What Does It Mean When a Pension Plan Is Underfunded?

Defined-benefit plans are the ones referred to when you hear comments on the news about underfunded pension plans. If you don't have a defined-benefit plan, your contributions, together with your employer's contributions to your pension plan, accumulate over the years. What you have in the plan when you retire is your pension. Depending on how the stock and bond markets affect pension fund investments over the years, your defined benefit pension fund might be overfunded or underfunded, but these plans promise a specific pension income. Unfortunately, promises are not always reliable, which is why the Pension Benefit Guarantee Corporation was created to insure some pensions in the same way that bank deposits are insured by the FDIC.

There are two ways defined-benefit plans can become underfunded. One way is if the investments in the plan portfolio suffer losses because of a market crash or poor choices on the part of the investment manager. The other way is if your employer experiences a budget shortfall and puts off making the annual pension fund contribution. In a defined-benefit plan, the employer is supposed to contribute a certain amount of money to the plan every year, based on your earnings. During bad economic times, companies and municipalities often can't afford to make the full contribution -- or any contribution at all. They list an I.O.U. on their books for that amount, hoping to make up the deficit in future years. However, when there is an extended period of economic problems, their underfunded pension liability grows.

The Pension Protection Act of 2006 sought to solve the problem of underfunded pensions by requiring that companies with underfunded pensions bring them current by 2015. In the case of a failed or underfunded pension, the PBGC insures vested pension payments to those 65 and older up to a cap of $56,000 a year, but like FDIC insurance for bank accounts, this figure can change. In 2012, the PBGC was itself underfunded by approximately $26 billion. Not all pension plans are protected under the PPA and the PBGC, so check with your pension administrator to learn about your protection.

The Congressional Budget Office 2009 public fund survey of 126 state and local pension funds found they had approximately $2.6 trillion in assets to meet future payment liabilities of $3.3 trillion -- less than their required 80 percent coverage. However, strong financial markets and a booming economy can reverse the extent of underfunding, even creating surpluses. For example, in 2007 corporate pension funds were approximately 4 percent overfunded. But after the 2008 stock market crash, their assets had dwindled to 75 percent of their total payment liabilities. Because of the volatile nature of some pension plans, it's a good idea for young couples to save extra money on their own to diversify their retirement savings.