Pension funds are either defined benefit funds or 401Ks. In a defined benefit fund, the employer promises to pay the employee a certain percentage of his income, as earned in the final years of his employment. In a 401K, many employers promise to match the employee's contribution each year. These promises create pension fund liabilities.
The American Accounting Association estimates the total underfunding of the nation's pension funds, as of the time of publication, to be greater than $3 trillion in market valuation. The plans report $438 billion in underfunding by using return on investment assumptions that are not marked to market. When assumptions are not marked to market, during periods of low interest rates or market crashes the mispriced assumptions cause the pension funds to be over-estimated. When it comes time for pensions to be paid out to retired employees, if the money is not available in the pension fund it must come out of the earnings of the company or the general fund of the municipality. Unfunded pension liabilities were a major cause of the bankruptcy of several major industrial companies, including General Motors and most of the American steel companies.
Employers sometimes use the money they owe their pension accounts to fund operations, figuring they have time to make it up in following years before the employee retires. Sometimes the employers go out of business first, leaving large unfunded pension liabilities. Other sources of unfunded pension liabilities are inaccurate projections of the amount of money that will be made on investments in the pension fund. This happens when interest rates decline below the actuarial assumption of return on investment.
Actuarial assumptions are calculations that take into account the amount of yearly contributions to a pension fund and assume that money is invested in bonds at a certain interest rate, or invested in stock that provides a certain return on investment through dividend payments and price appreciation. Actuaries make these assumptions to predict how much money must be invested each year to meet the pension obligations of the employer.
Actuarial assumption errors tend to take three forms: inaccurate longevity assumptions that don't take into account increased longevity; failure to adequately factor in inflation risk that increases pensioners' payout needs and failure to adequately estimate cost risks caused by regulatory changes and wage inflation. These assumption errors have resulted in greater than realistic return on investment expectations, which gives employers a false sense of security about delaying funding their pension liabilities and leads to large unfunded pension liabilities that have caused great concern about potential municipal and corporate bankruptcies as well as labor problems after the financial crisis of 2008.
- American Enterprise Institute; The Market Value of Public-Sector Pension Deficits; Andrew G. Biggs; April 2010
- New York University Stern School of Business; Pensions and OPEBs; Paul Zarowin
- American Accounting Association: The Mispricing of Pension Cash Flows and Accruals
- "The Baltimore Sun"; Beth Steel Gets Back on Solid Ground Company's Unfunded Pension Liability Nearly Eliminated; Sean Somerville; April 1998
- Oxford University; The "Crisis" in Defined Benefit Corporate Pension Liabilities: Current Solutions and Future Prospects; Clark and Monk
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