4.2.2. Pension Funding

Pension Funds can be funded or unfunded⁷⁷.

Funded pension funds

Funded pension reserves pension plan have accumulated dedicated assets (may be identified reserves in the plan sponsor's balance sheet or/and segregated assets) to pay for the pension benefits. The way in which funding levels are measured varies from country to country.

The asset portfolio of funded plans has to return sufficient value to serve the members claims.

In principle, and applying the time value of money concept (see also chapter 5.2), the Pension Funds liabilities can be calculated as the present value of all probable future payments to the beneficiaries during their retirement phase.

With FV= future value of benefit, PV = present value, i = discounting factor, n = number of periods

To get this calculation to result some assumptions need to be made. Future value (defined benefit) and the number of periods may be filled with expected values from statistical distributions for the key variables member age, statistical age of retirement, and statistical longevity and guaranteed benefit neet to be applied. Such statistical data is available today in sufficient form and extend and it seems reaconable to use it. The value of the assets, on the other hand, has to be evaluated in accordance to accounting rules.

The funding level of DB plans has direct impact on the liabilities of the sponsor. Regulations mandate at certain levels corrective actions 78 . The funding level of assets to liabilities shall always be greater 100%. (some regulations require more than that). If, for any reason, this level drops to a level of e.g. 90% the fund is required to start a recovery plan with the involvement of the sponsor, who is finally liable. Funding levels greater e.g. 115% lead to contribution holidays of the sponsor, even greater levels to possible withdrawals.

Unfunded pension funds

Unfunded pension plans are those that are financed directly from contributions from the plan sponsor or provider and/or the plan participant. Unfunded pension plans are said to be paid on a current disbursement method (also known as payas-you-go, PAYG). Unfunded plans may still have associated reserves to cover immediate expenses.

Sources of unfunded plans are the actual contribution from active members that are used to pay the actual benefits of the retired members. The Pension Fund faces now a different risk scheme, which is not focused on the optimum risk/ return profile of its investment portfolio but solely on the ratio of active members to retired members and the rate of contribution. In mature and aging countries (e.g. Germany, Japan, Greece) this is leading to adjustments of contribution rate, begin of retirement and replacement rate by politics (as seen in the past years in Germany and other aging countries) to reduce subsidies required to match the needs.

Illustration 15: Scheme for funded and unfunded funds

⁷⁷ Yermo, Juan, REVISED TAXONOMY FOR PENSION PLANS, PENSION FUNDS AND PENSION ENTITIES, OECD 2002
⁷⁸ PRIVATE PENSION SERIES N° 8 Pension Fund Regulation and Risk Management, Protecting Pensions: Policy Analysis and Examples from OECD Countries, OECD 2007