Look beyond funded ratios for hidden pension risks

Public pension fund-related risks have been incorporated into the analysis of municipal securities with evolving depth throughout a multi-phase life cycle. As a baseline, the analytical mindset throughout the decade of the 1990s did not view public pension liabilities on a level playing field with the fiscal obligations of conventional bond debt. 

While consideration was given to governments' ability to make required contributions and the attendant effects on budgetary operations, bond pricing disproportionately weighed the metrics of associated obligor debt, with secondary consideration given to unfunded pension obligations. Throughout the 1990s, the equity markets enjoyed strong performance — the key driver behind material improvement in pension funding levels — the likely rationale for a less concentrated focus on public pensions. 

This article will look at the journey public pension risk has taken over the past three and a half decades and its metamorphosis from a general financial disclosure-centric consideration to a debt-like credit attribute that now focuses on asset-allocation as part of a government's — or revenue enterprise unit's — investment strategy. The basic mission of a public pension fund is to capture sufficient returns to meet employee benefit obligations. 

The question we must ask is: are pension funds accumulating concentrations of correlated risks that may not be obvious in conventional asset-allocation reporting and are these exposures being booked without triggering potentially higher governmental pension contributions?  

In many respects, the design and structure of the public pension plan may matter more than the funded ratio. Not all plans are created equal and care must be given to understand the operational mechanics of each. Overreliance on the top-line funded ratio number may lead to incomplete or misleading conclusions about the overall health of the program. 

A pension plan with an 80% funded ratio using, for example, an unrealistically high discount rate and faulty mortality assumptions, represents a riskier and less stable plan than one that has conservative assumptions, contribution discipline and a somewhat lower funded ratio. Generally, the funded ratio can signal the magnitude of future contributions.   

Today's public pension conversation should reflect the potential trappings of the underlying assumptions applied to performance expectations and the appropriate levels of portfolio diversification. Well-respected research organizations specializing in the funding and sustainability of public pension plans are questioning the appropriate amount of portfolio exposure to AI-centric activity. This observation extends beyond the "AI investment craze" and elicits a wider debate surrounding asset allocation execution and surveillance practices. 

Public pension risk should be top of mind for all market stakeholders. By no means should we sound the alarm. Simply, the lens by which we assess public pension risk has extended beyond the scope of funded ratios, and we need to adjust the aperture to allow more relevant analytical light to pass through to the credit assessment process. 

A few decades ago, public pension risk was widely discussed with meaningful concern, but any substantively adverse credit impact was given a 20-year window to develop. On one hand, the 20-year horizon made sense as pension liabilities are inherently long-dated, yet the liability behaves differently than that of a long-dated bond. 

While a 20-year bond has a fixed payment schedule, with debt paid down evenly over time, and a set maturity, there are scenarios which could disrupt this schedule, such as a refinancing or a default and restructuring event that could potentially extend the bond maturity. Apart from such examples, principal is generally repaid as promised. 

Conversely, a pension liability cannot be amortized in the same manner as a bond since it relies on actuarial assumptions and variable costs, given changes based on market returns. The emphasis is placed on employee lifespans, retirement ages and salary shifts. Pension costs change each year based on investment performance and interest rates. Given heavy exposure to the vagaries of equity market performance, plan unfunded liabilities are subject to erratic movement, resulting in shifting amortization schedules.  

Pension plans employ distinct rules to spread out unexpected losses over many years, a concept rooted in amortization of unfunded actuarial accrued liability. Public pension plans apply a discount rate to determine the present value of future pension payments owed retirees. Discount rates greatly impact a plan's funding status. 

A higher discount rate assumes investments will provide higher returns over time, requiring a lower monetary set aside. Conversely, a smaller discount rate requires the plan to retain more assets to cover future distributions. Discount rates are often subject to change and are typically higher for public plans relative to corporate programs. Public pension plans generally use the expected rate of return on the plan's investment portfolio.  

While a public pension plan may seem suitably diversified across public and private equity, private credit, fixed income, real estate, infrastructure, commodities and venture capital, correlated exposures can be hidden by the veil of diversification. 

Taking a closer look at our AI allocation concern, it is not a far leap to identify exposure to this singular investment cycle as a common denominator within all of these asset classes. For example, AI presents itself in semiconductor manufacturers, hyperscale data centers, cloud computing, power generation, infrastructure, technology-centric stocks and real estate. 

