Unfunded Pension Plan: What it is, How it Works

What Is Unfunded Pension Plan?

An unfunded pension plan is an employer-managed retirement plan that uses the employer’s current income to fund pension payments as they become necessary. This is in contrast to an advance funded pension plan where an employer sets aside funds systematically and in advance to cover pension expenses like payments to retirees and their beneficiaries.

Key Takeaways

• Unfunded pension plans do not have assets set aside, meaning retirement benefits are usually paid directly from employer contributions.
• Also called pay-as-you-go plans, these retirement accounts can be set up by companies or governments.
• Government pension programs of many European countries are considered unfunded plans.

Understanding Unfunded Pension Plans

A pension plan is a program offered by certain employers that provides salary replacement when an employee is no longer working (e.g., when the employee retires). When employers offer a pension plan, they can plan for the financial requirements of the pension plan and set aside money regularly—and invest the money to ideally grow the fund or fund the pension plan out of current earnings.

An unfunded pension plan is sometimes referred to as a pay-as-you-go pension plan. Many public pension arrangements provided by a state are unfunded, with benefits paid directly from current workers’ contributions and taxes. The pension systems of many European countries are unfunded, with benefits paid directly out of current taxes and social security contributions.

Hybrid vs. Fully Funded

Several countries have hybrid systems, which are partially funded. Spain set up the Social Security Reserve Fund and France set up the Pension Reserve Fund. In Canada, the wage-based retirement plan (CPP) is partially funded, with assets managed by the CPP Investment Board, while the U.S. Social Security system is partially funded by investment in special U.S. Treasury Bonds.

Fully funded, in contrast, describes when a pension plan has sufficient assets to provide for all accrued benefits. To be fully funded, the plan must be able to make all anticipated payments to pensioners. A plan’s administrator can predict the amount of funds needed on a yearly basis, helping determine the financial health of the pension plan.

Pay-As-You-Go

Both individual companies and governments can set up pay-as-you-go pensions. The level of control exercised by individual participants of an unfunded pension plan depends on the plan’s structure and whether the plan is privately or publicly run. Unfunded pension plans run by governments may use the word "contribution" to describe the money entering the fund, but usually, these contributions are taxed at a set rate and neither workers nor employers who contribute have any choice about how much they pay into the plan. Private pay-as-you-go pensions, however, offer their participants some discretion.

If an employer offers a pay-as-you-go pension plan, an individual participant likely gets to choose how much of their paycheck they wish to deduct and contribute toward their future pension benefits. Depending on the plan’s terms, a participant may either have a set amount of money pulled out during each pay period or contribute the amount in a lump sum. This is similar to how several defined-contribution plans, such as 401(k) plans, are funded.