Underfunded

What Is Underfunded?

"Underfunded" refers to a financial state where the existing assets of a fund or program are insufficient to cover its projected future liabilities. This term is most commonly encountered in the context of pension plans and other long-term benefit obligations, falling under the broader category of Financial Management and often intersecting with Public Finance. When a plan is underfunded, it indicates a shortfall between the money currently available (plus expected future contributions and investment returns) and the total amount required to pay out all promised benefits over time. Addressing an underfunded status is critical for maintaining the financial health and long-term solvency of the entity responsible for the obligations.

History and Origin

The concept of underfunding in pension schemes gained significant public attention and regulatory scrutiny following notable failures in the mid-20th century. A pivotal event was the collapse of the Studebaker automobile company's pension plan in 1963. Thousands of workers at the South Bend, Indiana, plant lost substantial portions of their promised pension benefits because the plan was severely underfunded. This incident, among others, highlighted the urgent need for federal protection and oversight of private pension plans.¹³,¹²

In response, the U.S. Congress passed the Employee Retirement Income Security Act (ERISA) in 1974. ERISA established minimum standards for most private industry defined benefit plans, including requirements for funding, vesting, and fiduciary conduct. It also created the Pension Benefit Guaranty Corporation (PBGC), a federal agency designed to insure the pension benefits of workers and retirees in private-sector defined benefit plans. ERISA aimed to prevent future instances of widespread underfunding and ensure that workers received their promised retirement income, even if their employer's plan terminated.¹¹,¹⁰

Key Takeaways

• Underfunded means that an entity's current assets and projected income are insufficient to meet its future financial obligations.
• This condition is most frequently observed in defined benefit pension plans, but it can apply to any long-term financial commitment.
• An underfunded status poses risks to beneficiaries, requiring difficult choices between increased contributions, reduced benefits, or higher taxes.
• The severity of underfunding is often measured by a plan's funding ratio.
• Economic conditions, investment performance, and actuarial science assumptions significantly influence a plan's funded status.

Formula and Calculation

The concept of "underfunded" is quantitatively expressed through the comparison of a plan's assets to its liabilities, often encapsulated by the funding ratio. While "underfunded" itself isn't a direct formula, the underlying calculation to determine if a plan is underfunded is as follows:

[
\text{Unfunded Liability} = \text{Present Value of Future Benefits} - \text{Current Plan Assets}
]

If the Unfunded Liability is greater than zero, the plan is underfunded.

Alternatively, the funding ratio is calculated as:

[
\text{Funding Ratio} = \frac{\text{Current Plan Assets}}{\text{Present Value of Future Benefits}} \times 100%
]

Where:

• (\text{Current Plan Assets}) refers to the fair market value of the investments held by the plan.
• (\text{Present Value of Future Benefits}) represents the actuarial estimate of all promised benefits that will be paid out over the lifetime of current and future retirees, discounted back to today's value. This calculation involves complex actuarial science assumptions regarding life expectancy, salary growth, and discount rates.

A funding ratio below 100% indicates an underfunded status. For instance, a 70% funding ratio means the plan has only 70 cents for every dollar of future obligations.

Interpreting Underfunding

Interpreting an underfunded status requires understanding the context and the magnitude of the shortfall. A slightly underfunded plan (e.g., a 90-95% funding ratio) might be considered manageable, especially if it's due to temporary economic downturns or short-term investment performance fluctuations. Conversely, a plan with a significantly low funding ratio (e.g., below 70%) indicates a serious and potentially unsustainable imbalance.

The implications of being underfunded vary depending on the type of entity. For corporate pension plans, an underfunded status can lead to increased required contributions, affecting a company's cash flow and profitability. For public sector pension plans (state and local governments), underfunding can strain government budgeting, potentially leading to higher taxes, cuts in public services, or reductions in promised benefits for employees. The long-term nature of these liabilities means that underfunding can compound over decades, making future corrections more challenging.

Hypothetical Example

Consider the "Evergreen City Employees Pension Fund," a hypothetical defined benefit plan for municipal workers.

1. Current Situation: As of the latest actuarial science valuation, the Evergreen City Employees Pension Fund has current assets totaling $1.5 billion.
2. Projected Liabilities: Based on projections of current and future retirees' benefits, life expectancies, and salary increases, the present value of the fund's future liabilities is calculated to be $2.0 billion.
3. Determining Underfunded Status:
   • Unfunded Liability = $2.0 billion (Liabilities) - $1.5 billion (Assets) = $0.5 billion.
   • Since the unfunded liability is $500 million, the plan is underfunded.
4. Funding Ratio:
   • Funding Ratio = ($1.5 billion / $2.0 billion) * 100% = 75%.
   • A 75% funding ratio confirms the underfunded status. This means for every dollar the plan expects to pay out in the future, it currently holds only 75 cents in assets. Evergreen City's leaders would need to consider strategies to bridge this $500 million gap over time.

