Why Investors Should Be Watchful of Underfunded Pension Funds

A pension plan can keep paying regular pensions to its buyers if it continues to generate more cash inflows or assets than its total liability in the form of a payable pension. Unfortunately, many pension plans in India can be at risk of being underfunded, which means their liabilities outweigh their assets.

An underfunded pension plan can be a government-sponsored or company-sponsored plan. Such plans do not have adequate funds to cover current and impending retirements.Therefore, such plans might need regular assistance from the government to continue disbursing the fixed pension amount that is assured to the current recipients and the future beneficiaries of such plans.

Defined-benefit plans are the pensions plans where a fixed amount of retirement is been assured to the subscriber in advance. Such plans consider the salary history and the number of years in service of the retired individual.In India, central civil services pension and various public sector bank pensions for their employees can be categorized as defined-benefit pension plans.Such plans can be underfunded because of the following reasons.

• The life expectancy of people has significantly increased due to the improvement in medical sciences and the developments in medical infrastructure in India. This has resulted in retired people living longer and hence drawing a pension for a longer period.
• Market uncertainties like decreasing bank interest rates, sudden fall in stock prices, economic slowdown, or unforeseen global events like the current Covid-19 pandemic can negatively affect the investment returns of the fund. Despite this, the fund is bound to pay a regular pre-defined pension amount to the pensioners.

This leads to increasing pressure on the financial accounts of the fund.All these factors lead to a situation where the fund is unable to generate profit or grow its cash reserve for trouble-free sustenance of its operations in the long term.Furthermore, common investors might find it difficult to determine whether the fund is underfunded because pension payment is a future liability and the presently buoyant market or economic conditions can present an overly optimistic projection for the future.Moreover, the company or the fund house bears the investment risk as it has to keep paying a fixed pension regardless of the amount of return it can generate.

As the name suggests, overfunded pension plans are just the opposite of underfunded pension plans. These are the funds that have considerably higher assets than liabilities.A pension plan can be overfunded for a few reasons.

• Favourable market conditions like a booming stock market, stable economy, or steady interest rates can result in a higher return on investments.
• Consistently rising participation in pension contributions from new employees can result in an increase in the fund size.
• Government policies can directly or indirectly favour certain schemes. For example, both the employer and the employee must contribute to the employee provident fund, which results in a steady increase of the cash inflow in such fund.

At the onset, overfunded plans might seem a good investment option as they don’t have issues regarding cash inflows. However, such plans should not be an automatic investment choice because of the following reasons.

• These funds are often not transparent with their investment choices. A common man might not have access to the information about what these funds are buying or their investment strategy.
• The market condition can change overnight, and the subsequent returns of such funds can also be affected.
• These funds can often be bound by statutory obligations that prohibit them from fully utilizing their surplus cash for business or growth.
• The funds of a government-backed defined-benefit plan, if overfunded, can be used by the government for bailing out troubled government entities or other such matters.
• Overfunded pension funds may end up paying more taxes as the underutilization of funds can show up as higher profits in the accounts.
• Since the pension benefits are fixed beforehand, the subscribers do not benefit from the profits of such plans.

Unlike defined-benefit plans, defined-contribution plans work on a profit-sharing model that can be more sustainable in the long run. In such plans, the company or the government contributes a specific amount to the employee’s retirement fund account instead of directly paying a fixed pension to the retired employee.The National Pension Scheme (NPS) is a defined-contribution plan.

• Investors with a higher risk appetite can opt for higher contributions to their pension fund to increase their chances of beating the inflation and getting better pension benefits.
• Risk-averse investors who prefer lower but safe returns can control their exposure to market-linked instruments.

• Active Investment If an investor is confident of his investment abilities and wants to decide the asset mix and proportion in his fund, he can choose the active investment.
• Automatic Investment In this option, an investor doesn’t have to worry about asset proportion in his account. Assets are automatically allotted and changed from high-risk to low-risk financial instruments as the investor approaches his retirement age.

• Since there are no fixed benefits, employees can get higher returns and better pensions depending upon their fund performance.
• Investors can decide asset allocation patterns in such plans.
• The NPS offers two investment choices-

As an employee, you may have a statutory obligation to invest a certain amount in defined-benefit pension plans like EPF or GPF, regardless of whether they are underfunded or overfunded. However, you should not be solely dependent on such a fund for securing your retirement.Instead, you can consider opening an NPS account as a parallel investment that can potentially better secure your retired life.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.