What it means
For a company or public body running a defined benefit scheme (one that promises members a set income in retirement), a shortfall is also called a deficit or underfunding. It appears when the present value of all promised pensions is larger than the fair value of the assets set aside to pay them.
The present value (today's worth of money due in future) depends heavily on the discount rate chosen. Shortfalls arise for several reasons, and usually for more than one at a time.
Investments may earn less than expected, people may live longer than assumed, interest rates may fall so liabilities grow, or the sponsor may have skipped contributions in earlier years. Why does this matter to a manager who is not a pension specialist?
Because the sponsor is on the hook for the gap, and in many countries must pay extra contributions into the scheme over a recovery period. Those payments reduce cash available for hiring, investment and dividends, and the deficit can feature in loan covenants, credit ratings and takeover negotiations.
On an individual level, a pension shortfall means projected retirement income falls below the target. A planner will set a target such as 70% of final salary, estimate the pension and state benefits likely to arrive, and treat the difference as the amount that must come from extra saving or later retirement.
Closing it is a matter of saving more, working longer or lowering spending expectations. The key nuance is that the size of a corporate deficit is an estimate, not a fixed fact.
A small change in the discount rate or the life expectancy assumption can move the reported figure by millions, so two reasonable analysts can produce different numbers for the same scheme.
In practice
Real-world examples.
Example
A regional bus operator reports a pension deficit of $15,000,000 in its annual accounts. Lenders ask the finance director how the company will fund it, and the answer shapes the covenants on its next bank facility.
Example
A 45-year-old marketing manager estimates she will need $60,000 a year in retirement. Her workplace pension and state benefits are projected to provide $42,000, so her personal shortfall is $18,000 a year and she raises her monthly contributions.
Example
A private equity buyer values a small food producer and finds its legacy pension scheme is 70% funded. The buyer lowers its offer by an amount equal to the deficit, because the new owner will inherit the obligation to fill it.
Formula
Calculation
Pension shortfall = present value of promised benefits - fair value of scheme assets
Funded ratio = scheme assets / present value of promised benefits
Suppose a manufacturer's scheme has promised benefits with a present value of $48,000,000 and holds assets worth $38,400,000. The shortfall is 48,000,000 - 38,400,000 = $9,600,000. The funded ratio is 38,400,000 / 48,000,000 = 0.80, or 80%. If the company agrees a ten-year recovery plan, it must find about 9,600,000 / 10 = $960,000 a year, before allowing for investment returns on the contributions.Case study
Seen in the real world.
Calder Steelworks is an illustrative, fictional manufacturer with a closed pension scheme and 1,200 members. At the last valuation the scheme held $210,000,000 against promised benefits of $250,000,000, a shortfall of $40,000,000.
The finance team ran the numbers under two assumptions. When it lowered the discount rate by half a percentage point the shortfall widened sharply, and when it assumed members would live a year longer the figure rose again. The board realised that the deficit it had been reporting was a range, not a single number.
The company agreed a recovery plan of $5,000,000 a year for eight years with the scheme trustees, tied to a promise to pause dividends if the funding level fell. The illustrative lesson is that a pension shortfall behaves like a debt, and it should be managed with the same discipline as a bank loan.
Watch out
Common mistakes.
- Treating the reported deficit as a precise fact, when it moves with the discount rate and life expectancy assumptions.
- Assuming a pension shortfall is only a problem for the pension scheme, when the sponsoring company must usually fund it from its own cash.
- Ignoring inflation when judging an individual shortfall, so that a pension that looks adequate today buys much less in twenty years.
Questions
People also ask.
Who pays if a company pension scheme has a shortfall?
The sponsoring employer is normally responsible for topping it up, and if the employer fails, many countries have a protection fund that pays reduced benefits.
How do you close a personal pension shortfall?
You can save more, retire later, reduce planned spending or look for additional income, and the earlier you start the smaller each step needs to be.
Is a funded ratio below 100% always an emergency?
No, many schemes run below 100% for years under agreed recovery plans, but a low and falling ratio deserves close attention.
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