What Are Unfunded Liabilities?

Definition & Examples of Unfunded Liabilities

A middle-aged couple discuss problems with their pension fund.
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Unfunded liabilities are debt obligations that do not have enough funds set aside to pay them. Most of the time, they refer to the U.S. government's debts or pension plans and their impact on savings and investment securities. Unfunded liabilities can have a major adverse impact on the total economic health of a nation or corporation.

What Are Unfunded Liabilities?

A liability is a legal duty of a person, organization, or government entity to pay a debt that comes from a past or current contract or action. In brief, a liability is a claim on the debtor's current or future assets.

An unfunded liability is a debt that does not have existing or projected assets to cover it. The entity the debt belongs to does not have funds to pay the debt.

How Unfunded Liabilities Work

A firm or government can fund their operations with debt and create plans to pay the debt off. They might not ever pay off their debts. In corporate finance, this is not a bad practice, depending on the way the firm is set up and the way it holds its assets.

An unfunded liability is a debt to a fund designed to make payments to people or entities. There is no money available to pay the debt. These funds are expected to increase in value over time through investments in mutual funds, stocks, bonds, or other chosen ways to improve growth and stability.

Economic and market ups and downs play a vital part in pension plan funding and the balance between recipients and contributors.

There are some times when the funds in these accounts are not funded or managed the way they should be. The funds are usually designed so that current workers of a firm pay into a fund from which the recipients are drawing. If a firm shrinks in size, it might face the issue of having more people getting a pension than current workers putting money into the plan.

To keep a fund afloat in this situation, a business would have to give up profits and free up some cash to ensure these accounts have enough money in them to stay solvent. To keep making a profit, the company might react by downsizing, which means the fund will decrease in amount even more.

The result is a snowball effect. The options are more downsizing, reduced payouts, getting rid of the fund, filing bankruptcy, or shutting down the business.

Types of Unfunded Liabilities

Unfunded liabilities can be any anything an entity owes in which funds to cover the required payments do not exist. The most common type is a pension fund.

Pension Funds

Pension funds are designed for workers to contribute to the fund while they are working. When they retire, they then receive a pension in exchange for their years of work. In order to keep the fund going, managers may invest the money in the fund and put the money earned back into the fund. As the fund's managers keep investing the money in the pension fund, the stock market goes through its normal ups and downs. People can lose confidence in the market and begin moving their assets. They may also sell off assets that belong to pension funds.

Stock market changes and investor sentiments can add to pension fund underfunding risk because economic downturns cannot be predicted. Also, there are more retired people who expect to get payouts from pension funds as baby boomers continue to retire and draw from the funds.

For these reasons, pensions are less common than they used to be. More and more employers have begun to offer other plans for retirement, such as the 401(k) plan. These plans, aside from employer matching funds, are mostly funded by the employee and do not rely on others for funding.

Employee-funded retirement plans are more popular with employers. Most large businesses provide some form of matching funds as a benefit.

Governmental

An example of an unfunded government liability is the Social Security Trust Fund. When Franklin D. Roosevelt started the Social Security Administration (SSA) in 1935, there were more than enough payees to support the number of people getting SSA payments (retirees).

In 1960, the ratio of payees to people getting payments was 5.1 to 1. By 2005, it was 3.3 to 1. The Social Security Trustees project predicts that the ratio will continue to decline. Medicare is another program that also has a problem with funding. This is because as members of the large U.S. workforce have begun to retire, the SSA fund is being paid into by fewer workers.

What It Means for Investors

The stakeholders of unfunded liabilities include government entities, taxpayers, corporations, lenders, and investors. For example, taxpayers feel the effects of unfunded liabilities of pensions because they are funding the revenue to pay the wages and benefits of government employees.

The rising number of unfunded liabilities creates the need for higher payments, which means more funds go to pensions that could go to other resources and services. Corporations funded by stockholders might see reduced returns as the businesses work to feed their funds.

Manufacturers are forced to raise prices to reduce pension costs while working to remain attractive to investors. If investors are not happy with returns, the funding needed for operations or growth can drop.

People who want to invest in a business should look over its finances. A signal that there might be an unfunded liability within the business would be a balance sheet entry for pensions. This entry would list a net liability.

Finding a pension in a company you want to invest in might not mean you should forget about doing so. You should also look at the rest of the financials before you decide whether or not to buy stock.

The Issue Grows

Federal and state governments—and some large corporations—are feeling the pinch and burden of the rising debts of benefit payouts to former workers. Governments are forced to reduce benefits, increase taxes, or both.

Corporations with unfunded liabilities must find more profits by getting more efficient or charging more for their products and services. They may also accept lower profits, decrease dividends to investors, or use some combination of these.

Pension Fund Failure Insurance

Congress created the Pension Benefit Guarantee Corporation (PBGC) to insure the pensions of Americans who worked for private companies. The goal of the program is to ensure people who get pensions still receive their money even if their pension program folds.

Multi-employer programs are pension funds that several companies contribute to. Many employers with pension plans have taken part in these programs to reduce pension funds' financial burden.

Multi-employer plan insurance continues to decline in financial position. Experts predict they won't be able to pay the debts for these plans by 2027.

Single-employer pension plan insurance fares better. THE PBGC predicts it will have enough funding to keep insuring these plans.

Key Takeaways

  • Unfunded liabilities are debts that do not have the necessary funding.
  • Pension plans are the most unfunded liability in the U.S.
  • Concerns for pension plans are generated from there being more people getting money from the plans than workers paying into them.
  • You should inspect a company's retirement plans and look for proof of unfunded liabilities if you want to invest in it.