Pension funds must maintain a certain funding status, or value of assets relative to liabilities, in order to be able to afford retirement benefits for employees. An underfunded pension plan is one that does not have enough assets to afford its liabilities, and it can be caused by mismanagement. Pensions rely on cash contributions from the employer, also known as a plan sponsor, coupled with deposits from plan members to maintain the size of the plan. Also, retirement plans invest those assets into financial markets in an attempt to increase the total size of the pension fund. When any of these factors are weakened, whether it be contributions or investments, an underfunded pension plan can be the result.
A pension can find itself in an underfunded status whether it is a public or private plan. Public plans could be funded by a regional budget, for example, from a city, state, or a university. Corporate plans found in the private sector are run by corporations, not governments. In either plan type, the plan administrator or investment committee has a fiduciary responsibility to the governing body to keep the plan at a funded status so that employees or plan members will receive benefits upon retirement. Unfortunately, this does not always occur.
On the investment side, assets in a pension are placed into financial markets via investment funds run by professional money managers or by an internal money management team. Mutual funds are a common investment choice. If the pension assets are not allocated properly to achieve a certain level of diversification, the pension could be vulnerable to losses, which could lead to an underfunded pension plan. This could be a result of not maximizing investment opportunities in different categories or suffering a serious downturn in the financial markets that the plan was not prepared for.
Plan sponsors, which could be a public entity such as a government or a private corporation, are responsible for contributing money to pensions. This amount is usually decided on an annual basis and may be adjusted. If an employer or other plan sponsor does not make the required cash contributions, this too could lead to an underfunded pension plan.
Retirement plan members might be asked to contribute more to a fund to help toward recovery. Another option is taking more investment risks in the markets in an attempt to grow the plan by profits. Unless it is a crippling underfunded pension plan, retirees are not necessarily in danger of not being paid, but if the funding status does not improve, it could head in that direction.