Unfunded plan: Overview, definition, and example
What is an unfunded plan?
An unfunded plan is a type of financial arrangement, typically used in the context of employee benefits, where there is no set aside pool of assets to cover the plan's future obligations. In such plans, the funds to pay out benefits (such as pensions, bonuses, or retirement benefits) are not pre-funded by contributions or investments. Instead, the company or entity responsible for the plan pays the benefits from its operating revenue or general assets as they come due.
Unfunded plans are often contrasted with funded plans, where the entity contributes to a separate account or fund that grows over time to meet future liabilities. Unfunded plans are more reliant on the ongoing financial health of the employer or plan sponsor, meaning that the employer’s financial ability to meet obligations can vary over time.
Why are unfunded plans important?
Unfunded plans are important because they represent a simpler, more flexible way for companies to provide benefits to employees without the need for significant upfront investment or long-term financial commitments. These plans are generally less expensive to set up and manage compared to funded plans since they do not require setting aside large amounts of capital or managing investments.
However, the key risk of an unfunded plan is that its long-term viability depends entirely on the financial health of the employer. If the company faces financial difficulty, it may not be able to meet its obligations to employees, leading to potential problems with benefit payments.
Understanding unfunded plans through an example
Let’s consider a company, TechWorks, that offers unfunded retirement benefits to its employees. Instead of contributing to a pension fund each year or setting aside money for future payouts, TechWorks promises its employees a pension once they retire, but it doesn’t set aside specific funds to cover that promise. The company will pay the pension directly from its operating revenue when the time comes, based on the amount due to each employee.
For example:
- TechWorks promises employees a $1,000 monthly pension when they retire, but instead of saving up the money in advance, it simply agrees to pay this amount when the employee reaches retirement age.
- If TechWorks is financially healthy when an employee retires, it can easily meet this obligation. However, if the company faces a financial crisis and doesn’t have sufficient cash flow, it might struggle to pay out the promised pension.
This reliance on the company's future financial stability makes unfunded plans riskier for employees, as there is no guarantee the company will be able to meet its obligations.
Example of an unfunded plan clause
Here’s how an unfunded plan clause might appear in an employee benefits contract:
“The Employer agrees to provide the Employee with post-retirement benefits as outlined in the plan, with the understanding that such benefits will be paid from the Employer’s general assets at the time they are due. The Employer does not maintain a separate trust or fund to cover these future benefits, and the payment of benefits is subject to the continued financial viability of the Employer.”
Conclusion
Unfunded plans are financial arrangements where future obligations, such as pensions or employee benefits, are not supported by a dedicated pool of assets. Instead, the company or plan sponsor is responsible for meeting these obligations from its general funds as they come due. While unfunded plans offer simplicity and flexibility, they carry the risk that the company may not have the necessary resources to fulfill its commitments if financial challenges arise. Understanding the nature of unfunded plans is essential for both employers and employees, as it helps manage expectations about the security of promised benefits.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.