How do Defined Benefit Plans become Underfunded?
Many Defined Benefit Plans have promised more benefits than they have assets set aside from which to pay. Such plans are said to be underfunded. The news regularly reports on the effect these underfunded plans have on the company’s bottom line. Clearly, an underfunded plan impacts the stock value as well as the return to shareholders; other stories focus on the risk involved for participants. Luckily, at least a portion of most plan participants’ benefits are guaranteed by the Pension Benefit Guaranty Corporation (PBGC).
The PBGC itself is placed at risk both by the number of underfunded plans and the total size of underfunding of covered plans, because it has to accept the benefit liabilities of the covered plans that undergo Involuntary Plan Terminations. While the PBGC has reserves from the premiums it collects from the covered plans, the reserves fall short of the cumulative underfunding. Because of this, society at large is exposed to the risk created by underfunded plans.
How is a Plan Underfunded?
There are two ways Defined Benefit Plans can become underfunded:
- The investments in the plan’s portfolio suffer losses due to a market crash or poor choices by the investment manager;
- The employer experiences a budget shortfall and puts off making the annual pension fund contribution.
In a DB Plan, the employer is supposed to contribute a specific sum of money every year, based on employee earnings. During bad economic times, companies may not be able to make the full contribution -- or any contribution at all. They might list an I.O.U. on their books for the specified amount, intending to make up the deficit in future years. However, should there be a prolonged period of economic glitches, their underfunded pension liability grows.
Weighing the Contributions
Based on the actuarial valuation, companies fund their pension plans through annual tax-deductible contributions. For example, if the current value needed to pay future pensions is $1,000,000, and the plan's assets are valued at $900,000, the company must make a $100,000 contribution to keep the plan fully funded. If it can only afford to contribute $50,000, the plan is 5 percent underfunded.
New plans often start off in an underfunded status because they can grant benefit credit for past service worked with the employer. To offset the potential for a participant to quit his/her job immediately after the plan is established and gain a windfall lump-sum benefit, the plan could use a vesting schedule that begins with the effective date of the plan and phases in vesting over a period of up to 7 years. Using this type of schedule, the vested benefits start at $0, and the vested benefits of the plan are more than likely to be fully funded by assets, even if the full value of accrued benefits remain underfunded.
As a plan ages, the actuarial funding methods’ goal is for the plan to become fully funded. But different sets of assumptions might be used to measure the actuarial liabilities of the benefits, and will vary depending on the specific question asked. Due to the code requirement (417e) for Lump Sum payments which uses highly conservative assumptions and thus inflates the calculated lump sum of plan benefits, the underfunding determined on a Plan Termination basis tends to be larger than the amount of underfunding determined via other means.
Years of bear-market asset performance have created actuarial losses, further impairing the measurement of the underfunding for many plans. Some of the requirements placed on plans to discourage underfunding include:
- PBGC Variable Rate Premiums are imposed on plans with unfunded vested benefits.
- Minimum Funding Requirements (412) stipulate a sound long-term funding strategy.
- Additional Funding Requirements are placed on plans having more than 100 participants that are less than 90% funded.
- FAS 87/132 require a corporation to recognize certain underfunding as a corporate liability.
- An underfunded plan cannot be terminated by a sponsor at will.
- Proposed legislation may mandate a 100% funded level as the target for contribution requirements. FASB is preparing new accounting guidelines.
There are also some requirements placed on plans that have assisted the problem of underfunding and these include:
- Funding liabilities are often less than the plan termination liability and thus a plan can appear to be funded in compliance only to end up having a substantial shortfall.
- In the event the plan is overfunded at Plan Termination, punitive excise taxes are placed on reversions from the plan back to the employer. Consequently there is a decided incentive for a plan not to be too-well funded and this has played into decisions that have weakened the funded position of numerous plans.
One way to improve the funded status of an underfunded Defined Benefit Plan is to merge it with an overfunded Defined Benefit Plan. The two plans could be with the same employer, or the overfunded plan could be acquired through a business transaction.
Underfunded Defined Benefit plans pose a risk to everyone involved -- plan participants, shareholders, the PBGC, and society at large.