Underfunded liability

What Is Underfunded Liability?

An underfunded liability represents a financial obligation for which the designated assets set aside to meet that obligation are insufficient. This concept is central to accounting and finance, particularly in the context of long-term obligations like pension plan benefits or other post-employment benefits (OPEB). When a company or government entity has an underfunded liability, it means the present value of its future payment commitments exceeds the current value of the assets allocated to cover those payments. This shortfall can significantly impact an entity's financial health and requires careful management and disclosure on its financial statement and balance sheet.

History and Origin

The concept of underfunded liabilities, particularly in pension systems, evolved significantly with the growth of defined benefit plans and the increasing need for robust financial reporting standards. In the United States, a pivotal moment arrived with the enactment of the Employee Retirement Income Security Act of 1974 (ERISA). This federal law established minimum standards for most voluntarily established retirement and health plans in private industry, aiming to protect individuals by setting requirements for funding, participation, vesting, and fiduciary responsibilities.¹³,¹² ERISA also created the Pension Benefit Guaranty Corporation (PBGC) to insure benefits in private-sector defined benefit plans. The law necessitated more rigorous calculations of future benefit obligations and the assets held to meet them, bringing the issue of underfunded liabilities to the forefront for corporations and public entities alike.

Key Takeaways

An underfunded liability occurs when the assets set aside for an obligation are less than the calculated present value of that obligation.
It is most commonly observed in defined benefit pension plans and other post-employment benefits.
The calculation heavily relies on actuarial assumptions regarding future returns, salary growth, and life expectancy.
Underfunded liabilities can pose significant risks to an entity's financial stability, potentially requiring increased contributions or adjustments to services.
Regulatory bodies often mandate disclosure of these liabilities to ensure transparency.

Formula and Calculation

An underfunded liability is not calculated by a standalone formula but rather is the result of comparing the present value of future obligations to the current fair market value of dedicated assets. For a defined benefit pension plan, the fundamental relationship is:

\text{Underfunded Liability} = \text{Projected Benefit Obligation (PBO)} - \text{Fair Value of Plan Assets}

Where:

Projected Benefit Obligation (PBO): This is an actuarial estimate of the present value of all benefits earned by employees to date, including expectations for future salary increases. It represents the total liability for future pension payments. The calculation of PBO involves numerous actuarial assumptions like employee turnover, mortality rates, and salary growth.
Fair Value of Plan Assets: This is the market value of the investments held by the pension fund to pay for the future benefits.

If the PBO exceeds the Fair Value of Plan Assets, an underfunded liability exists. If assets exceed PBO, the plan is overfunded.

Interpreting the Underfunded Liability

Interpreting an underfunded liability requires understanding its context and magnitude. A large underfunded liability suggests that an entity may face significant challenges in meeting its long-term commitments without additional funding or adjustments to its operations. For companies, this could mean allocating more cash flow to the pension plan, potentially impacting profitability or investment in other areas. For public sector entities, a substantial underfunded liability can strain the government budget, possibly leading to tax increases, service cuts, or increased debt. The funded status, often expressed as a percentage (assets divided by liabilities), provides a clear snapshot of how well an entity is positioned to meet its future obligations.

Hypothetical Example

Consider "Company A," a manufacturing firm with a defined benefit pension plan for its employees. At the end of its fiscal year, Company A's actuaries calculate the Projected Benefit Obligation (PBO) for all current and retired employees.

Calculate Projected Benefit Obligation (PBO): Based on future salary projections, life expectancies, and an assumed discount rate of 6%, the actuaries determine the PBO to be $500 million. This is the estimated present value of all pension benefits earned by employees to date.
Determine Fair Value of Plan Assets: The pension fund's investment portfolio, consisting of stocks, bonds, and other securities, has a fair market value of $400 million.
Calculate Underfunded Liability:
Underfunded Liability = PBO - Fair Value of Plan Assets
Underfunded Liability = $500 million - $400 million = $100 million

In this example, Company A has an underfunded liability of $100 million, meaning its pension fund has $100 million less than what is currently estimated to be needed to cover its promised future pension payments.

Practical Applications

Underfunded liabilities are a critical consideration across various sectors, particularly in corporate finance and public policy.

Corporate Pensions: Many corporations sponsor defined benefit pension plans for their employees. An underfunded liability in such plans can impact a company's financial ratings, stock valuation, and ability to attract or retain talent. Regulators monitor these liabilities closely.
Public Sector Pensions: State and local government entities often face significant underfunded pension and other post-employment benefit (OPEB) liabilities. These shortfalls can create substantial fiscal pressure, impacting public services and tax rates. As of fiscal year 2022, unfunded state pension liabilities across the U.S. grew to nearly $1.3 trillion, primarily due to lower-than-expected investment returns.¹¹,¹⁰,⁹
Mergers and Acquisitions: When evaluating a company for acquisition, potential buyers scrutinize any underfunded liabilities, as these represent future obligations that will transfer with the acquired entity.
Investor Analysis: Investors and analysts use the level of underfunded liabilities to assess a company's or government's true financial health and long-term sustainability. A significant underfunding can signal higher future cash demands or potential insolvency risk.

