Unfunded accrued liability

Unfunded Accrued Liability

What Is Unfunded Accrued Liability?

An unfunded accrued liability represents the shortfall that occurs when the estimated future benefit obligations of an entity, particularly for pension plans or other post-employment benefits, exceed the value of assets set aside to meet those obligations. It is a critical concept within accounting and public finance, reflecting a gap between promises made and resources accumulated. This liability signifies the portion of accumulated benefits that an organization is committed to paying, but for which it has not yet secured sufficient funding. While commonly associated with public sector pension systems, unfunded accrued liability can also arise in corporate finance within private sector defined benefit schemes.

History and Origin

The evolution of accounting for pension obligations has been a significant journey, driven by the need for greater transparency and consistency in financial reporting. Historically, pension costs were often recognized on a cash basis, meaning expenses were recorded only when benefits were actually paid. This approach often obscured the true long-term financial commitments. In the United States, significant changes began to emerge with the advent of regulations from bodies like the Financial Accounting Standards Board (FASB) for private entities and the Governmental Accounting Standards Board (GASB) for state and local governments.

For public sector entities, a pivotal moment arrived with the issuance of GASB Statement No. 67 and GASB Statement No. 68 in 2012. These standards significantly improved the accounting and financial reporting for public employee pensions, requiring governments to recognize their long-term obligation for pension benefits as a liability on the balance sheet for the first time¹⁴. Prior to these statements, many pension liabilities were primarily disclosed in the notes to financial statements rather than being fully recognized on the face of the financial reports¹³. This shift aimed to provide a clearer and more comprehensive picture of the true financial health of public entities and their long-term commitments.

Key Takeaways

An unfunded accrued liability indicates the amount by which an entity's future benefit obligations (like pensions) exceed the assets currently available to pay them.¹²
It primarily arises in defined benefit plans, where a specific benefit is promised to employees upon retirement.
The calculation relies on actuarial assumptions about factors such as future employee salaries, life expectancies, and expected investment returns.
High unfunded accrued liabilities can strain an organization's finances, potentially impacting its credit rating, budget decisions, and ability to fund other essential services.
Addressing this shortfall often involves increased contributions, adjustments to benefit structures, or revised investment strategies.

Formula and Calculation

The unfunded accrued liability is calculated as the difference between an entity's actuarial accrued liability and the fair value of its plan assets. The actuarial accrued liability represents the present value of benefits earned by employees for past service, based on various actuarial assumptions.

The formula can be expressed as:

$\text{Unfunded Accrued Liability (UAL)} = \text{Actuarial Accrued Liability (AAL)} - \text{Fair Value of Plan Assets (FVA)}$

Where:

Actuarial Accrued Liability (AAL): The present value of all pension benefits attributed to employee service rendered up to a specific date, calculated using actuarial methods. This is a measure of the total obligation accrued by the plan.
Fair Value of Plan Assets (FVA): The market value of the assets held in the pension trust or fund, available to pay future benefits.

If the fair value of plan assets is less than the actuarial accrued liability, an unfunded accrued liability exists. Conversely, if assets exceed the liability, the plan has an overfunded status.

Interpreting the Unfunded Accrued Liability

Interpreting an unfunded accrued liability requires understanding its context and the underlying assumptions. It does not necessarily mean an entity is unable to pay its current obligations, but rather that it faces a long-term shortfall if corrective actions are not taken¹¹. A growing unfunded accrued liability can signal potential future financial strain, indicating that current contributions, combined with anticipated investment earnings, are insufficient to cover promised benefits.

For public entities, a significant unfunded accrued liability can lead to difficult choices, potentially requiring tax increases, cuts to other public services, or reductions in future benefits to address the budget deficit ¹⁰. For corporate entities, it can impact the company's cash flow and risk management strategies. Analysts often examine the "funded ratio," which is the ratio of plan assets to accrued liabilities, to assess the financial health of a pension plan. A ratio below 100% indicates an unfunded status.

Hypothetical Example

Consider a hypothetical municipal pension plan, "Cityville Retirement System," at the end of its fiscal year.

Actuarial Accrued Liability (AAL): An actuary determines that the present value of all benefits earned by current and retired Cityville employees for service rendered to date is $500 million. This figure incorporates various actuarial assumptions, including projected salary increases, employee turnover, mortality rates, and the chosen discount rate.
Fair Value of Plan Assets (FVA): The pension fund currently holds investments and cash totaling $400 million.
Calculation of Unfunded Accrued Liability:
$\text{UAL} = \text{AAL} - \text{FVA}$
$\text{UAL} = \$500 \text{ million} - \$400 \text{ million}$
$\text{UAL} = \$100 \text{ million}$

In this scenario, Cityville Retirement System has an unfunded accrued liability of $100 million. This means that, based on current obligations and available assets, the plan has a $100 million shortfall in funding the benefits that its employees have already earned. To address this, Cityville might need to increase its annual contributions, explore alternative investment strategies to boost investment returns, or adjust future benefit provisions to ensure the long-term solvency of the pension plan.

