What Are Unfunded Liabilities?

Unfunded Liabilities Definition, Examples, and How They Impact Investors

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Unfunded liabilities are debt obligations that do not have sufficient funds set aside to pay the debt. These liabilities generally refer to debts of the U.S. government or of pension plans and their impact on savings, investing, and general economic health of a nation or corporation can be negative and significant.

Although the impact to investors may be indirect, unfunded liabilities point to problems in the future if nothing is done to address the liabilities.

Unfunded Liabilities Definition and Basics

In finance and economics, a liability is a legal obligation of a person, organization or government entity to pay a debt arising from a past or current transaction or action. In brief, a liability is a claim on the debtor's current or future assets. An unfunded liability is a liability that does not have current or projected assets to cover the liability; therefore it is said to be unfunded.

Examples of Unfunded Liabilities: U.S. Government and Pensions

In reference to the U.S. government a prime example of an unfunded liability is Social Security. When Social Security was first implemented by Franklin D. Roosevelt in 1935, there were more than enough payees (working taxpayers) to support the number of Social Security beneficiaries (retirees). In 1940, the ratio of payees to beneficiaries was 159 to one. Today the ratio of workers to beneficiaries is less than three to one.

Medicare has a similar problem with unfunded liabilities.

Another example of unfunded liabilities is with pension plans. For example, state pension plans reportedly have more than $6 trillion in unfunded liabilities. The worst states include California, New York, Illinois, Ohio and Texas. A pension plan is a retirement benefit sponsored and fully funded by an employer on behalf of their employees.

Most pensions pay out a stated percentage of an employee's pre-retirement income. The pension then becomes a source of income for the retiree for the remainder of their life. But while the employee is still actively-employed, they are promised the pension, assuming the employee meets certain requirements, such as remaining employed with the employer sponsor for a certain number of years.

Pensions are becoming increasingly uncommon because of the financial burden of the plan sponsor and as means of preventing more unfunded liabilities. For this reason, the vast majority of employers offer defined contribution plans, such as the 401(k) plan, which is primarily funded by the employee. The only employer contribution to 401(k)s are the employer match, which is often discretionary.

How Unfunded Liabilities Can Impact Taxpayers, Investors and Consumers

The stakeholders of unfunded liabilities include government entities, taxpayers, corporations, lenders, and investors. For example, taxpayers are impacted by this unfunded liabilities of pensions because they are the ones funding the revenue to pay the wages and benefits of government employees. The increasing unfunded liabilities create higher payments to the debt, which means more funds go to pensions that could go to other resources and government services, such as public safety, roads, and education.

Investors are impacted by swelling unfunded liabilities when they hold shares of stock of a company that finds it increasingly difficult to fund their debt. Higher liabilities translate into a lower bottom line (net income), which then becomes a drag on profits. Lower profits can mean lower growth in share price and/or lower dividends for the investor.

Unfunded liabilities also impact consumers by higher cost of goods. For example, the debt burden of pensions for the major U.S. auto makers is known to have increased the cost of American made cars compared to overseas competitors that do not offer pensions to their employees.

Bottom Line on Unfunded Liabilities

Unfunded liabilities can be described as the elephant in the room when it comes to the future health of the U.S. economy. With federal and state governments and some large corporations becoming more and more burdened by increasing debts of benefits, governments are forced to take away benefits, increase taxes, or a combination of both.

Corporations with unfunded liabilities must find more revenue by increasing efficiency, charging more for their products and services, accept lower profits, decrease dividends to investors, or some combination of these.

With no solution or action to reduce and eliminate unfunded liabilities, the U.S. and other economies will continue to see more inflation and problems with poverty. Investors should also look to see if a corporation has large unfunded liabilities before investing in the company's stock.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.