Many Defined Benefit Plans have promised more benefits than they have assets set aside to pay for. Such plans are said to be Underfunded. News reports often focus on the effect of underfunded plans on the bottom line of the employers. It is clear that an underfunded plan impacts the stock value and the return to shareholders. Other news stories point to the risk involved for participants in such underfunded plans. Fortunately, for most plan participants at least a portion of their benefits is guaranteed by the Pension Benefit Guaranty Corporation(PBGC). However, the PBGC itself is put at risk by the number of underfunded plans and the total size of underfunding of covered plans, because the PBGC has to accept the benefit liabilities of the covered plans that undergo Involuntary Plan Terminations. While the PBGC has accumulated reserves from the premiums it collects from the covered plans, the reserves are far short of the aggregate underfunding. This in turn means that society at large is exposed to the risk posed by underfunded plans.
New plans often start off in an Underfunded status because they can grant benefit credit for past service worked with the employer. To counterbalance 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 may 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. In this way, the vested benefits start at $0, and the vested benefits of the plan are likely to be more than fully funded by assets, even if the full value of accrued benefits is underfunded.
As a plan ages, the goal of the actuarial funding methods and assumptions is for the plan to become fully funded. There are, however different sets of assumptions used to measure the actuarial liabilities of the benefits, which means that the funded status of a plan will be different, depending on the specific question asked. Because of the code requirement (417e) for lump sum payments--which uses very conservative assumptions and thus inflates the calculated lump sum of plan benefits, the underfunding determined on a Plan Termination basis is generally larger than the amount of underfunding determined on other bases. As the current interest rates have dropped in recent years, the present value of future benefits calculated at these lower rates increases.
In addition, several years of bear-market asset performance have created actuarial losses, further exacerbating the measurement of the underfunding for many plans.
Several requirements are placed on plans to discourage underfunding. These include:
PBGC Variable Rate Premiums are imposed on plans with unfunded Vested benefits (see article on PBGC).
Minimum Funding Requirements (412) prescribe a sound long-term funding strategy.
Additional Funding Requirement are placed on large plans (more than 100 participants) that are less than 90% funded.
FAS 87/132 require a corporation to recognize certain underfunding as a liability of the corporation.
A sponsor can not terminate an underfunded plan at will.
In addition, proposed legislation (2006) may mandate a 100% funded level as the target for contribution requirements, and FASB is preparing new accounting guidelines.
On the other hand several requirements placed on plans have helped to cause the problem of underfunding; these include:
Full Funding Limits keep an employer from contributing to the plan when, according to certain measures, all benefits are fully funded.
Current Liability calculations produce less conservative liability numbers than, say, a lump sum benefit calculation.
Punitive excise taxes are placed on reversions from the plan back to the employer in the event the plan is overfunded at Plan Termination. That is, there is a huge incentive for a plan not to be too-well funded, and this negative impetus has played into decisions that have weakened the funded position of numerous plans.
One of the methods that can improve the funded status of an underfunded defined benefit plan is to merge it with an Overfunded Defined Benefit Plan. These may be two plans of an employer, or the overfunded plan may be acquired under favorable terms through a business transaction. See article on Strategic Sale For Overfunded Plan for more discussion on this option.
Watson Wyatt Worldwide 2002 article Pensions in Crisis shows historical trends and discusses causes of underfunding.