Practical Applications

Unfunded accrued liability is a critical metric across various financial domains:

Public Sector Finance: State and local governments routinely assess their unfunded accrued liabilities for public employee pension plans and other post-employment benefits (OPEB). These liabilities represent significant long-term commitments that can impact municipal bond ratings, budgeting decisions, and the overall fiscal health of states and cities. Organizations like The Pew Charitable Trusts regularly report on the substantial funding gaps in state pension systems, highlighting the scale of these unfunded obligations and their implications for public services and taxpayers⁹. The reported funding gap for state pension plans in the U.S. jumped significantly in 2022 due to investment losses, underscoring the volatility impacting these liabilities⁸.
Corporate Accounting: While less prevalent due to the shift from defined benefit plans to defined contribution plans in the private sector, companies that still offer defined benefit pensions must report their unfunded accrued liabilities on their balance sheet under accounting standards set by the FASB. This impacts their reported net income and overall financial position.
Investment Analysis: Investors and credit rating agencies closely monitor an entity's unfunded accrued liability. For governmental bonds, a large unfunded liability can indicate higher fiscal risk, potentially leading to higher borrowing costs⁷. For corporate equities, it can signal a hidden drain on future profits or a potential need for significant future cash infusions, influencing stock valuations.
Policy and Regulation: Regulatory bodies and policymakers use unfunded accrued liability data to develop new accounting standards and funding policies. Discussions around pension reform, changes to fiduciary duty, and long-term fiscal planning are often driven by the size and growth of these obligations. The Federal Reserve Bank of San Francisco, for instance, has examined the impact of low interest rates on public and private pension funding, noting that such conditions can exacerbate unfunded liabilities by making it harder for plans to meet their assumed rates of return⁶.

Limitations and Criticisms

Despite its importance, the concept and measurement of unfunded accrued liability face several limitations and criticisms:

Actuarial Assumptions: The calculation of actuarial accrued liability heavily relies on a set of actuarial assumptions about future events, such as salary growth, employee longevity, and crucially, the discount rate used to present value future obligations⁵. If these assumptions are overly optimistic, the reported unfunded accrued liability may be understated, creating a false sense of security. For example, some critics argue that public pension plans often use discount rates tied to expected investment returns rather than risk-free rates, which can significantly understate the true economic liability⁴.
Market Volatility: The value of plan assets can fluctuate significantly due to market conditions. While actuarial methods often employ smoothing techniques to dampen the impact of short-term market volatility, large, sustained downturns can rapidly increase the unfunded accrued liability, sometimes catching entities unprepared.
Political Influence: Especially in the public sector, decisions regarding contributions, benefit levels, and actuarial assumptions can be influenced by political considerations rather than purely financial prudence. This can lead to underfunding in the short term, pushing the burden of unfunded accrued liability onto future generations³.
Complexity: The intricate nature of pension accounting and actuarial science makes it challenging for non-experts to fully understand and scrutinize the reported unfunded accrued liability. This complexity can sometimes hinder effective oversight and public accountability. Academic research has highlighted that firms with lower asset values tend to underfund their pension plans, leading to a complex relationship between firm value and unfunded pension liabilities that is difficult to isolate empirically².

Unfunded Accrued Liability vs. Actuarial Liability

While often used in the same breath, "unfunded accrued liability" and "actuarial liability" refer to distinct, though related, concepts.

Actuarial liability, also known as actuarial accrued liability (AAL), represents the total present value of all pension benefits that have been earned by employees for their service up to a specific valuation date. It is the comprehensive measure of the financial obligation for benefits accumulated to date, calculated using a variety of actuarial assumptions and methodologies. It reflects the total "debt" owed by the pension plan for past service, regardless of whether assets have been set aside to cover it.

Unfunded accrued liability, on the other hand, is the portion of that total actuarial liability that is not covered by the plan's current assets. It is the deficit or shortfall when the actuarial liability exceeds the fair value of assets held in the pension fund. Essentially, actuarial liability is the total amount owed, while unfunded accrued liability is the part of that total that is currently unsecured or "unfunded." Thus, an unfunded accrued liability can only exist if an actuarial liability is present and the plan's assets are insufficient to cover it.

FAQs

What causes an unfunded accrued liability?

An unfunded accrued liability primarily arises when the contributions made to a pension plan, combined with the actual investment returns earned, are insufficient to meet the promised future benefits. Other factors include overly optimistic actuarial assumptions, unexpected changes in demographics (e.g., people living longer), or benefit enhancements that are not adequately funded.

Is unfunded accrued liability a good or bad thing?

While "unfunded" sounds negative, it's a measure of a financial obligation that requires careful management. A small or manageable unfunded accrued liability may not be a significant concern, especially if there's a clear plan to address it over time. However, a large and growing unfunded accrued liability can indicate serious financial challenges, potentially leading to fiscal stress, reduced public services, or financial instability for the sponsoring entity.

How is unfunded accrued liability typically addressed?

Entities typically address unfunded accrued liability through a combination of strategies. These may include increasing contributions from the employer or employees, adjusting actuarial assumptions to be more realistic, modifying benefit formulas for future accruals (e.g., increasing the retirement age or adjusting cost-of-living adjustments), or pursuing strategies to improve investment returns. Some entities also explore issuing bonds to fund the liability, though this effectively converts one type of debt into another.

Does unfunded accrued liability affect my personal finances?

If you are a public employee or a retiree covered by a defined benefit plan, a significant unfunded accrued liability could potentially impact the long-term security of your promised benefits, although many plans have legal protections. As a taxpayer, large unfunded liabilities in public sector pension plans can lead to higher taxes, reduced public services, or increased municipal debt, indirectly affecting your personal finances.

Is unfunded accrued liability the same as pension debt?

Yes, "unfunded accrued liability" is often used interchangeably with "pension debt" or "pension funding shortfall," especially in the context of public sector pension plans¹. Both terms refer to the gap between the promised benefits that have been earned and the assets currently held to cover those promises.