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Pension liabilities are the present value of the retirement benefits a defined benefit pension plan has promised to pay its employees. In other words, if we think of a pension plan as a debt that sponsors have promised to pay, then the value of that debt can be seen as the pension liability.
Understanding pension liabilities is important to anyone involved in a pension plan because they can impact an organization’s funded status, retirement security, and long-term financial well-being. In this article, we break down the concepts that influence pension liabilities, how they work, and why they matter.
Since pensions are promises to pay a specified amount at a future date, actuaries use a series of calculations to determine how much an organization needs to save today to meet future liabilities. The amount needed is known as the present value.
Present value is calculated using the value of the future payment, the years until the first payment, and a discount rate, which is a percentage used to reflect the changing value of money over time.
Below is the formula for calculating the present value for one payment expected to be made ‘n’ years in the future:
Present Value = Future Payment ÷ (1 + Discount Rate)ⁿ
The calculation is performed for each future payment year. The sum of all present value calculations then produces the final pension plan liability.
In practice, actuaries apply additional assumptions to gauge risk, making educated assumptions on certain values, like longevity, expected salary, job changes, discount rate, and more. Since these values cannot be exactly predicted, there is some uncertainty around the expected liability.
The first item to discuss is how pension liabilities influence a pension plan’s funded status. Funded status is determined by subtracting a plan’s liabilities from its total assets, where assets are funds and investments the organization currently holds.
A plan is considered fully funded if its assets exceed its liabilities and underfunded if the reverse is true. Underfunded plans with significant liabilities can impact various individuals, from organizations to investors. Below are a few considerations:
Organizations: Unfunded pension plans increase risk for organizations. To make up for liabilities, organizations will need to pay the difference, affecting yearly financials.
Employees and Retirees: Unfunded plans are less stable, affecting the security of the employee’s retirement.
Investors: Significant pension liabilities can impact the value of the company and reduce the stock price.
Other individuals may also be impacted, depending on the plan. For example, local governments, and therefore taxpayers, could be affected by an underfunded plan.
Whether financial or legal risks, we believe that sponsors need the right tools and advice to appropriately assess and manage pension plan risk. Learn how October Three can support your pension plan risk management with a quick call today.