Legal Definitions - nonactuarially sound retirement system

A nonactuarially sound retirement system refers to a pension or retirement plan that primarily relies on current contributions from active members and existing funds to pay benefits to those who are already retired. Instead of strategically investing these contributions over time to grow a substantial reserve that will cover future benefit obligations, such a system essentially operates on a "pay-as-you-go" basis for a significant portion of its payouts. This approach creates a risk of future financial instability, as there may not be enough money saved and invested to meet the long-term promises made to all participants.

Here are some examples to illustrate this concept:

• Municipal Employee Pension Fund: Imagine a city's pension fund for its police officers, firefighters, and sanitation workers. Due to a series of budget shortfalls, the city council has consistently reduced its annual contributions to the pension fund's investment portfolio. Instead, a large portion of the money collected from current city employees' paychecks and a direct allocation from the city's general tax revenue each year are immediately used to cover the monthly pension checks of current retirees. The fund is not building up a robust, invested reserve that is projected to be sufficient for all future payouts.

  How it illustrates the term: This system is nonactuarially sound because it is using today's incoming money (current employee contributions, tax revenue) to cover today's outgoing payments (current retirees' benefits). It is not adequately investing those funds to grow over decades, which is necessary to ensure there will be enough money to pay the pensions of current active employees when they eventually retire. This creates a future funding gap.

• Legacy Corporate Defined-Benefit Plan: Consider a manufacturing company, "Industrial Gears Inc.," that established a traditional defined-benefit pension plan for its employees hired before 2005. After experiencing several years of declining profits, the company significantly reduced its annual contributions to the pension trust. Rather than fully funding the trust with investments designed to mature and cover future payouts, Industrial Gears Inc. began using a larger portion of its current operating revenue and the limited contributions from its remaining pre-2005 employees to directly pay the monthly benefits of those who had already retired.

  How it illustrates the term: This scenario demonstrates a nonactuarially sound system because the company is prioritizing immediate payouts using current cash flow and new, insufficient contributions. It is not ensuring that the pension fund has enough invested assets to meet its long-term commitments to all participants, including those who are still working and will retire in the future. This approach risks the plan's ability to pay promised benefits down the line.

• Union-Managed Industry Benefit Fund: A multi-employer union benefit fund, managing retirement and health benefits for workers in a specific construction trade across several states, finds itself in a precarious financial situation. Due to an unexpected downturn in the industry and overly optimistic financial projections, the fund's administrators realize that the weekly contributions from active union members and their employers are almost entirely consumed by current expenses – paying the medical bills and small retirement stipends of current retirees and those on disability. Very little capital is left over to invest for the long-term retirement benefits of younger, active members.

  How it illustrates the term: This fund is nonactuarially sound because it operates on a "treadmill," where current income is almost entirely consumed by current expenses. It is not building up a sustainable, invested reserve that can reliably cover the future retirement benefits of its younger members. This indicates a reliance on future contributions to pay future obligations without sufficient prior investment, making the system vulnerable to future shortfalls if contributions decline or expenses rise.