What Is Funded Status?
Funded status compares the assets to the liabilities in a defined-benefit (DB) pension plan. This data point is useful in understanding how many employees are truly covered in a worst-case scenario if the company or other organization is forced to pay all of its retirement benefits at once.
Key Takeaways
- Funded status is the financial status of a pension plan.
- Funded status is measured by subtracting pension fund obligations from assets.
- If the funded status of the plan falls below a certain level, the employer may be required to make additional contributions to the plan to bring the funding level back in line.
- A fully-funded pension plan has enough assets to meet its liabilities.
Understanding Funded Status
The equation to determine a plan’s funded status is:
Funded status = plan assets - projected benefit obligation (PBO)
Future liabilities, or benefit obligations, are what the plan owes employees for service. Plan assets, which are usually managed by an investment team, are used to pay for retiree benefits. Funded statuses can range from fully funded to unfunded. Many industry experts consider a fund that is at least 80% funded to be healthy, though pension plans are regulated and may be required to contribute to the plan if funding falls below a certain level as calculated by the plan's outside actuaries each year.
Companies typically choose not to have a pension fund be 100% funded. This is because a rise in interest rates will push the funded status over 100%. It is very difficult to take money out of a pension fund legally, so money that could be used for other purposes is essentially trapped, a situation that makes analysts and shareholders unhappy.
An analyst can calculatea company's funded status using figures in the pension footnote. This is in the company's financial statements. Some have proposed that companies move their pension deficits or surpluses onto the balance sheet rather than just show them in the footnotes. Moving the funded status of pension plans, as well as other retirement benefit obligations like healthcare plans, onto the balance sheet could force many companies to recognize this potentially large liability.
Defined-Benefit Plan vs. Defined-Contribution Plan
There are two main types of pension plans: a defined-benefit plan (DB) and a defined-contribution plan (DC). As of the end of 2021, U.S. corporate DB assets totaled $3.8 trillion, according to Investment Company Institute (ICI) data. At the same time, U.S. corporate DC plan assets totaled $11 trillion. Corporations are increasingly closing pension plans to new employees, or shutting them down, and moving employees to DC plans.
In a DB plan, the employer guarantees that the employee receives a definite amount of benefit upon retirement, regardless of the performance of the underlying investment pool. The employer is liable for a specific flow of pension payments to the retiree (the dollar amount is determined by a formula, usually based on earnings and years of service).
In a DC plan, the employer makes specific plan contributions for the worker, usually matching to varying degrees the contributions that employees make. The final benefit that the employee receives depends on the plan's investment performance. A DC plan is less expensive for a company than a traditional pension because the company is on the hook for whatever the fund can't generate.
The best-known defined-contribution plans are the 401(k) and its equivalent for non-profit workers, the 403(b).
How Does a Pension Shortfall Happen?
A pension shortfall occurs when a defined-benefit pension plan does not have enough money on hand to cover its current and future obligations. It is then said to be underfunded. This can happen for a number of reasons, but most often is due to poor assumptions about future investment returns, interest rates, and inflation. Shortfalls may also be caused by investment losses, poor planning, or demographic change.
What Is an Overfunded Pension?
An overfunded pension plan has more than enough assets presently to cover current and future benefits to employees. This can happen due to above-expected investment returns, rising interest rates, or favorable demographic changes. An overfunded pension plan will not, however, result in increased participant benefits and cannot be used by the business or its owners. The surplus can be booked as net income, but cannot be paid out to shareholders.
What Happens When a Pension Becomes Underfunded?
When a defined benefit plan is underfunded, it means that it does not have enough assets to meet its payout obligations to employees. If a plan is underfunded, then it must increase its contributions to be able to meet these obligations. A plan may allow for employees to increase their contributions or a plan may decide to reduce the payout for employees. This is usually the case if a plan is significantly underfunded rather than slightly underfunded; the latter of which may be due to temporary adverse market movements.
