What Is an Underfunded Pension Plan?

Underfunded Pension Plans Explained in Less Than 4 Minutes

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An underfunded pension plan is an employee benefit plan for retirement income that has fewer assets than liabilities, or what it owes in benefits. 

If a pension plan is underfunded, it is not on track to have enough money to pay out all of its promised benefits and other expenses. An underfunded pension plan usually refers to a defined benefit plan, such as a pension for state employees or a multiemployer pension plan, rather than a defined contribution plan like a 401(k).

Learn more about what a pension plan is, how it is funded, and what happens when it’s underfunded. 

Definition and Examples of Underfunded Pension Plans

An underfunded pension plan is an employee benefit plan that has less money than what is needed to fulfill its obligations to provide retirement income.

For example, a pension plan might owe $10 billion in employee benefit payments, but only have $5 billion in current assets. That means it has only a 50% funded status.

  • Alternate names: Unfunded pension plan, unfunded pension liability

Both public and private pension plans can be underfunded, and these shortfalls can affect more than just retirees. Underfunded state pension plans, for example, could lead to shifts in taxes and/or public spending that affects the general population. Meanwhile, those within the pension system may face changes, such as increased contributions and/or adjusted benefit payouts.

An underfunded pension plan isn’t necessarily in permanent debt. If a plan is underfunded, it may be the case that it isn’t on track to fully pay out what it promised to participants, but it can potentially get back on track to meet its obligations.

What Affects Pension Plan Funding

Pension plans are funded in three main ways: employee contributions, employer contributions, and investment returns. A significant portion of pension plans’ revenue comes from the latter—investment returns. And these returns can fluctuate for a number of reasons, from interest rate changes to stock market trends.

It’s possible that a pension plan could go from underfunded one year to overfunded the next, such as if rising interest rates enable the plan to lower its liability assumptions.

In recent decades, the U.S. has been in a generally low-interest-rate environment and many pension plans became underfunded. For the fiscal year 2021, major state and local pension plans in the U.S. were projected to have an aggregate funded status of 74.7%, according to the Center for Retirement Research.

For private pension plans, the average funded ratio of the 100 largest corporate defined benefit plans in the U.S. was 95.8% as of July 31, 2021, as measured by the Milliman 100 Pension Funding Index (PFI).

How Do Underfunded Pension Plans Work?

Determining whether a pension plan is underfunded or overfunded can involve calculations that are often highly complex and can be somewhat subjective. 

That’s because determining liabilities, for example, requires assumptions made by professionals like actuaries, who account for factors like life expectancies of retirees and future investment return expectations in relation to pension benefits.

Different types of pension plans may follow different procedures for calculating assets versus liabilities to determine their funded status. Some may make more aggressive assumptions as to how much they can expect in investment returns, others are more conservative.

While many pension plans are underfunded, that doesn’t necessarily mean that they did not receive enough funding from employees and/or taxpayers. A pension plan can be underfunded for several reasons. For example, public funds earmarked for a pension plan may be used elsewhere. Or, expected returns on investments could fall short if the stock market crashes. 

Fixing an underfunded pension plan can involve multiple solutions and may depend on what caused the issue. If a pension plan is closer to being 100% funded, for example, and is slightly off due to stock market changes, a company may decide to stay the course and count on long-term trends compensating for the short-term loss.

For pension plans with larger funding gaps, solutions might include increasing employee contributions or reducing employee payouts. 

Underfunded public pension plans also may benefit from governments raising taxes or shifting public spending to correct underfunding. 

Key Takeaways

  • Underfunded pension plans are retirement income plans that are not on track to be able to fully pay out what they promised to participants.
  • Major U.S. corporate and public pension plans were generally underfunded as of 2021.
  • Bringing a pension plan from underfunded to fully funded status may require increasing employee contributions or reducing employee payouts, among other solutions.
  • Governments may adjust taxes and public spending to remedy underfunded public pension plans.