Allocated Funding Instrument

It may sound like a term some kid's music teacher uses on tax forms to describe a rented bassoon. But in reality, it has to do with pensions.

If you run a pension plan (or even if you just belong to a fantasy pension league) you can use an allocated funding instrument to pay your retired workers. Basically, the employer buys an annuity contract from an insurance company. Employee contributions are paid into the plan, essentially covering the annuity premiums. In retirement, the insurance company pays out the benefits, taking the burden off the employer to cover the ongoing benefits.

The allocated funding instrument has the benefit of being backed by an insurance company, which is in a better position to guarantee that the annuity will be paid. If a pension plan attempts to manage the funds itself, there is an increased risk that the plan will become underfunded if investment growth rates fall behind expectations. This can lead to a situation down the road where pension obligations dramatically outstrip the funds it has available (remember, pension plans have to keep multi-decade timelines in view).

Passing some of the burden off to an insurance company by buying an allocated funding instrument limits this risk.