Now that general economic conditions are improving and the stock market is recouping some of its losses from late 2008 and early 2009, it seems as though we’re going to avoid any sort of “doomsday” scenario stemming from the recession, housing and credit crises. However, that does not mean that we’re entirely out of the woods. Indeed, one potential problem is underfunded pension plans. 

First, a little background on pension plans and pension accounting. There are two main types of pension plans: defined contribution and defined benefit. A 401(k) is an example of a defined contribution plan. A company pays a discretionary amount of money into the plan, but that’s the extent of its involvement or obligation, and employees bear all the financial risk of investing the assets. In a defined benefit plan, however, the company stipulates what it will give to employees after retirement (typically a mix of cash and benefits), based on factors such as time of service, salary, etc. In a defined benefit plan, the company takes on all the financial risk, and it is the funded status of these plans that is a bit worrisome.

The funded status of a defined benefit plan is the difference between the fair value of the plan’s assets and the projected benefit obligation (PBO). The PBO is the present value of benefits that employees have earned, assuming that participants stay with the company until retirement, and that their salaries grow at a certain rate. It is the best measure of a company’s full pension liability.

Asset returns and contributions from the sponsor are the only two ways to fund a plan. When markets are climbing and assets are increasing, a company doesn’t need to contribute much cash, but the recent severe market contraction weighed heavily on plan assets. To be sure, the broad market rally that has taken place over the past seven months has helped a great deal, but many plans remain underfunded by 20% or more. Investors need to keep an eye on the funded status of a defined benefit plan, since it could result in large contributions down the line, which would weigh on earnings and make less cash available for expanding the business through positive net present value projects.

Investors should also be aware of the assumptions that a company uses in calculating its PBO. Due to management’s discretion and the large amount of assumptions needed to calculate the PBO, it is fairly easy to tweak the numbers in order to make the funded status of a plan appear more attractive. The discount rate and the rate of compensation growth are two of the most important assumptions that go into the calculation of the PBO. The discount rate is the divisor used to transform future dollars into today’s value. A higher discount rate will lower the PBO, as will a reduction in the compensation growth rate, which is the rate at which employees’ salaries are assumed to grow.

Just because a company has an underfunded pension plan doesn’t mean that it’s headed for financial difficulty, or do changes in actuarial assumptions necessarily mean that a company is engaging in questionable accounting. However, these are things that investors should be aware of and keep in mind when making investment decisions, as a severely underfunded defined benefit pension plan could cause problems down the road.