As credit managers, from time to time we need to dig into a financial statement to understand a potential customer’s credit worthiness. In doing so, there may be a tendency to only look at the easily identifiable current assets and liabilities, sales, profits, and a few other accounts to get some commonly calculated financial ratios.
But did you know that the pension liabilities account is a current liability that should also be carefully looked at? This is crucially important since it is an area that can be very telling about a potential customer’s credit worthiness, especially if it is in an unfunded status.
Unfunded pension liabilities, or what is sometimes considered to be hidden pension liabilities, refer to the obligations a company has towards its pension plan participants that are not fully funded. These liabilities arise when the assets set aside to cover future pension obligations are insufficient to meet the expected payouts to retirees and beneficiaries.
Pension plans typically operate by collecting contributions from employers and employees, investing those funds, and using the returns to pay out pensions when employees retire. The goal is to accumulate enough assets over time to cover the promised retirement benefits.
However, if the pension plan’s assets are not enough to meet the expected obligations, a shortfall occurs. This shortfall represents the hidden pension liabilities. It also means that the pension plan does not have enough funds to cover the full amount of promised benefits, and the employer sponsoring the plan must make up the difference.
There are several reasons why hidden pension liabilities may arise:
- Inadequate funding: If the employer fails to contribute enough money into the pension plan, the assets will not grow sufficiently to meet future obligations.
- Poor investment performance: If the plan’s investments underperform or experience losses, the fund’s assets may not grow as anticipated, leading to a funding shortfall.
- Longevity risk: If plan participants live longer than expected, the pension plan will need to pay benefits for a longer duration, increasing the overall liabilities.
- Changes in actuarial assumptions: Assumptions regarding future investment returns, employee turnover, salary growth, and mortality rates can have a significant impact on the projected pension obligations. If these assumptions turn out to be inaccurate, it can result in hidden pension liabilities.
Hidden pension liabilities can pose significant financial challenges for employers. If the shortfall is large, it may lead to budgetary strains, increased contributions, reduced benefits, or even the need for a bailout to fulfill the pension obligations.
It is imperative for credit professionals to evaluate the status of an unfunded pension plan on a financial statement as its materiality could greatly impact the financial stability of a potential or current customer.
Your questions and comments are most welcome (nseiverd@cmiweb.com).
Nancy Seiverd, President, CMI Credit Mediators, Inc.
