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Unfunded Pension Plan

Definition

An Unfunded Pension Plan is a retirement scheme where no assets are set aside to cover future obligations to employees. Instead, pensions are paid directly from the employer’s current earnings or operating expenses. This is in contrast to funded pension plans, where contributions are invested to generate funds for future retirements.

Phonetic

The phonetics of the keyword “Unfunded Pension Plan” would be: ʌnˈfʌndɪd ˈpɛnʃən plæn

Key Takeaways

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  1. Benefit Payments from Current Earnings: Unfunded pension plans are typically financed from the current earnings of the employer rather than from a pool of funds set aside for this purpose. This means the employer pays out pensions from its operating income, making the system sustainable as long as the company’s profits are stable.
  2. No Investment Risk for Employees: Since an unfunded pension plan does not involve investment of funds, employees are protected from any potential investment risk. This is contrasting to funded pension plans where fund values can fluctuate due to market conditions.
  3. Higher Threat to Long-term Security: While unfunded pension plans may provide stable benefits in the short term, they pose a greater risk in the long term. If the employer faces financial difficulties or an increase in retirements, they may not be able to meet their pension obligation because no money has been specifically saved or invested for this purpose.

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Importance

An Unfunded Pension Plan is a significant term in business/finance because it refers to a retirement plan in which the employer does not set aside funds specifically for an employee’s future retirement benefits. Instead, the benefits are paid out directly from the company’s current revenues. This approach is important because it poses a higher risk to employees’ retirement security. If the company experiences financial difficulties, it may struggle to meet its pension obligations. Additionally, it creates a potential future liability for the company, resulting in financial instability and possible insolvency if not managed correctly. It has significant impacts on the business’s financial planning, cash flow management, employee satisfaction, and long-term sustainability.

Explanation

An Unfunded Pension Plan is employed by organizations as part of its strategy to provide for its employees’ retirement benefits. This type of pension plan does not have a dedicated investment portfolio to secure the future payments; instead, the benefits are paid directly from the employer’s current revenue or capital. The main purpose of an unfunded pension plan is to create an attractive compensation package for employees, potentially attracting more skilled individuals and providing them with a level of security upon retirement.With an unfunded pension plan, businesses can distribute retirement benefits to their employees without the need for setting aside a large amount of capital in low-yield investments, which could otherwise be used in potentially more profitable business operations. Businesses use this plan when they are confident of their ability to generate sufficient revenue or capital in the future to cover these obligations. The unfunded nature of this plan underscores the importance of organizational stability and long-term sustainability, as failure to meet retirement obligations can have serious repercussions, both legally and in terms of employee relations.

Examples

1. City of Detroit’s Municipal Pension: In 2013, the City of Detroit declared bankruptcy due in large part to $3.5 billion in unfunded pension liabilities. The city had promised pensions to its municipal workers but did not have the funds set aside to fulfill these obligations.2. General Motors’ Pension Plan: In 2012, General Motors announced that it had $25.4 billion in unfunded pension liabilities in its U.S salaried pension plan. The company took steps to lower this liability such as offering lump-sum payouts and annuities to its pensioners instead of periodic pension payments.3. United Airlines’ Pension Plan: In 2005, United Airlines transferred its four pension plans, which had a total of $9.8 billion in unfunded pension obligations, to the Pension Benefit Guaranty Corporation (PBGC), a U.S government agency that insures pension plans. This was the largest pension default in U.S history and resulted in many retirees receiving less pension than they were originally promised.

Frequently Asked Questions(FAQ)

What is an Unfunded Pension Plan?

An unfunded pension plan is a retirement plan that is paid directly from the current earnings of the company instead of being funded by separate pension fund assets. This means when pension payments are due, they are paid out directly by the company rather than sourced from a pre-funded pension plan investment pool.

Is there a risk to the pensioner in an unfunded pension plan?

Yes, in an unfunded pension plan, pensioners bear the risk of the company’s inability to fulfill its pension obligations due to financial difficulties or going out of business.

Are unfunded pension plans common?

They are less common than funded pension plans, as many organizations and companies opt to provide security to their employees by maintaining separate funds for pensions.

How does an unfunded pension plan impact a company’s finances?

Unfunded pension plans are not set aside as separate assets, hence they do not initially impact a company’s financial statements. However, the obligation to pay pensions from the company’s operating budget can put significant strain on the company’s cash flow in the long term.

How are unfunded pension plan liabilities accounted for?

Liabilities related to unfunded pension plans are usually recorded on a company’s balance sheet. They are considered as future obligations that the company has to meet.

Is there any regulatory framework governing the creation and operation of unfunded pension plans?

Yes, laws and regulations for pension plans vary by country and are often complex. It’s essential for businesses to consult with qualified pension advisors or legal professionals to ensure proper compliance with these regulations.

What is the benefit of having an unfunded pension plan for a company?

Some companies prefer this method, especially smaller or family-run businesses, because it can result in substantial cash flow advantages in the company’s early years. It allows companies to defer the cash costs of pension plans until a later date.

What separates an unfunded pension plan from a funded pension plan?

Unlike a funded pension plan where resources are pre-allocated to meet future pension obligations, an unfunded pension plan draws from a company’s current earnings when those obligations become due.

Are unfunded pension plans protected against bankruptcy?

No, unfunded pension plans have no protection against company bankruptcy. If a company goes bankrupt, pension beneficiaries may receive significantly less than they would have otherwise, or nothing at all.

Related Finance Terms

  • Defined Benefit Plan
  • Pension Obligation
  • Actuarial Liability
  • Underfunded Pension
  • Pension Deficit

Sources for More Information

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