For many retirees, a pension plan is a financial safety net, providing guaranteed income during retirement. However, not all pension plans are fully funded. When a pension plan is underfunded, its liabilities (promises made to current and future retirees) exceed its assets or the funds set aside to fulfill those promises. This shortfall can raise concerns about the plan’s ability to meet its obligations, potentially impacting the financial security of retirees and employees nearing retirement.
A financial advisor can help you review your pension plan to ensure your retirement is protected.
An Underfunded Pension Plan – Definition and Meaning
An underfunded pension plan occurs when the total assets held are insufficient to cover the projected benefits owed to participants. This shortfall could be due to several factors, including poor investment performance, inadequate employer contributions or changes in actuarial assumptions, such as life expectancy or expected returns on investments.
Impact on Participants
With a pension plan underfunded for an extended period, it can lead to potential consequences for plan participants, such as these.
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Reduced benefits: In extreme cases, participants may receive less than their promised benefits.
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Delays in payments: Employers may delay payouts if they struggle to meet funding requirements.
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Plan restructuring: Companies might freeze the plan, halting further accruals or shift to alternative retirement options like 401(k) plans.
Regulatory bodies, such as the Pension Benefit Guaranty Corporation (PBGC) in the U.S., often intervene to protect participants in private-sector plans, but this may only cover a portion of benefits.
How a Pension Plan Is Funded
Pension plans have a funding ratio that includes a combination of contributions, investment returns and actuarial assumptions.
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Employer contributions: Employers regularly contribute to the pension fund based on actuarial estimates of the plan’s obligations.
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Employee contributions: In some plans, employees also contribute a percentage of their salaries to the fund.
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Investment returns: The funds are invested in a diversified portfolio of assets, such as stocks, bonds and real estate, to generate returns over time.
The plan’s financial health depends on the balance between these inflows and the outflows required to pay current and future retirees.
Underfunded vs. Overfunded Pension Plans
An underfunded plan has liabilities that exceed its assets. This indicates the plan lacks sufficient funds to meet all future obligations. Employers with underfunded plans may need to increase contributions or take other corrective actions to address the shortfall.
Conversely, an overfunded pension plan has more assets than liabilities. This surplus can provide additional financial stability and may allow employers to reduce contributions temporarily or reinvest excess funds in other areas of the business.
Knowing the funding status of your pension plan can give you insight into its long-term viability and potential risks.
How to Know If a Pension Plan Is Underfunded
There are several ways to determine whether a pension plan is underfunded:
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Review the funded status: Check the plan’s funded ratio, which compares its assets to its liabilities. A ratio below 100% indicates underfunding.
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Annual reports: Pension plans are required to file financial disclosures, such as Form 5500 in the U.S., which detail the plan’s funding status.
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Actuarial valuations: Review actuarial reports that provide insights into the plan’s assumptions and funding levels.
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Communications from plan administrators: Employers or plan administrators may inform participants of funding challenges and any corrective measures being taken.
By staying informed about your pension plan’s funding status, you can take proactive steps to safeguard your retirement.
What to Do If Your Pension Plan Is Underfunded
If you discover your pension plan is underfunded, consider the following actions:
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Monitor plan updates: Stay informed about changes to the plan’s funding status and any actions being taken by your employer or regulators.
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Understand PBGC coverage: If your plan is private-sector, research the extent of coverage provided by the Pension Benefit Guaranty Corporation.
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Diversify retirement savings: Increase contributions to other types of retirement accounts, such as IRAs or 401(k)s, to reduce reliance on the pension.
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Consult a financial advisor: Seek guidance on how the underfunded status may impact your retirement income and explore alternative savings strategies.
Bottom Line
With a pension plan underfunded, it can raise concerns about the security of your retirement income, but understanding the issue and taking proactive measures can help mitigate the risks. Whether through increased savings, consultation with a financial advisor or monitoring plan updates, you can better prepare for potential challenges. If you are unsure about your pension plan’s status or its impact on your financial goals, working with a financial expert can provide valuable insights and strategies to protect your future.
Tips for Retirement Planning
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Retirement planning can require expertise that you may not have. A financial advisor helps clients understand their financial goals and how they can achieve them during retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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A retirement calculator can help you better understand how much money you might need to save for the retirement you want.
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