What Are Unfunded Pension Liabilities and Their Effects on Financial Statements?

by Jack Ori

State governments and private companies that have pension funds must list the funds as either an asset or a liability on their financial statements. If the pension has enough funds to pay out all of its future obligations, the pension is said to be funded. If not, it is unfunded. U.S. and international accounting standards differ regarding reporting unfunded pension liabilities.

Definition

The difference between assets in a pension fund and the amount of benefits the fund is required to pay out are considered unfunded pension liabilities. For example, if a pension fund has $1 million in funds and owes benefits of $1.5 million, then the $500,000 of benefits that it cannot pay would be considered an unfunded pension liability.

Net Assets

As of the time of publication, U.S. law requires companies that fund pensions to list the pension's net value as an asset or liability on the balance sheet. If the business has an unfunded pension liability, it is listed as a net liability under "pensions" on the balance sheet. This does not give investors complete information about the funds in the pension; it just informs them of how much more money the pension owes than it has available for payment.

Amortization Problem

Prior to 2006, U.S. businesses were allowed to amortize unfunded pension liabilities on their balance sheets. Instead of listing the entire unfunded pension liability at once, businesses were allowed to list a portion of the liability each year for 40 years. Thus, a balance sheet from prior to 2006 might list the pension fund as a net asset when in reality it was underfunded and thus a liability.

International Rules

International standards have not changed along with the U.S. standards. Thus, if an investor examines a balance sheet from a foreign company, the sheet may list pensions as a net asset even though the pensions are unfunded. The balance sheet does list the unfunded pension liability underneath the pension assets, but the entire amount may not be subtracted from the asset due to amortization rules.

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