Underfunded Defined Benefit Plan: The Complete Guide

Define benefit plans are excellent retirement structures for high-income business owners. But problems certainly can arise. Specifically, underfunded defined benefit plans can be a big problem.

In many situations with high-income taxpayers, overfunding is not a problem. The owners make very aggressive contributions, leading to overfunding issues. These problems are a little bit more typical. But for very large corporations, we have found that underfunding can be a bigger problem.

In this post, we will look at underfunding issues and guide you on how to solve the problem. You can take various steps, but getting funding back in line is imperative to your plan.

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What is a defined benefit plan?

A defined benefit plan is a type of retirement plan that guarantees a specific benefit amount to employees upon their retirement. It is typically sponsored and funded by employers or government entities. The benefit amount is determined by a formula that considers factors such as an employee’s salary history, years of service, and age at retirement.

Unlike defined contribution plans, such as 401(k) plans, where the retirement benefit depends on the amount contributed and the investment performance, defined benefit plans provide a predictable income stream to retirees.

In a defined benefit plan, the responsibility for managing investments and bearing the investment risk lies with the plan sponsor, not the individual employees. The sponsor is typically responsible for contributing funds to the plan during the employee’s working years and investing those funds to ensure they grow over time.

Upon retirement, the employee receives a regular payment for the remainder of their life, often in the form of a monthly pension. The amount of the pension is typically based on a percentage of the employee’s final average salary or a specific formula outlined in the plan.

Defined benefit plans have been a traditional form of retirement benefits offered by many employers. They provide retirees with a sense of financial security, as the pension payments are often guaranteed by the plan sponsor, such as the employer or government entity.

However, the prevalence of defined benefit plans has declined in recent years due to their cost and complexities. Many employers have shifted towards defined contribution plans, which place more responsibility on employees to manage their own retirement savings and investment decisions.

What is an underfunded defined benefit plan?

An underfunded defined benefit plan refers to a retirement plan in which the plan’s assets are insufficient to cover the promised benefits to the plan participants. A defined benefit plan is a type of pension plan where the retirement benefits are based on a formula, typically using factors such as an employee’s salary, years of service, and age.

In a well-funded defined benefit plan, the plan’s assets, such as contributions and investment returns, are expected to be adequate to meet the future obligations to retirees. However, if a plan becomes underfunded, it means that the assets are not enough to fully cover the promised benefits.

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Underfunding can occur due to various reasons, such as inadequate contributions, poor investment performance, or an increase in the number of retirees compared to active participants. In some cases, the plan sponsor (often an employer or a government entity) may not have made sufficient contributions to the plan over time, leading to a shortfall.

When a defined benefit plan is underfunded, the plan sponsor may need to take corrective measures to address the shortfall. This can involve increasing contributions, adjusting benefit formulas, reducing benefits, or implementing investment strategies aimed at improving returns. In certain cases, underfunded pension plans may pose financial challenges for the plan sponsor and could require additional funding or restructuring to ensure the long-term sustainability of the plan.

Underfunded defined benefit plans can be a concern for plan participants who may worry about the security and stability of their retirement benefits. It is important for individuals with such plans to stay informed about the financial health of their plan and any actions taken by the plan sponsor to address the underfunding.

Balance Calc$ Amount
Beginning of year balance$30,000
Interest crediting rate4%
W2 Compensation$50,000
Pay credit60% of comp
End of year balance$61,200

Final thoughts

Underfunded defined benefit plans pose significant challenges and concerns for both plan participants and plan sponsors. Firstly, for plan participants, the underfunding of a defined benefit plan raises doubts about the security and stability of their retirement benefits.

They may worry about whether their promised benefits will be fully paid out when they retire, especially if the plan sponsor is facing financial difficulties. This uncertainty can create anxiety and financial stress, as retirees rely heavily on these benefits to cover their living expenses during retirement.

Secondly, underfunding can place a substantial financial burden on the plan sponsor. If the plan’s assets are insufficient to meet the promised benefits, the sponsor may be required to inject additional funds to bridge the shortfall.

This can strain the sponsor’s financial resources, impacting their ability to invest in other areas or meet other obligations. In extreme cases, underfunded defined benefit plans have contributed to financial distress or even bankruptcy for some companies and government entities.

Lastly, underfunding can have wider economic implications. If a significant number of defined benefit plans are underfunded, it can put pressure on the pension insurance systems, such as the Pension Benefit Guaranty Corporation (PBGC) in the United States, which serves as a safety net for certain pension plans. If the PBGC or similar institutions have to step in to cover the shortfalls, it can strain their financial viability and potentially lead to increased costs for other plan sponsors and taxpayers.

In conclusion, underfunded defined benefit plans represent a critical problem as they undermine the retirement security of employees, burden plan sponsors, and can have broader economic consequences. It is crucial for both plan participants and plan sponsors to actively monitor the funding status of the defined benefit plan, seek appropriate solutions to address underfunding, and explore measures to ensure the long-term sustainability and reliability of retirement benefits.

Paul Sundin

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