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Underfunded Pension Plan

Posted on October 19, 2025October 20, 2025 by user

Underfunded Pension Plan

An underfunded pension plan is a company-sponsored defined-benefit retirement plan whose liabilities (the present value of promised benefits) exceed its assets. That shortfall means there may not be enough money to pay current or future retirees the benefits they expect.

How these plans work

  • Employers fund a pension trust and invest assets to generate returns that will cover promised benefit payments.
  • The plan’s funded status compares plan assets to plan liabilities. When liabilities exceed assets, the plan is underfunded; when assets exceed liabilities, it is overfunded.
  • Employers must estimate long-term obligations using assumptions (discount rates, expected investment returns, mortality). Those assumptions strongly influence reported funding levels.

Common causes of underfunding

  • Investment losses during market downturns.
  • Lower-than-assumed long-term returns on stocks and bonds.
  • Declines in interest rates, which raise the present value of future benefit obligations.
  • Insufficient employer contributions or poor actuarial planning.
  • Overly optimistic assumptions that understate liabilities.

Rules for funding

  • Contributions may be made in cash or (to a limited extent) company stock. Regulatory limits restrict concentration; for example, no more than 5% of plan assets may be held in any single employer’s stock.
  • Employers may be required to make additional cash contributions when a shortfall exists. Large mandated payments can reduce earnings per share and affect the company’s financial health and credit agreements.

How to determine if a plan is underfunded

  • Compare the fair value of plan assets to the accumulated benefit obligation (the current and future amounts owed to retirees). If assets are less, a pension shortfall exists.
  • Public companies disclose pension assets, liabilities, and footnote details in their annual 10-K filings.
  • Be wary of management assumptions; optimistic return assumptions can mask funding problems.

Consequences of underfunding

  • For retirees: Benefits already earned generally cannot be reduced. However, promised future accruals or benefit increases can be limited if the plan is significantly underfunded.
  • For employers: Required catch-up contributions can strain cash flow, lower reported earnings, and potentially trigger covenant breaches on loans — with consequences ranging from higher borrowing costs to bankruptcy risk.
  • For the plan: Persistent underfunding increases the risk that promised benefits will not be paid in full unless corrective measures are taken.

Underfunded vs. overfunded

  • Overfunded plan — assets exceed liabilities, providing a cushion for future payments. Excess assets are generally restricted; companies cannot freely extract surplus funds without tax or regulatory consequences.
  • Underfunded plan — liabilities exceed assets, requiring additional contributions or plan changes to restore an acceptable funded status.

Withdrawals and access

  • Participants in defined-benefit plans generally cannot withdraw plan assets like they could from defined-contribution accounts. Hardship withdrawals are rare and tightly restricted; loans are possible only under specific plan rules. Withdrawals are typically not permitted if a plan is underfunded.

Key takeaways

  • An underfunded pension has more obligations than assets, creating risk for retirees and the sponsoring employer.
  • Causes include market losses, lower interest rates, inadequate contributions, and optimistic actuarial assumptions.
  • Regulators limit concentration in employer stock and require disclosures; significant shortfalls can force employers to make cash contributions that affect financial results.
  • Earned benefits are usually protected, but future accruals and company finances may be materially affected until the plan’s funded status is restored.

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