The term pension liability refers to the amount of money that a private company—or a city or state or federal government—has to account for in order to make future pension payments.
In other words, a pension liability is the difference between the total amount due to retirees and the actual amount of money the company has on hand to make those payments. What it's not—and this is an important distinction—is the total amount that gets paid in future pensions.
Of course, the company or government may have more money currently than it needs to pay future pensions, and that's known simply as a pension surplus.
Which pensions have liabilities?
A pension liability will only occur in defined benefit schemes.These are the old-fashioned traditional pensions where workers and their employers agree to contribute a certain amount into the pension fund over time for a guaranteed source of retirement income.
Where liabilities don't happen is in the more prevalent retirement form that companies offer workers—a defined contribution pension or a 401(k) plan.
This plan allows company and worker financial contributions, though not all companies may put money in and workers are under no obligation to have a defined contribution pension. If a woker has a 401(k), there is no guaranteed amount at retirement.
(Read more: What is private equity?)
The monies from defined contribution plans are placed in investment vehicles without the company being responsible for the performance of the investments and without any liability to make up any financial losses. So there is no pension liability there.
How do pension liabilities come about?
A firm can get into this situation through various ways—or even all of them at once.
It starts with the fact that a company does not usually pay a pension directly. Instead, it buys what's called an annuity, which is a financial product that eventually converts a flat amount of cash into a guaranteed annual payment for the pensioner's lifetime. (Government pensions work much the same way)
But the annuity invests the money it gets, in the hopes of increasing the value of the pension's fund, and that can be a problem. The amount of money the company needs to fund a guaranteed pension can change dramatically from year to year.
That's because, as was seen in the Great Recession, the stock market can decline dramatically and so too can pension fund annuities that invested in the market. That leaves less money in the fund and creates pension liabilities.
(Read more: What is a recession?)
Another way liabilities come about is when governments or companies divert money scheduled for pension contributions to other areas of spending, while promising to fund the pensions at a later date. When they don't go back and put in the money, they create a liability.
Yet another way to create a liability is having a large amount of workers hitting retirement age at roughly the same time, without the contributions from a dwindling work force adding to the pension fund.
What is the danger from pension liability deficit?
There are rules in place to prevent the mismanagement and misuse of pension fund monies. And depending on local accounting laws, some or all of a firm's liabilities must appear on its balance sheet.
This can often mean an otherwise healthy company appears deeply in debt. In some situations, a company can even find itself technically insolvent.
And that's why a larger-than-expected pension liability can force a company out of business or cause it to go into bankruptcy. And pensioners can miss some or all of their retirement payments.
(Read more: CNBC explains Social Security)
Governments also face problems with pension payments they must pay to government workers. With the proportion of retirees to taxpayers rising,some cities and states have to raise taxes or cut pension payments to make the books balance.
One area of relief for pensions in trouble is the U.S. government's Pension Benefit Guaranty Corporation. Created in 1974 in light of several company bankruptcies and pension plan failures, the PBGC is designed to protect many pension benefits in private-sector defined benefit plans.
The PBGC uses insurance premiums paid by corporations— and its own financial investments—to pay a portion of pension funds to retirees on plans that have been terminated.