What it means
A defined benefit plan promises employees a set income in retirement, usually based on salary and years of service. To pay for that promise, the employer puts money into a fund and invests it.
The plan is fully funded when the fund holds enough to cover all the benefits earned so far. Funding status is measured by comparing the fund's assets with its obligations.
Obligations are estimated by discounting expected future benefit payments back to today, using an interest rate. The lower the discount rate, the higher the obligation looks, which is why falling interest rates often push plans into deficit.
A deficit does not mean the plan is about to fail. Pensions are long-term promises, and benefits are paid over decades.
The sponsor typically agrees a recovery plan with the trustees or regulator, paying extra contributions over a set number of years until the gap closes. Even so, an underfunded plan is a real liability for the sponsoring company.
Analysts treat the deficit as debt-like, adding it to net debt when they judge how leveraged the business is. A large deficit can also reduce a firm's ability to pay dividends, make acquisitions or borrow.
Several factors cause or worsen underfunding. These include poor investment returns, falling discount rates, people living longer than expected, benefit increases and employers skipping contributions.
Management can respond with higher contributions, a change to the investment mix, closing the plan to new members or moving to a defined contribution plan. For readers of accounts, the notes to the financial statements are the place to look.
They show the assumptions used, such as the discount rate and life expectancy, and a small change in either can swing the deficit by tens of millions. Comparing these assumptions with those of similar companies shows whether the reported deficit is cautious or optimistic.
In practice
Real-world examples.
Example
A manufacturing company with 3,000 retirees reports plan assets of $450,000,000 and obligations of $540,000,000. The funded ratio is 83%, and the deficit of $90,000,000 is shown as a liability on the balance sheet. Credit analysts add this amount to the company's net debt when they judge its borrowing capacity.
Example
A bank considering buying a business learns that its pension plan is $30,000,000 underfunded. The buyer subtracts that amount from the offer price, because it will inherit the obligation to fund it. The sellers argue that the investment portfolio is likely to recover, but the buyer insists on a price reduction.
Example
A retailer's interest rates fall, raising the value of its pension obligations by $15,000,000 although its investments are unchanged. The finance team explains to the board that the deficit has widened because of the discount rate and not because of poor management.
Formula
Calculation
Funded ratio = Plan assets / Projected benefit obligation
Deficit = Projected benefit obligation - Plan assets
A company's pension plan holds assets of $80,000,000 against a projected benefit obligation of $100,000,000. The funded ratio is 80,000,000 / 100,000,000 = 80%. The deficit is 100,000,000 - 80,000,000 = $20,000,000. If the sponsor agrees to close the gap over 10 years, ignoring investment growth, it must contribute about 20,000,000 / 10 = $2,000,000 a year.Case study
Seen in the real world.
Ironbridge Steel is an illustrative, fictional company with a long-standing defined benefit plan. After several years of weak markets and a fall in discount rates, the plan's funded ratio dropped from 95% to 78%, leaving a deficit of $66,000,000.
The chief financial officer worked with the trustees to agree a ten-year recovery plan, with annual extra contributions of $8,000,000. The company also reduced its dividend for two years and closed the plan to new employees, who joined a defined contribution scheme instead.
The illustrative result was that the funded ratio climbed back to 92% over six years, helped by the extra contributions and a more stable investment mix. Lenders accepted the plan, and the company kept its credit rating by showing a clear route to closing the gap.
Watch out
Common mistakes.
- Treating the deficit as unimportant because it will be paid over many years, when it is a debt-like claim on the company.
- Looking only at asset returns, when changes in the discount rate and life expectancy can move the obligation as much.
- Assuming that a funded ratio of 100% is permanent, when it can fall as markets and rates change.
Questions
People also ask.
How is the deficit shown in the accounts?
Generally the deficit appears as a liability on the sponsor's balance sheet, with changes reported through profit or other comprehensive income depending on the standard.
Can an employer walk away from a deficit?
Usually not, because laws and plan rules require the sponsor to fund the promised benefits, and regulators can enforce contributions.
Does a deficit affect a company's value?
Yes, buyers and lenders treat it as debt-like, so it usually reduces the price they will pay or the amount they will lend.
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