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A pension plan is a retirement plan set up by a company, which guarantees a dollar amount paid per month based on the number of years an employee worked with the company. Usually employees must work 20-30 years before being able to collect a pension. Employees make contributions to their pension, or take a slightly lower wage in order to be able to collect a pension at a later date.
When you have an unfunded pension plan, this means that the company didn’t make any savings over the year to cover employees now receiving a pension. It also means that contributions made by current employees are being used to pay the pension of current retirees. This can be a dangerous situation for the person collecting a pension from the unfunded pension plan. If anything happens to the company, or current contributions to the plan drop, or if the workforce is diminished, the company has no way to continue to make pension payments.
Another issue at hand is that current employee contributions to an unfunded pension plan may not ensure their own pensions or retirement. Furthermore, the employees of today may be financing a lot of pensions for others depending upon how many retirees exist. If there are more retirees in a company than there are employees, an unfunded pension plan can break the company, since it may owe far more in yearly pension payments than it collects from current workers.
Unfortunately, recourse for collecting from an unfunded pension plan if the company becomes insolvent is not available. Employees, if they qualify in age, may be able to collect a higher amount of social security payments, but it is usually not enough to make up the difference between what they would have received from their pension. Several large companies that have collapsed have left employees faced with difficult choices because they had unfunded pension plans. After assuming for most of their working lives that they’d receive a pension, these former and current employees are suddenly faced with having no pension to collect, since no money was put aside to fund the plan.
To address this legitimate situation, many companies have switched to 401ks, IRAs or employee cash accounts to help fund retirement. Money to retire upon is based not on what the company has, but on what an employee has invested (possibly matched by company funds). The employee and not the company owns these plans. Collapse of the company can thus have no effect on money available. However, money invested in such plans is subject to risk or loss if the employee makes bad investment choices or interest rates or the stock market take a downturn. Yet, since unfunded pension plans still exist, this issue will continue to be a problem, and is likely to most affect those who have worked their whole lives, and now face no financial security in retirement.