2025 Guide: Understanding the $X Billion Risk of Underfunded Pension Plans for Investors

Underfunded pension plans pose a significant yet often misunderstood risk to investors evaluating a company’s financial health. The challenge lies in deciphering the murky accounting and limited disclosures surrounding these plans. This article breaks down the essential factors investors need to understand about pension risk and how to navigate them.

Key Insights

• Only defined-benefit pension plans carry underfunding risk, as employees bear investment risk in defined-contribution plans.
• Underfunding occurs when pension liabilities surpass the assets set aside, requiring companies to increase cash contributions.
• Determining underfunding is complex due to future payment obligations and optimistic return assumptions.

What Is Pension Risk?

Pension risk refers to the potential negative impact on a company’s earnings per share (EPS) and overall financial condition stemming from an underfunded defined-benefit pension plan. Unlike defined-contribution plans, where employees carry investment risk, defined-benefit plans obligate the company to pay fixed benefits regardless of investment performance.

Defined-Benefit vs. Defined-Contribution Plans

In defined-benefit plans, companies promise specific retirement benefits and must invest prudently to fulfill these commitments, bearing the investment risk themselves. Conversely, defined-contribution plans shift investment risk to employees, with companies contributing fixed amounts to retirement accounts.

While defined-benefit plans have declined over recent decades, they remain prevalent, especially among unionized firms, which face the highest pension risk.

Assessing pension risk starts by evaluating the funding status: underfunding means liabilities exceed assets accumulated through corporate contributions and investment returns.

IRS and accounting regulations allow pension funding through cash and company stock, though stock contributions are capped. Companies often maximize stock contributions to reduce cash outflows, but this can lead to overexposure to their own financial health—a risky strategy.

If pension assets fall below 95% funding at the start of the year or 80% at any point, companies must boost cash contributions, potentially reducing EPS and equity and triggering loan covenant violations with serious consequences.

Understanding Shortfall Risk

Shortfall risk arises when the fair value of pension assets is less than the accumulated benefit obligation—the present value of current and future pension payments. This gap, disclosed in company financial footnotes, signals underfunding.

However, since pension obligations are long-term, comparing current assets to total liabilities can be misleading, much like comparing a mortgage balance to current savings without considering future income.

Note:

Unionized companies typically carry the greatest pension underfunding risk.

Assumption Risk Explained

Assumption risk involves companies using optimistic assumptions to reduce immediate pension funding needs. Since pension obligations are long-term and uncertain, assumptions about investment returns and discount rates are necessary but can be manipulated.

For example, assuming a 9.5% long-term return may lower required cash contributions but is often unrealistic given historical stock returns (~7%) and lower bond yields. Similarly, using a higher discount rate reduces the present value of pension liabilities, understating true obligations.

Investors should scrutinize these assumptions against current economic conditions to gauge their reasonableness.

Conclusion

Underfunded pension plans present a tangible and growing risk to companies and investors, especially amid aging workforces. While shortfall and assumption risks are challenging to assess, thorough analysis of pension funding status and assumptions is crucial for informed investment decisions in 2024.

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