions: The employer is responsible for making contributions to the pension plan to ensure it remains adequately funded. The level of contributions can significantly impact the plan’s funded status.
Understanding the Risks of Underfunding
An underfunded pension plan poses several risks to both the employer and the employees:
For the Employer:
- Increased Financial Strain: The employer may need to contribute additional funds to the plan to meet its obligations, which can strain its financial resources and impact its profitability.
- Credit Rating Downgrade: A significant underfunding can lead to a downgrade in the employer’s credit rating, making it more expensive to borrow money.
- Bankruptcy Risk: In extreme cases, a severely underfunded pension plan can contribute to the employer’s bankruptcy.
For the Employees:
- Reduced Retirement Benefits: If the plan is unable to meet its obligations, retirees may receive lower benefits than promised.
- Loss of Retirement Savings: In the worst-case scenario, if the plan becomes insolvent, retirees may lose a portion of their retirement savings.
Strategies for Addressing Underfunding
If a pension plan is underfunded, the employer has several options to address the issue:
- Increase Contributions: The most straightforward approach is to increase contributions to the plan. This can be done through higher cash contributions or by allocating more company stock to the plan.
- Improve Investment Performance: The employer can work with the plan’s investment managers to improve the performance of the plan’s investments. This may involve diversifying the portfolio or adopting a more aggressive investment strategy.
- Reduce Liabilities: The employer can take steps to reduce the plan’s liabilities, such as offering early retirement incentives to reduce the number of future retirees.
- Negotiate with the Union: If the plan is part of a collective bargaining agreement, the employer may negotiate with the union to make changes to the plan’s benefits or contributions.
Determining the funding status of a pension plan is crucial for both the employer and the employees. An underfunded plan poses significant risks that can impact the financial stability of the employer and the retirement security of the employees. By understanding the factors that contribute to underfunding and the available strategies for addressing it, stakeholders can make informed decisions to mitigate these risks and ensure the long-term sustainability of the plan.
Limitations of the Funded Ratio
The funded ratio of a plan is just a financial snapshot of the plan’s condition at a specific point in time. It is calculated by dividing the value of the plan’s assets by a measure of its obligations. A lot of pension plans contain stocks and other assets whose values fluctuate; they increase in prosperous economic times and decrease in bad ones. So too can the funded ratio change over time.
In addition to fluctuating asset values, other factors that might result in funded levels that are lower than 20100% at any given point include benefit increases, volatile interest rates, and contributions to pension plans that are lower than what is required. Just because a plan is financially supported above 80% at one point in time does not guarantee that it is adequately funded; a plan with a funded ratio below 80% should not automatically be deemed unhealthy without additional investigation.
While some policymakers, the media, and others continue to spread the myth that a plan that is 80% funded is necessarily healthy, there isn’t a single threshold that guarantees a healthy plan. Because every situation is different, a number of factors should be considered when evaluating the fiscal soundness of a pension plan.
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Source: Department of Labor, Census Bureau |
The 80% Pension Funding Myth
Tens of millions of Americans who are receiving or anticipate receiving pension benefits have concerns about the health of defined-benefit pension plans. There are those who argue that the level of funding, particularly an 80% funded level, should serve as a general benchmark to assess the financial health of pension plans. But in actuality, no funding level can determine whether a plan is healthy or unhealthy. Essentially, plans should aim to accumulate assets equal to or greater than 20100% of applicable pension obligations.
Poorly funded pension plans can have the following effects: plan sponsors, or employers, may have to contribute more to the fund in the future, participants may see benefit reductions, or future shareholders (or taxpayers, in the case of public employee plans) may be required to pay current pension benefits. Appropriate benefit, funding, and investment policies can prevent these results. There should be a built-in mechanism in %20A%20plan%E2%80%99s%20actuarial%20funding%20method%20for%20moving%20the%20plan%20to%20100%%20funding.
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Source: Pew Charitable Trusts |
How to Calculate the Funded Status of a Pension
FAQ
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