Can a Pension Run Out? And What Happens If It Does?

The possibility of a pension running out is a common concern for many individuals planning retirement. This article explores pension funding mechanisms, factors impacting their financial health, and protections in place to safeguard retirement benefits.

Understanding Pension Structures

Pension plans fall into two main categories: defined benefit (DB) plans and defined contribution (DC) plans. Defined benefit plans, also called traditional pensions, promise a specific monthly benefit during retirement, calculated based on an employee’s salary and years of service. The employer bears the investment risk, ensuring sufficient funds are available to pay promised benefits regardless of investment performance. This contrasts with defined contribution plans, such as 401(k)s, where the employee contributes to an individual account. The retirement benefit depends on contributions and investment returns, with the investment risk resting with the employee.

A defined benefit pension fund operates as a separate legal entity from the sponsoring company. Contributions from the employer, and sometimes employees, are pooled and invested to generate returns that cover future benefit payments. Actuaries regularly assess the plan’s future obligations, considering factors like employee demographics and life expectancy, to determine required funding levels.

Factors Influencing Pension Health

The financial health of a defined benefit pension plan is influenced by several interconnected factors. Investment returns play a significant role; strong returns can bolster a plan’s assets, while poor performance can create deficits. Pension funds invest in a variety of assets, including stocks and bonds, with strategies designed to meet long-term obligations.

Interest rates also directly impact pension liabilities. When interest rates rise, the present value of a plan’s future liabilities decreases, which can improve the plan’s funded status. Conversely, falling interest rates increase the present value of these liabilities, requiring greater upfront contributions to meet long-term obligations.

Demographic shifts, such as increased longevity among retirees and declining birth rates, place pressure on pension systems. As the number of retirees receiving benefits grows relative to active workers contributing to the fund, plans can experience negative cash flow. The financial health of the sponsoring employer is also important, as their ability to make required contributions directly affects the plan’s funding level.

Protections and Guarantees for Pensioners

Several layers of protection safeguard pension benefits, particularly for private-sector defined benefit plans. The Employee Retirement Income Security Act of 1974 (ERISA) established the Pension Benefit Guaranty Corporation (PBGC) to insure these plans. The PBGC acts as a federal insurance program, paying guaranteed benefits if an insured pension plan becomes insolvent or is terminated. It covers most private-sector defined benefit plans.

The PBGC is funded primarily through insurance premiums paid by the employers sponsoring defined benefit plans, as well as from investment income and assets recovered from failed plans. The maximum monthly benefit guaranteed by the PBGC is set by law and adjusted annually; for plans ending in 2024, a 65-year-old retiree in a single-employer plan could receive up to $7,107.95 per month. This amount can be lower for those who retire early or choose survivor benefits, and higher for those who retire after age 65. The PBGC guarantees basic benefits like pension payments at normal retirement age, most early retirement benefits, and disability benefits, but it does not cover benefits like health and welfare benefits or certain supplemental benefits.

Beyond the PBGC, ERISA imposes fiduciary duties on plan administrators, requiring them to manage pension assets prudently and solely in the interest of plan participants and beneficiaries. Mandatory funding requirements also exist, compelling employers to contribute sufficient amounts to their pension plans to meet future obligations. While public sector pensions are not insured by the PBGC, they often have state-specific protections and oversight mechanisms designed to ensure their long-term solvency.

Scenarios of Pension Underfunding or Failure

When a private-sector defined benefit pension plan faces severe underfunding, the sponsoring employer is generally required to make additional contributions to address the shortfall. If the employer is in financial distress and cannot continue funding the plan, a distress termination may occur. In such cases, the PBGC takes over the plan as trustee and begins paying benefits to participants, up to its guaranteed limits. The termination process involves notifying participants and regulators, and the PBGC works to ensure that benefits are distributed according to legal requirements.

For private plans that are sufficiently funded, an employer may choose a standard termination, where all accrued benefits are paid, often by purchasing annuities from an insurance company or providing lump-sum payouts. The PBGC’s guarantee ends once benefits are distributed through these methods. While the outright loss of all pension benefits is rare for PBGC-insured plans, especially for basic benefits, individuals may receive less than their originally promised amount if their benefits exceeded the PBGC’s guarantee limits.

Public sector pension plans, not being covered by the PBGC, handle underfunding differently. While they do not typically “run out” in the same way private plans might, severe underfunding can lead to measures such as reduced cost-of-living adjustments (COLAs) or, in unusual circumstances, legislative changes to benefit structures. These adjustments are often aimed at restoring the plan’s financial stability and ensuring its long-term viability for all beneficiaries.