Practical Applications

Underfunding appears in various financial contexts, predominantly within long-term obligations:

• Public Sector Pensions: Many state and local government pension plans across the United States are underfunded. As of fiscal year 2022, the nationwide gap between promised pension benefits and set-aside funds for state pension plans reached nearly $1.3 trillion.⁹ This condition can lead to fiscal stress, potentially impacting a municipality's credit rating and necessitating difficult political decisions regarding increased contributions from taxpayers or adjustments to employee benefits. The Federal Reserve provides detailed state-level data on these funding statuses.⁸
• Corporate Defined Benefit Plans: While less prevalent than in the past due to a shift towards defined contribution schemes, some corporations still sponsor defined benefit plans that can become underfunded due to market volatility or insufficient contributions.⁷
• Social Security and Entitlement Programs: Large government-sponsored social insurance programs, like Social Security in the U.S., face long-term solvency challenges that are often characterized as underfunding. Projections indicate that the Social Security Old-Age and Survivors Insurance (OASI) Trust Fund will be able to pay 100% of scheduled benefits until 2033, after which it will only be able to pay 77% if no legislative changes are made.⁶
• Healthcare and Post-Retirement Benefits: Beyond pensions, employers and governments may offer post-retirement healthcare benefits that are also subject to underfunding if adequate reserves are not set aside to cover projected future medical costs.
• Infrastructure and Maintenance Funds: In a broader sense, funds set aside for future infrastructure repair or maintenance can be considered underfunded if the allocated amounts fall short of projected repair costs. This highlights the importance of proactive risk management in long-term financial planning.

Limitations and Criticisms

The assessment of whether a plan is underfunded, and the severity of that underfunding, is not without its limitations and criticisms:

• Actuarial Assumptions: The calculation of future liabilities heavily relies on actuarial science assumptions such as projected rates of return on investments, inflation, salary increases, and life expectancy. If these assumptions are overly optimistic, a plan can appear better funded than it truly is, masking an underlying underfunded status. Critics, including researchers from Stanford, argue that many public pension plans use unrealistic return assumptions, leading to a significant understatement of their true underfunded liability.⁵ The IRS has also noted that unreasonable actuarial assumptions can lead to disallowance of deductions and penalties.⁴
• Discount Rates: The choice of discount rate used to calculate the present value of future benefits is particularly contentious. A higher discount rate will result in a lower calculated present value of liabilities, making a plan appear more adequately funded. Public pension plans often use higher assumed rates of return on their investment portfolio as their discount rate, which can lead to a rosier picture of their financial health.
• Market Volatility: Even with sound assumptions, market downturns can quickly render a previously well-funded plan underfunded. While a temporary dip in assets might not immediately jeopardize benefit payments, prolonged periods of poor investment performance or significant economic downturns exacerbate the problem.
• Political Factors: In the public sector, political considerations can sometimes lead to insufficient contributions to pension funds, pushing the burden of underfunding to future generations of taxpayers or beneficiaries. This deliberate underfunding can create a perception of fiscal solvency in the short term, but it accumulates larger problems over the long run.

Underfunded vs. Underfunded Liability

While often used interchangeably in casual conversation, "underfunded" and "underfunded liability" refer to related but distinct concepts.

Underfunded describes the state or condition of a fund or program. When a pension plan, for example, is described as underfunded, it means that its current resources are insufficient to meet its future obligations. It's an adjective describing the financial health of the entity.

Underfunded Liability (also known as unfunded accrued liability or unfunded actuarial accrued liability) refers to the specific monetary amount of the shortfall. It is the calculated numerical difference between a plan's future obligations (liabilities) and its present assets. It represents the precise deficit that needs to be covered to bring the plan to a fully funded status.

Think of it this way: if your checking account is short of the money needed to pay all your upcoming bills, your account is "underfunded." The exact dollar amount you are short is your "underfunded liability."

FAQs

Q1: What causes a pension plan to become underfunded?

A pension plan can become underfunded due to several factors, including insufficient contributions from the employer, lower-than-expected investment returns, changes in demographic assumptions (such as people living longer), or generous benefit increases without corresponding funding adjustments.³,²

Q2: Is being underfunded always a serious problem?

Not necessarily. A temporary underfunded status due to a short-term market downturn or an economic downturn might not be critical if the plan has a solid long-term funding strategy and can recover. However, persistent or severely underfunded conditions indicate a serious challenge to the plan's long-term solvency and may require significant corrective action.

Q3: How do authorities regulate underfunded private pensions?

In the U.S., the Employee Retirement Income Security Act (ERISA) and the Pension Benefit Guaranty Corporation (PBGC) set minimum funding standards for private defined benefit plans. The PBGC also insures benefits up to a certain limit if an underfunded plan terminates.,¹

Q4: What happens if a government pension plan is underfunded?

If a government pension plan is underfunded, it can place a significant burden on taxpayers and the government's budgeting. Potential consequences include pressure to raise taxes, cut public services, or reduce promised benefits to current or future retirees. The specific outcomes depend on state laws, constitutional provisions, and the severity of the underfunding.

Q5: Can underfunding affect an individual's benefits?

For private pensions, if a company's defined benefit plan becomes severely underfunded and terminates, the PBGC generally steps in to pay guaranteed benefits, though these might be less than the full amount promised by the original plan. For public pensions, benefit reductions are possible, but they are often subject to complex legal and political processes.