Limitations and Criticisms

While essential for assessing financial obligations, the calculation and interpretation of underfunded liabilities come with certain limitations and criticisms:

Reliance on Actuarial Assumptions: The present value of future obligations relies heavily on complex actuarial assumptions about discount rates, inflation, salary increases, employee longevity, and investment returns. Small changes in these assumptions can lead to significant swings in the reported liability. For instance, lower interest rates increase the present value of future obligations, thereby exacerbating reported underfunding.⁸ Critics argue that these assumptions can sometimes be overly optimistic, especially regarding assumed rates of return on investments, leading to an understatement of the true underfunded liability.⁷
Market Volatility: The fair value of plan assets is subject to market fluctuations. A sudden downturn in financial markets can drastically increase an underfunded liability, even if the underlying obligations haven't changed.
Discount Rate Sensitivity: The chosen discount rate is particularly sensitive. A lower discount rate (which is often tied to long-term bond yields) results in a higher calculated present value of future benefits, thereby increasing the reported underfunded amount. This sensitivity means that external economic conditions, such as prevailing interest rates, can significantly impact reported funding levels.⁶,⁵,⁴
Long-Term Horizon: Pension and OPEB liabilities span decades, making precise forecasting inherently difficult. The long time horizon means that current estimates of underfunded liability are projections that may change considerably over time.
Accounting vs. Economic View: Debates exist regarding the appropriate accounting methods for these liabilities. Some argue that generally accepted accounting principles (GAAP) may not always reflect the full economic reality of the liability, especially in the public sector, leading to different reported figures depending on the methodology used.³

Underfunded Liability vs. Unfunded Liability

While often used interchangeably, "underfunded liability" and "unfunded liability" can have slightly different connotations in financial discourse, though their practical impact is similar.

An underfunded liability specifically implies that there are assets set aside to meet an obligation, but these assets are insufficient to cover the total calculated present value of that obligation. It suggests a partial funding, just not enough to be fully funded. This is common in pension plans, where a trust holds assets for future payouts, but those assets fall short of the total projected benefit obligation.

An unfunded liability, on the other hand, can imply a situation where no specific assets have been explicitly set aside to meet a future obligation, or if they have, they are negligible. A common example is Other Post-Employment Benefits (OPEB) like retiree healthcare, where entities often pay benefits directly from current operating budgets rather than from dedicated, pre-funded trusts. In many cases, the entire liability for these benefits might technically be considered "unfunded."

However, in common usage, especially concerning pension plans, the terms are frequently used synonymously to describe a deficit where obligations exceed assets. The core distinction often lies in whether any assets are available versus simply not enough assets. Regardless of the precise terminology, both highlight a shortfall in financial provisions for future commitments.

FAQs

What causes a liability to become underfunded?

A liability typically becomes underfunded when the assets dedicated to it grow slower than the obligations, or when the estimated value of the obligations increases. This can happen due to poor investment returns on the assets, changes in actuarial assumptions (such as employees living longer or salary growth exceeding expectations), or insufficient contributions made by the sponsoring entity.

Are underfunded pension plans common?

Yes, underfunded pension plans are common, especially for state and local government plans. Factors like volatile investment markets, demographic shifts, and the setting of actuarial assumptions contribute to their fluctuating funded status. Many public pension systems, for example, collectively face significant underfunded liabilities.²,¹

How does an underfunded liability affect a company's financial standing?

An underfunded liability can negatively impact a company's net worth and overall financial health. It represents a future claim on the company's resources, which could require higher cash contributions, potentially reducing earnings, affecting credit ratings, and limiting funds available for other investments or operations. It is disclosed on the company's balance sheet as a long-term liability.

What are the risks of an underfunded liability for a government?

For a government, a significant underfunded liability can strain the government budget, potentially leading to difficult choices such as raising taxes, cutting public services, or issuing more debt to cover pension shortfalls. It can also impact the government's creditworthiness and its ability to fund other essential programs.

Can an underfunded liability ever be eliminated?

Yes, an underfunded liability can be eliminated if the assets grow to meet or exceed the obligations. This typically requires a combination of strong investment returns, increased contributions from the sponsoring entity, and potentially adjustments to future benefit structures or actuarial assumptions.