Defined benefit pension plans were once the cornerstone of American employee benefits, and a worker often stayed with one employer for many years until he was eligible for retirement. When he stopped working, he received a pension check each month for the rest of his life. The company contributes periodically to the pension fund. The fund manager invests these contributions for future growth, so that when the employee retires, money is available to pay the benefits. When a company uses these contributions to pay present benefits, future payable benefits may not be funded sufficiently, leading to unfunded liabilities.
1. Determine the values that you will use for certain projected values. You will need to estimate the interest rate the pension plan expects to earn on its assets. This rate will also be used to discount the projected future value of benefits to represent the present value of the pension payouts.
2. Calculate the actuarial value of pension fund assets. This is based on the the present value of the pension assets, less the discount rate. This is an interest rate based on the prevailing rate of high-quality investments. For example, a pension fund may have $1,000 in present assets, with the interest rate estimated at 4 percent per year. In 20 years, the projected, or actuarial, value of assets is $2,191.12.
3. Determine the actuarial value of liabilities, or what the plan must pay in the future. This number depends on the projected future benefits the plan will pay, which is based on inflation and future benefits increases, as well as how long pension plan participants will work, and how long they are expected to live. These calculations are complex, and estimates are based on statistics about the existing population.
4. Subtract the actuarial value of liabilities from the actuarial value of the pension fund assets. The result is the unfunded pension liability. This figure is based on vested pension benefits that are due to be paid, and does not take into account any pension plan members who may become vested in the future. If our example pension expects to pay a total of $3,000 in earned benefits, it has unfunded vested benefits of $808.88
- Unfunded vested pension benefits are often shown as a liability on a company balance sheet, because the company will need to pay the money that it has promised in the future. This affects the present financial position of the company.
- It is difficult to estimate the exact numbers to calculate unfunded pension benefits, and the estimates vary considerably based on the values used in the calculation. Be careful when evaluating the financial health of a company that you make sure the unfunded benefits are calculated realistically.
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