Care must be taken to ensure portfolio diversification is not overstated. It is not enough to simply diversify across asset classes. A more meaningful analytical measure would be the identification of economic and cyclical risks embedded within those distinct asset classes. The full continuum of AI risk may be tied to AI data center demand, disruption, CAPEX cycle and valuations. 

This is especially relevant given that public pension funds have steadily expanded their allocations into alternative investments. It would be important to know how much of the assumed performance relies on alternative investments. Stakeholders would also want to know the extent to which a government is essentially depending on investment performance to achieve specific funding targets. Market participants should insist that a pension portfolio have appropriate diversification and liquidity during times of stress to absorb a meaningful correction in the assets assumed to produce anticipated long-term returns. 

Attitudes and behavior showed a meaningful shift during the early 2000s, with the first major reassessment of public pension plans thanks to the "dot-com" collapse. Funded ratios dropped precipitously after 2000. Per the Government Accountability Office, the percentage of public plans with funding ratios below 80% rose from only 8.9% in 2000 to 41.5% in 2006.  

During this period, it was brought to light that pension funding was deeply reliant upon investment performance. Assumed rates of return and actuarial smoothing fell under intense scrutiny and the market viewed pension obligation bonds more critically. Many fiscally challenged governments applied overly favorable actuarial assumptions to lower required contributions. Such behavior masked underlying weakness in the pension system. 

The real turning point for municipal credit emerged during 2008-2012 as the financial crisis created material fiscal stress and altered the rules of pension plan engagement. Erosion was visible across investment assets, tax receipts and budgetary performance. Investment gains were insufficient to close funding gaps and recessionary conditions greatly reduced the ability to increase contributions. Consideration moved beyond pension affordability to the budgetary realities of forgoing contributions in favor of meeting basic essential services. Pension obligation bonds became even more suspect. 

Debt-like attributes for pension liabilities were cemented from 2012-2015, with credit analysis focusing on a broader picture of balance sheet leverage. Pension plan transparency greatly improved with the 2012 release of the Governmental Accounting Standards Board (GASB) statements 67 (effective FY 2014) and 68 (effective FY 2015). GASB 67 revised financial reporting for state and local public pensions, requiring plans to report net pension liability directly, eliminate asset smoothing and disclose annual money-weighted rates of return. GASB 68 shifted pension liabilities onto the government's financial statements as opposed to keeping related information in supplementary disclosures. 

These developments created a more standardized measure of a government's net pension liability and led the rating agencies to more formally develop methodologies for adjusting reported pension obligations. 

The analytical framework continued to advance from 2015 through 2019, with sharper focus on the long-term structural drivers of pension liabilities. More astute consideration was given to funded ratios, actual versus required contributions, investment risk exposure as opposed to only investment returns, sensitivity to assumption changes, contribution trends and governance and funding discipline. The overall leverage analysis expanded to include pension obligations and pension obligation bonds. 

The arrival of the COVID-19 pandemic underscored the importance of stress-testing during the 2020-2022 period. Market volatility amplified the uncertainty surrounding plan funding status and challenged the fiscal adaptability of municipal governments. Operating under normal economic and fiscal conditions is difficult, but unprecedented circumstances hardened the response to declining investment returns, operating revenue, and payroll growth against a backdrop of rising contribution pressure and fixed debt service requirements. 

Today, we must assess pension investment strategy in terms of its correlation to a government's  debt management philosophy and practices. Overall leverage, portfolio liquidity and economic exposure take on meaningful significance with the AI and technology investment play. Stress-testing under various assumed declines in portfolio valuations is more important than ever and consideration must be given to simultaneous drops in private and public market valuations. Governmental contribution flexibility and the ability of reserves to absorb higher pension contributions must be quantified and qualified. 

Prominent pension-centric research institutions include the National Conference on Public Employee Retirement Systems (NCPERS), Equable Institute, Pew Charitable Trusts and Milliman Multiemployer Pension Funding Study. 

A recent study by Equable, which tracks 253 state and local pension plans, shows:

• National funded ratio for 2026 expected to be 85% (+3.9pp vs. 2025).  If 2026's projected 85% funded ratio holds, it would be the best year since 2009 — yet nearly 60% of public plans remain fragile or distressed despite four straight above-target return years.

