As the government tries to thaw the credit freeze, the next potential catastrophe is starting to heat up. I am beginning to see more and more written on the pending problem of underfunded pension plans. Unfortunately, this problem could have many faces and take a significant amount of time to sort out.

First, a short primer for those fortunate enough not to be involved in pension accounting.  There are two basic types of company sponsored retirement plans - defined contributions (DC) and defined benefits (DB) plans.  As the names imply, a DC plan defines what the company will contribute to the plan on behalf of the employee. An example of a DC plan is a 401(k) where the company will match the first 5% contributed by the employee. There is no guarantee of what the employee will get out of the plan. The DB plan in contrast defines the benefit the employee will receive upon retirement, such as a salary of 80%  of his or her highest earnings year, weighted by years of service.  In the DC plan the employee assumes the risk of under-performance, while in the DB plan the employer assumes the risk.

For DB plans, actuaries will look at the number of employees, their ages, their income and other factors to determine what the company’s future liability will be. The actuaries will then look at the invested assets, estimate a future return and determine if the assets will be sufficient to cover the future liability. When the market is spiraling up, assets are usually greater than the liabilities and the company does not have to put any money in the plan, thus it does not have recognize an expense.  But when the market is down, as it has been lately, the liability is greater than the assets on hand. This is referred to as underfunded, and over time the company has to come up with cash and recognize an expense.

One of the biggest pension plans in the world is General Motors (GM).