What it means
In a funded plan, the employer pays contributions into a trust, invests them and uses the pool to pay pensions. In a truly unfunded plan, there is no such pool: the employer simply pays pensions out of its cash flow when retired employees are due their payments.
This is sometimes called pay-as-you-go. Many governments run social security systems this way, with today's workers' taxes paying today's pensions.
Some employers do the same for special arrangements, such as supplementary plans for senior executives, and some countries allow companies to keep pension obligations on their own balance sheet instead of funding a separate trust. The key concern is that a promise has been made but the money is not yet put aside.
Under accounting rules the employer must still record a liability for the pension obligation, measured as the present value of benefits earned so far. That liability appears on the balance sheet and reduces equity, even though no cash has yet changed hands.
People also use unfunded loosely to mean underfunded, where a plan has assets but fewer than needed. The gap between the projected benefit obligation (the present value of promised pensions) and the plan assets is the unfunded liability.
Management may need to make extra contributions over time to close the gap. For analysts and buyers of businesses, unfunded obligations are a form of debt-like claim.
They are often included when calculating enterprise value or net debt, because someone has to pay the pensions eventually. Interest rates matter a great deal, since a fall in the discount rate increases the present value of the obligation.
Regulators generally prefer funding because it protects retirees if the employer fails. If a company becomes insolvent with unfunded pensions, retirees may rank as unsecured creditors, though some countries have insurance schemes that provide partial protection.
In practice
Real-world examples.
Example
A mid-sized manufacturer promises its two top executives a supplementary pension of $100,000 a year each, paid from company cash when they retire. It records a liability on its balance sheet but holds no separate fund. An actuary estimates the size of the liability each year.
Example
A local authority pays pensions to retired staff from its annual budget. When the number of pensioners grows, a rising share of the budget goes to pensions instead of services.
Example
An acquirer examining a target company finds a pension plan with a $45,000,000 deficit. It deducts that amount from its offer price, since it will have to fund the shortfall after the purchase.
Formula
Calculation
Unfunded liability = Projected benefit obligation - Fair value of plan assets
Funded ratio = Plan assets / Projected benefit obligation
A company's pension plan has a projected benefit obligation of $120,000,000 and plan assets of $90,000,000.
Unfunded liability = $120,000,000 - $90,000,000 = $30,000,000
Funded ratio = $90,000,000 / $120,000,000 = 75%
If the company decides to close the gap in five equal annual payments, ignoring investment returns and interest, each payment would be $30,000,000 / 5 = $6,000,000 a year. For a plan with no assets at all, the unfunded liability equals the full $120,000,000 and the funded ratio is 0%.
The $6,000,000 annual payment assumes no investment return on the extra contributions, so in practice a plan earning a good return could close the gap faster.Case study
Seen in the real world.
Calder & Finch is an illustrative, fictional printing group that promised generous final-salary pensions to its staff in the past but never built a fund to pay them. Its annual pension payments were around $4,000,000 and rising as more employees retired.
When a buyer expressed interest, its advisers calculated the present value of the pension obligation at $70,000,000, which was almost the same as the group's whole market value of $75,000,000. The buyer lowered its offer sharply and asked for a special fund to be created.
The group's board began making annual contributions of $5,000,000 into a trust. The illustrative story shows how a liability that is invisible in cash flow for years can suddenly dominate a negotiation. The new trust reduced the buyer's concern, and the sale went ahead at a price closer to the original offer.
Watch out
Common mistakes.
- Assuming that no fund means no liability, when the accounts must still show the obligation.
- Using unfunded and underfunded as if they were exactly the same, when one means no assets set aside and the other means assets that fall short.
- Ignoring the effect of interest rates, which can change the size of the obligation sharply.
Questions
People also ask.
Is an unfunded pension plan illegal?
No, many arrangements are unfunded by design, although regulators often require funding for ordinary company plans.
Who pays if an unfunded plan fails?
Retirees may become unsecured creditors of the employer, though some countries have insurance schemes that give partial protection.
Why do buyers care about unfunded pensions?
Because the shortfall is a debt-like obligation that reduces the real value of the business they are buying. Actuaries re-estimate the obligation every year, so the reported liability can move even when no new benefits are earned.
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