What is a UAL in finance?

In finance, UAL stands for Unfunded Accrued Liability. It is a crucial concept, particularly in the context of defined benefit pension plans, representing a significant financial shortfall.

What is Unfunded Accrued Liability (UAL)?

Unfunded Accrued Liability (UAL) refers to the gap that exists when the estimated cost of future benefits promised by a defined benefit plan exceeds the assets that have been set aside to pay for those benefits. Essentially, it's the amount of money a pension plan needs to have today to meet all its future obligations to retirees and beneficiaries, minus the assets it currently holds.

This liability primarily arises in:

• Public Sector Pension Plans: State, county, and municipal employee retirement systems often face substantial UALs due to various factors like investment underperformance, demographic shifts (people living longer), and insufficient contributions.
• Private Sector Defined Benefit Plans: Although less common now, some older corporations still manage defined benefit pension plans that can develop UALs.

Why is UAL Important?

UAL signifies a future financial obligation that is not adequately covered by existing funds. This can have significant implications for the entities responsible for these plans, whether they are government bodies or corporations.

• Financial Strain: A large UAL can put a tremendous strain on budgets, potentially requiring higher contributions, increased taxes, or cuts to other essential services (for governments).
• Credit Ratings: For governmental entities, a growing UAL can negatively impact their creditworthiness, making it more expensive to borrow money for other projects.
• Benefit Security: Ultimately, an unfunded liability poses a risk to the security of the promised benefits for retirees and future pensioners.

How is UAL Calculated?

The calculation of UAL is a complex actuarial process, but at its core, it is straightforward:

UAL = Estimated Cost of Future Benefits - Current Plan Assets

• Estimated Cost of Future Benefits: This involves projecting how much will need to be paid out in pensions over decades, considering factors like employee salaries, retirement ages, mortality rates, and cost-of-living adjustments. Actuaries use sophisticated models and assumptions for these projections.
• Current Plan Assets: This includes the current market value of all investments and cash held by the pension fund.

Impact of Unfunded Accrued Liability

The presence and size of a UAL can have widespread effects:

• For Governments and Taxpayers:
  • Increased Budgetary Pressure: Funds that could go towards infrastructure, education, or public safety might be diverted to cover pension shortfalls.
  • Potential Tax Hikes: Governments may need to raise taxes or fees to meet their pension obligations.
  • Credit Rating Downgrades: A high UAL can signal financial instability, leading to lower credit ratings and higher borrowing costs for the municipality or state.
• For Companies:
  • Reduced Profitability: More cash flow needs to be diverted to the pension fund, impacting a company's bottom line.
  • Balance Sheet Implications: UALs appear as liabilities on a company's balance sheet, affecting its financial ratios and attractiveness to investors.
• For Pensioners and Employees:
  • Uncertainty: While benefits are typically protected, persistent unfunding can lead to concerns about the long-term security of promised payments.
  • Benefit Modifications: In extreme cases, plans may need to adjust future benefits or contribution rates for active employees.

Managing Unfunded Accrued Liability

Addressing a UAL requires a multi-faceted approach. Key strategies include:

• Increased Contributions: The most direct way to reduce UAL is for the plan sponsor (e.g., government, company) to contribute more money to the pension fund.
• Investment Strategy Review: Optimizing investment returns within acceptable risk parameters can help assets grow faster to meet liabilities. However, relying solely on high returns is risky.
• Benefit Modifications: This can involve adjusting future cost-of-living increases, retirement ages, or other benefit formulas for active employees, though this is often politically sensitive.
• Bond Issuance: Some governmental entities issue pension obligation bonds to fund their UAL, aiming to earn a higher return on the invested bond proceeds than the interest paid on the bonds. This is a risky strategy if investment returns don't materialize.
• Improved Actuarial Assumptions: Regularly reviewing and updating the assumptions used in UAL calculations (e.g., mortality rates, inflation, investment returns) to ensure they are realistic.

Understanding UAL is vital for stakeholders in public finance and corporate governance, as it highlights potential long-term financial risks and obligations that require proactive management.