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Finance Glossary

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Unfunded Pension Liabilities

Definition:

If a municipality offers a pension to its employees, often that pension results in obligations that won't come due for a long time, maybe several decades. It would be nice if the municipality put money in the bank on a regular basis to pay this obligation when it comes due, but there are two problems with this: (1) the municipality doesn't really known when this obligation will actually arise, and (2) it uses up money that politicians like to use for other things - things that get them reelected, for instance. As a result, the pension obligation is sitting on the books, but there's nothing yet going to pay for it. Until the city does start laying money aside, it's an unfunded obligation.

Example

Welcome to Detroit, the place where greatness comes to die.

Oh, it was once such a great city. It was the Silicon Valley of the 1950s. The best and brightest from Harvard Business School all wanted to work there. Cars were King and the city bustled.

Then along came lots of public workers who wanted pensions as part of their compensation. Voters didn't really pay attention to the true costs of things and didn't think a lot about the future —and couldn't imagine that Detroit would one day be renamed LoserVille (and become part of a popular mobile video game).

A city worker—let's say a janitor—would make (today's dollar, inflation adjusted) $37,000 a year with 5 weeks off for vacation and get $8,000 a year invested into his pension fund. He also got $3,000 worth of health care benefits and other perks. So it cost the city $48,000 plus various city taxes to employ the janitor.

And all of this was fine until, one day, a clever union negotiator tweaked one phrase: "defined contribution" became "defined benefit" and all of the sudden, the city was on the hook for making up losses that the janitor might have suffered in the stock market with his investments.

This worked fine—and was generally unnoticed when the market went up 10% a year for a long time—but along came the crash of 2008/9 and, well, that was the end of Detroit courtesy in large part to its pension liability. The result was that the pensioners sued and will likely end up getting only a small part of their pensions. So much for great negotiating and financial mismanagement. Lethal combos.

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