What Are Unfunded Liabilities?
Definition & Examples of Unfunded Liabilities
Unfunded liabilities are debt obligations that do not have sufficient funds set aside to pay them. These liabilities generally refer to the U.S. government's debts or pension plans and their impact on savings and investment securities. Unfunded liabilities can have a significant and negative impact on the general economic health of a nation or corporation.
What Are Unfunded Liabilities?
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 debt that does not have existing or projected assets to cover it—therefore, it is unfunded.
How Unfunded Liabilities Work
A business or government can fund their operations with debt and create plans to pay the debt off. They might not ever ultimately pay off their debts—in corporate finance, this is not a bad practice, depending on the business's financial structure.
An unfunded liability is generally considered a debt to a fund designed to make payments to individuals or entities, where there is no money to pay for it. These funds are commonly intended to increase value over time by investing in mutual funds, stocks, bonds, or other chosen investments because of their growth potential and stability.
Economic and market fluctuations play an important part in pension plan funding and the balance between recipients and contributors.
Sometimes, the funds are not funded or managed correctly. The funds are usually designed so that current employees pay into a fund from which the recipients are drawing. If a business downsizes, it might face the issue of having more pension recipients than contributors.
To keep a fund afloat in this situation, a business would have to sacrifice profits and free cash to ensure their funds do not become unfunded. To stay profitable, the company might follow the regular downsizing practice, which reduces the fund's input even more.
The result is a snowball effect, where the options are more downsizing, reducing payouts, getting rid of the fund, declaring bankruptcy, or shutting down operations.
Types of Unfunded Liabilities
Unfunded liabilities can be any liabilities an entity owes that do not have sufficient funds to cover the required payments. The most commonly discussed type is a pension fund.
Internet searches, journal articles, and scholarly discussion about unfunded liabilities focus on pension funds as the primary liabilities that are unfunded.
As the fund's managers continue investing in the pension fund, the stock market naturally fluctuates. Investors can lose confidence in the market conditions and begin rearranging their assets, possibly selling off assets that belong to pension funds.
Stock market fluctuations and investor sentiments increase pension fund underfunding risk because economic downturns cannot be predicted. Also, there are more retirees than contributors to pension funds as baby boomers continue to retire and draw from the funds.
For these reasons, pensions are becoming increasingly uncommon. More and more employers have begun to offer defined contribution plans, such as the 401(k) plan, which is primarily funded by the employee.
Employee funded retirement plans are more popular with employers. Most large companies provide some form of contribution matching to make them attractive to employees.
Government Unfunded Liabilities
An example of an unfunded government liability is the Social Security Trust Fund. When Franklin D. Roosevelt first implemented social Security in 1935, there were more than enough payees (working taxpayers) to support the number of Social Security beneficiaries (retirees).
In 1960, the ratio of payees to beneficiaries was 5.1 to one. The Social Security Trustees project predicts that the ratio will continue to decline. Medicare is another program that similarly has a problem with funding as a large workforce begins retiring and is supported by a smaller one.
- 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 recipients than contributors.
- Investors should inspect a company's retirement plans and look for indications of unfunded liabilities to reduce their risk.
What It Means for Individual Investors
The stakeholders of unfunded liabilities include government entities, taxpayers, corporations, lenders, and investors. For example, taxpayers are impacted by the unfunded liabilities of pensions because they are funding the revenue to pay the wages and benefits of government employees.
The increasing number of unfunded liabilities creates higher payment requirements, which means more funds go to pensions that could go to other resources and government 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, necessary funding for operations or expansions can drop.
Investors should look over a prospective investment's financial documents to look for indicators that there might be an unfunded liability, such as the balance sheet entry for pensions. This entry would list a net liability.
However, investors should take this information in context, not as a bad investment indication.
Federal and state governments—and some large corporations—are becoming more and more burdened by the increasing debts of benefit payouts. Governments are forced to reduce benefits, increase taxes, or a combination of both.
Corporations with unfunded liabilities must find more revenue by increasing efficiency 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 pension benefits of privately-employed Americans. The goal of the program is to ensure pensioners receive their defined-benefit pensions if their pension program folds.
Multi-employer programs are pension funds that multiple 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, with a projection of insolvency (not able to pay debts) for multi-employer plans by 2027.
Single-employer pension plan insurance fares better. THE PBGC predicts it will have enough funding to continue insuring single-employer plans.