What it is:
How it works (Example):
In a defined pension plan, where a company bears the risk of the investment of the pension pool and is obligated to provide the pension benefits to employees upon retirement, a poor investment performance by the investment pool may result in a pension shortfall. When a pension shortfall occurs, a company can try to increase the returns from its investment. More likely, however, a company must increase its cash contributions to the pension plan.
Why it Matters:
Such shortfalls and the required contributions by the companies to make up for the shortfall directly affect the company's net income. In particular, among legacy companies (i.e. older companies that have thousands of employees retiring each year), the risks of a pension shortfall increase substantially, especially during downturns in the investment markets. Many companies in this position, such as automakers, steelmakers, energy and chemical makers, and even communication companies have pension shortfalls that dramatically affect their profitability and, sometimes, their viability.
The US government passed the Pension Protection Act of 2006 to guard against pension shortfalls by requiring companies to increase their contributions to the pension funds if their investment pool asset valuation falls below 80% of the current pension obligation.