• $1.13 trillion funding shortfall (down $210B from 2025).

• 9.4% average investment return (beat 6.9% target).

• 31.83% employer contribution rate (percentage of payroll) is a historic high. 

• Over 27% of public pension assets could be overpriced or underpriced, based on the valuations used to determine their value — the highest level of valuation risk for public plans.

• Roughly 8%-10% of public pension assets are exposed to AI companies — likely an undercount, given limited transparency around private equity and externally managed stocks.

Equable states that pension funds are at their best funded status since 2009 (financial crisis). The researcher further observes that most states are paying full required contributions and 15-year-old amortization schedules are finally outpacing interest on pension debt. The sustainability of these trends is likely to be tested during the next recessionary period, if not sooner, and concern should be given to the alarming level of valuation risk. 

Current investment strategies that lack risk diversification are likely to be exposed during downcycles and sustainability of recent market returns is unlikely. Further, as state and local governments continue to encounter reduced budgetary flexibility, the ability to raise their pension contributions becomes restricted. This is never a good situation when plan administrators are forced to alter investment assumptions. 

According to Equable, the AI exposure is an estimate of direct exposure and the actual economic exposure could be considerably broader when private equity, venture capital, infrastructure, private credit and public-market holdings are included. While public securities are generally marked to market every day, private equity, venture capital, private credit, infrastructure and various real estate investments are tied to more infrequent valuation calculations. 

Therefore, a distinction exists between funded and economic value. Market stakeholders should be asking what happens to the funded ratio if private assets are marked against a stressed public-market environment rather than their reported valuations? Pension systems represent cash obligations and benefits must be paid regardless of private-equity valuations, data center operational schedules and the vagaries of the private credit markets. Placing most if not all bets in a growth and productivity basket is not prudent and does not represent a long-term viable strategy. 

A combination of illiquid assets, volatile public markets and fixed benefit mandates creates undue liquidity pressure. As we know, the most liquid assets are typically sold first to raise cash in a stressed scenario. With higher assumed investment returns there is usually a greater tolerance for risk, portfolio illiquidity and higher leverage. 

Pew notes public pension plans have gradually reduced expected return assumptions, with more recent expectations around 7%. There needs to be practical alignment between asset allocation and pension liabilities. In its summer Public Pension Funding Study, Milliman, which tracks 100 public plans, estimates that from July 2025 through June 2026, public employers and employees will contribute $289 billion to the plans; meanwhile, $387 billion will flow out to pay retiree benefits and expenses. 

Effective governance and oversight are key to pension plan portfolio performance. Interestingly, most public pension plans are heavily managed by external portfolio managers. It is estimated that most U.S. state and local pension funds outsource over 60% of their assets to professional investment managers. The balance is managed in-house. Most municipal governments do not have the resources and expertise to manage pension plan investments, raising oversight, investment policy guidelines and strategic concerns.

Proper management of plan assets requires a structured asset allocation review period.  Transparency needs to surround authority to change allocations, the amount of discretion given to external managers, the independence of the investment committee and supporting methodologies for measuring investment limits. Such methodologies envelop weightings given to asset class and economic exposure. If derivatives are used, concentration limits must be clearly expressed in the investment policy. 

Throughout the risk-assessment process, an evaluation must be performed to gauge impact upon legal provisions, such as rate covenants, additional bonds tests, actual debt service coverage, reserve requirements, disclosure obligations and material event notifications. Perhaps it makes sense to develop standards of reporting material credit disclosures for pension investments. Adverse pension developments could impact debt capacity, future borrowing needs, tax rates, operating margins and liquidity. These concerns should be of interest to all municipal stakeholder groups, especially when existing ratings are at risk. 

Parsing direct and economic risk goes beyond AI and technology exposure, but this topic represents an important issue for public pension plan portfolio assessment. Diversification needs to be considered in its broadest sense and investors must understand not only what specific assets are owned, but what economic, cyclical and thematic risks are owned by the portfolio.

It is not enough to focus on the funded ratio or whether investment returns will meet actuarial assumptions. Other factors can result in higher governmental contributions, leading to weaker budgetary flexibility and overall credit erosion.