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Pension liability refers to the fact that either a private company or a national government will have to account for making future pension payments. The methods used to make this accounting can vary immensely. A larger than expected liability can either literally force a company out of business or cause it to be insolvent on paper.
The term pension liability does not refer to the total amount a company will have to pay in future pensions. Instead it refers to the difference between that amount and the amount of money the company has earmarked to make those payments. Of course, the company may have more money than it needs, which is known as a pension surplus.
A pension liability will generally only occur in defined benefit schemes. This is where the company has agreed in advance to provide pensions of a set amount to staff, often set as a proportion of their salary in their last year of retirement. The alternative system, a defined contribution scheme, involves the company only guaranteeing how much it will invest towards future pensions. This means the pensions paid are unpredictable, depending on the performance of the investments, so logically there can't be a pension liability.
To make things more complicated, a company does not usually pay a pension directly. Instead it buys an annuity, which converts a flat amount of cash into a guaranteed annual payment for the pensioner's lifetime. The relationship between the cash payment and the annuity payout varies over time. This means the amount of money the company needs to fund a guaranteed pension can change dramatically from year to year.
Calculating pension liabilities can be an extremely complex subject. The amount of time for which forecasts are made can vary greatly, from simply working out the liability for the coming year to working out the total pension liability if every current member of staff continued being employed at the company until they retired. In many countries, there are standard systems to make sure all companies work out their liabilities in the same way.
Depending on local accounting laws, some or all of a firm's liabilities must appear on its balance sheet. This can often mean an otherwise healthy company appears deeply in debt. In some situations, a company can even find itself technically insolvent and have to take measures to fix this.
The term pension liability can also be applied loosely to government spending. In this instance it refers to the Social Security or state pension payments which the government must pay to retirees. With the proportion of retirees to taxpayers rising, some governments are finding they must either raise taxes or cut pension payments to make the books balance.