What is a pension fund?

A pension fund can be described as a scheme, plan, or policy of a country that provides income after the employees' retirement. Unions, employers, or agencies set up pension plans. The monetary contribution of both employee and employer is pooled, and funds are used to provide retirement benefits to the members or employees of the organisation. In most of the countries, the pension fund is one of the biggest investment blocks. Pension funds are dominant in the stock market from the investment perspective.

The pension funds are not subjected to capital gain taxes. Moreover, the earnings generated from the investment portfolio are either tax exempted or tax deferred.

If a professional fund manager manages the pension fund, the amount will be the submission of investment trusts, insurance companies, and institutional investors.

What is the meaning of an Underfunded Pension Plan?

The company-sponsored retirement plan and has more liabilities than the assets are known as the underfunded pension plan. Therefore, it can be understood as a plan that lacks funds to fulfil the future or current retirements.

In an underfunded pension plan, the future retirees do not have the assurance that they will receive the pension promised or the current retirees are not assured of the pension amount they received previously. Therefore, the underfunded pension plan is the complete opposite of the overfunded or fully funded pension plan.

Frequently Asked Questions (FAQs)

What is the working of an underfunded pension plan?

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In a pension plan, the member or the employee are promised that they will receive a payment during the retirement years under the plan. The company invests the funds pooled for the pension plan in a range of assets to generate income that can be used for fulfilling the pension plan commitment of the current retirees and future retirees.

The term “funded” in the pension plan stands for the proportion of liabilities and assets. “Underfunded” stands for the more proportion of liabilities; that is, the company’s obligation to pay pension is higher than the assets or funds required to fulfil those obligations. In brief, companies do not have enough funds to pay the promised amount to current and future retirees.

There are various reasons due to which the pension plan remains underfunded. For instance, stock market fall and change in interest rates can lead to falling in the value of assets. In the economic slowdown also, the risk of plans becoming underfunded is high.

As per the accounting and IRS rules, pension plans can be supported with company stocks and cash contributions. However, the support through company stock is limited to a specific per cent of the portfolio.

Generally, to manage the company’s cash flow, the companies generally increase the reliance on the stocks and limit the cash outflow. However, this practice is not generally advisable as it has an impact on portfolio management. There are high chances that overinvestment is done in the employer’s stock. Overinvestment in employer’s stocks leads to dependency upon the employers’ financial health.

The company is required to increase their contribution in the pension funds in form of cash when the funds are not funded by more than 90% from the last three years or not funding is less than 80% from the last year.

The company’s cash commitment can have a negative impact on the earnings per share and afterwards the stock prices. Moreover, with the reduction in equity, corporate loan agreements can also default, resulting in bankruptcy and higher interest rates.

How to ascertain whether the pension plan is underfunded?

To ascertain whether the pension plan is underfunded or not, the fair value and the accumulated benefit obligations are compared to each other. The main component is the amount owed to the current and future retirees. It will be concluded that there is a pension shortfall when the fair value is less than accumulated benefit obligations.

The company must disclose the pension shortfall (if any) in the 10-k annual financial statement. The information is disclosed through footnotes.

There is a high probability that the company might employ overly optimistic assumptions while predicting its future liabilities/obligations. Assumptions are a crucial part when predicting future obligations. The company might change the assumptions in order to avoid cash contribution and remove the situation of pension shortfall.

What can be the economic consequence of underfunded pension plans?

The underfunded pension plan can have the following economic implications –

• There is a risk that the economic growth will be retarded because of the underfunded pension plan. In case the pension plan is fully funded, then it implies that the savings of the workforce is invested productively, and the earnings will be used to make payment when they retire. If the investment is done in the government sector, in that case, the funds are also made available in the market for investment in private sectors. However, in underfunded pension plans, the employees' contribution in the plan is lower, and when they are not aware of the issue, they do not make savings keeping retirement in mind. As a result, the employees do not have enough funds to make a huge investment. In effect, the growth rate declines.
• The quality of the public services declines with the underfunded pension plan from a long-term perspective because the talented workforce is discouraged from applying for jobs in the public sector.