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Funded Status What it Means How it Works FAQs

Funded Status What it Means How it Works FAQs

Funded Status: What it Means, How it Works, FAQs

What Is Funded Status?

Funded status compares the assets to the liabilities in a defined-benefit (DB) pension plan. This data point helps understand how many employees are covered in a worst-case scenario if the company or organization pays all retirement benefits at once.

Key Takeaways

  • Funded status is the financial status of a pension plan.
  • Funded status is measured by subtracting pension fund obligations from assets.
  • If the funded status falls below a certain level, the employer may be required to make additional contributions to bring the funding level back in line.
  • A fully-funded pension plan has enough assets to meet its liabilities.

Understanding Funded Status

The equation to determine a plan’s funded status is:

Funded status = plan assets – projected benefit obligation (PBO)

Future liabilities, or benefit obligations, are what the plan owes employees for service. Plan assets are used to pay retiree benefits. Funded statuses can range from fully funded to unfunded. Many experts consider a fund that is at least 80% funded to be healthy, though pension plans are regulated and may be required to contribute to the plan if funding falls below a certain level calculated by the plan’s outside actuaries each year.

Companies typically choose not to have a pension fund be 100% funded. A rise in interest rates can push the funded status over 100%, making it difficult to withdraw money from the fund. This situation can make analysts and shareholders unhappy as it restricts funds that could be used for other purposes.

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An analyst can calculate a company’s funded status using figures in the pension footnote, which is in the company’s financial statements. Some propose moving pension deficits or surpluses onto the balance sheet to recognize the potential liability.

Defined-Benefit Plan vs. Defined-Contribution Plan

There are two main types of pension plans: a defined-benefit plan (DB) and a defined-contribution plan (DC). As of the end of 2021, U.S. corporate DB assets totaled $3.8 trillion, while U.S. corporate DC plan assets totaled $11 trillion. Corporations are increasingly closing pension plans and moving employees to DC plans.

In a DB plan, the employer guarantees a definite amount of benefit upon retirement, regardless of investment performance. The employer is liable for a specific flow of pension payments to the retiree based on earnings and years of service.

In a DC plan, the employer makes specific plan contributions for the worker, usually matching employee contributions. The employee’s final benefit depends on the plan’s investment performance. A DC plan is less expensive for a company because the company is on the hook for any shortfall.

The best-known defined-contribution plans are the 401(k) and the 403(b) for non-profit workers.

How Does a Pension Shortfall Happen?

A pension shortfall occurs when a defined-benefit pension plan does not have enough money to cover current and future obligations. It is then said to be underfunded. This can happen due to poor assumptions about future investment returns, interest rates, and inflation. Shortfalls may also be caused by investment losses, poor planning, or demographic change.

What Is an Overfunded Pension?

An overfunded pension plan has more than enough assets to cover current and future benefits to employees. This can happen due to above-expected investment returns, rising interest rates, or favorable demographic changes. However, an overfunded pension plan will not result in increased participant benefits and cannot be paid out to shareholders.

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What Happens When a Pension Becomes Underfunded?

When a defined benefit plan is underfunded, it does not have enough assets to meet payout obligations to employees. In such cases, the plan must increase contributions or reduce payouts. This is usually the case if a plan is significantly underfunded rather than slightly underfunded, which may be due to temporary adverse market movements.

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