What Are Unfunded Liabilities?

Definition and Example of Unfunded Liabilities

A liability is a legal duty of a person, organization, or government entity to pay a debt that comes from a past or current contract or action. In brief, a liability is a claim on the debtor's current or future assets.

An unfunded liability is a debt that does not have existing or projected assets to cover it. The entity the debt belongs to does not have funds to pay it.

For example, a company might have a pension plan in place in which each employee is due to be paid $35,000 per year in retirement. If the company has struggled financially and failed to fund its pension fund, it wouldn't have the money to meet the expected obligations for the retiring employees in the near future.

How Unfunded Liabilities Work

A firm or government can fund its operations with debt and create plans to pay the debt off. They might not ever pay off their debts. In corporate finance, this is not a bad practice, depending on how the firm is set up and how it holds its assets.

An unfunded liability is a debt to a fund designed to make payments to people or entities, meaning that there's no money available to pay the debt obligations. These funds might be expected to be funded via tax receipts or by investing the funds in mutual funds, stocks, or bonds to grow the balance to the point that the liabilities are adequately funded.

Sometimes, pension funds are not managed properly. A corporate pension fund might be designed in which current workers pay into a fund while current retirees receive pension payments. If a company shrinks in size, it might face the issue of having more retirees receiving a pension than current workers contributing to the plan.

To keep a fund afloat in this situation, a business might have to utilize profits, borrow money, or free up cash to ensure that the pension fund has enough money to remain solvent. To ensure profitability, the company might need to downsize, which means fewer employees available to contribute, leading to a decline in the total balance of the pension fund.

The result may lead to a snowball effect. The options are more downsizing, reduced payouts, getting rid of the fund, filing for bankruptcy, or shutting down the business.

Types of Unfunded Liabilities

Unfunded liabilities can be any anything an entity owes in which funds to cover the required payments do not exist. The most common type is a pension fund.

Pension Funds

Pension funds are designed for workers to contribute to the fund while they are working. When they retire, they then receive a pension in exchange for their years of work. In order to keep the fund going, managers may invest the money in the fund and put the money earned back into the fund.

As the fund's managers invest the money, the stock market may experience ups and downs. These stock market changes and investor sentiment can add to pension fund underfunding risk because economic downturns cannot be predicted. As a result, people can lose confidence in the market and begin to move their assets or sell off investments that belong to pension funds.

Also, the number of retirees greatly impacts the funding of pensions. There could be more retirees expected to receive payouts than the number of contributors. For example, as baby boomers continue to retire, they draw from pension funds while there may be fewer workers contributing to the funds.

For these reasons, pensions are less common than they used to be, leading employers to offer alternative retirement plans, such as 401(k) plans. Aside from employer matching funds, these plans are mostly funded by employees, which shifts the responsibility of saving for retirement to the employee instead of the employer.

Governmental

One example of an unfunded government liability is the Social Security Trust Fund. When Franklin D. Roosevelt started the Social Security Administration (SSA) in 1935, there were more than enough payees to support the number of people getting SSA payments (retirees).

In 1960, the ratio of payees to people getting payments was 5.1 to 1. By 2005, it was 3.3 to 1. The Social Security Trustees project predicts that the ratio will continue to decline. Medicare is another program that also has a problem with funding. This is because as more members of the U.S. workforce have begun to retire, the SSA fund is being funded by fewer workers.

What It Means for Investors

The stakeholders of unfunded liabilities include government entities, taxpayers, corporations, lenders, and investors. For example, taxpayers feel the effects of unfunded liabilities of pensions because they are funding the revenue to pay the wages and benefits of government employees.

The rising number of unfunded liabilities creates the need for higher payments, which means more funds go to pensions that could go to other resources and services. Corporations funded by stockholders might see reduced returns as the businesses work to feed their funds.

People who want to invest in a business should analyze its finances. One signal that there might be an unfunded liability within the business would be a balance sheet entry for pensions, which would list a net liability.

Finding an entry for a pension in a company you want to invest in might not mean that you should forget about doing so. You should also look at the rest of the financials before you decide whether to buy stock or not.

Criticisms of Unfunded Liabilities

Federal and state governments—and some large corporations—are feeling the pinch and burden of the rising debts of benefit payouts to former workers. Governments are forced to reduce benefits, increase taxes, or both.

Corporations with unfunded liabilities must find more profits by getting more efficient or charging more for their products and services. They may also accept lower profits, decrease dividends to investors, or use some combination of these.

Pension Fund Failure Insurance

Congress created the Pension Benefit Guarantee Corporation (PBGC) to insure the pensions of Americans who worked for private companies. The goal of the program is to ensure that pension recipients continue to get paid even if their pension program folds.

Multi-employer programs are pension funds that several companies contribute to, which helps corporations reduce the financial burden of pension funds. However, multi-employer plan insurance continues to decline in financial position. Experts predict they won't be able to pay the debts for these plans by 2027.

Single-employer pension plan insurance fares better. THE PBGC predicts that it will have enough funding to keep insuring these plans.