Don't Turn a Blind Eye to Pension Risk

Pension risk is something that investors and workers that have pension plans need to be aware of. Many people ignore the potential risks that come with a pension plan, but many of these risks are legitimate. Here are a few things to consider about pension risk.

Pension Risk

Pension risk is something that can play a role with defined benefit pension plans. With this type of defined benefit plan, there is always the chance that it could be underfunded. If the patient has more liabilities against it than assets, it is considered to be underfunded. This happens whenever the contributions to the plan and the investments do not add up to the amount of money that it will take to pay retirees. When this happens, the individuals that are retiring may not be able to get the amount of money that they were originally promised when they started working for the company. This can be a devastating scenario for retirees and it can negatively impact the company as well.

Contributions

Companies can contribute to their pension plan in two different ways. The first way that they can contribute is with cash. The other option that they have is to contribute company stock to the pension plan. In many cases, companies try to rely heavily on stock contributions. By doing this, they will not actually have to come up with any cash for the contributions. They can simply put stock that they have in the company treasury into the pension plan.

By funding the pension plan with company stock, the company is creating another source of risk. This is actually creating a scenario that is dangerous for employees. If the company does not perform as well as it should, the value of the stock is going to decline. When this happens, the value of the pension plan is going to decline as well. Many times, this has contributed to underfunded pensions.

Underfunded

In order to determine if a pension is underfunded, they are going to look at the value of the assets in the pension over the course of three consecutive years. If the value falls below 90 percent of what it should be, it is considered underfunded. If it goes below 80 percent in a single year, it is also considered underfunded. In this case, the company is going to have to up their contributions in the form of cash.

Assumptions

Another aspect of pension risk involves assumptions. Companies regularly make assumptions about their pension plan in order to reduce the amount of contributions that they need to make. For example, they might assume that they are going to make a return of 12 percent per year from the investments in the pension plan. Because of this, they do not need to contribute any more cash to the plan. The only problem with this type of assumption is that they are not likely to earn 12 percent per year from their investments. 

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