Public pensions and their risky investments

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Research by SIEPR Senior Fellow Joshua Rauh on U.S. pension plans raises questions about their managers’ financial optimism.

Executive Summary

Public sector pensions in the US face a significant funding shortfall. While official reports show a gap of $1.6 trillion, a more accurate assessment suggests a much larger problem of $5.1 trillion. This discrepancy arises from underestimating future pension obligations and relying on risky investments to meet those obligations.

Key Findings:

  • Public pension plans are underfunded by a much larger margin than reported.
  • Current accounting methods underestimate future liabilities and overestimate investment returns.
  • Public pensions are increasingly investing in risky assets to chase higher returns.
  • This strategy creates a false sense of security and puts future government finances at risk.


  • States may struggle to meet pension obligations, leading to cuts in public services.
  • Taxpayers may face increased burdens to fund pensions.
  • Public employee benefits could be reduced in the future.

Possible Solutions:

  • Transitioning to defined-contribution plans similar to 401(k)s.
  • Increasing contributions to existing plans.
  • Greater transparency about the true cost of public pensions.

Overall, the current system is unsustainable and requires reform to ensure the long-term viability of public pensions and the financial health of state and local governments.


More than 20 million Americans are covered by state and local government pensions. Unlike the 401(k) plans found in the private sector, these “defined benefit” plans promise to pay retirees a set amount of money every month for the rest of their lives.

For most public workers, these generous programs are a cornerstone of their financial security; for many, they’re one of the main attractions of government jobs. Yet the plans, by their own reckoning, are underfunded to the tune of $1.6 trillion.

That shortfall would leave them 75 percent funded, which may not sound too dire. But that figure vastly understates the issue, says Joshua Rauh, a finance professor at Stanford Graduate School of Business who leads the Hoover Institution’s State and Local Governance Initiative.

Rauh, who is also a senior fellow at the Stanford Institute for Economic Policy Research (SIEPR), estimates that unfunded pension liabilities — the gap between promised benefits and the assets set aside to pay for them — are actually closer to $5.1 trillion, which translates to an overall funding ratio of less than 50 percent.

Rauh and Oliver Giesecke, a research fellow at the Hoover Institution, gathered data on the pensions in every state, as well as the 170 biggest cities and 100 biggest counties in the U.S. Their sample covers 90 percent of public pension funds by assets from 2014 to 2022.

The problem, as they explain in a recent paper, is that future pension obligations are being grossly undervalued — and the discrepancies are adding up. Over the nine-year span of their study, unfunded liabilities grew by 50 percent, even as stocks surged and state and local budgets contributed more to pension plans. Meanwhile, to generate more revenue, fund managers chased higher returns by investing in riskier assets like real estate, private equity, and hedge funds.

That combination of a huge funding gap and growing risk exposure should raise alarms about the long-term viability of these plans, Rauh says. “The current system is not sustainable, and state and local governments are not being candid with their employees or taxpayers about it.”

Rose-colored assets

“When a state government promises to pay its workers a pension after they retire, it’s essentially incurring a debt on which future payments must be made,” Rauh explains. States set aside money from their budgets each year to pay those benefits.

Of course, that money doesn’t sit idle; annual contributions to the pension fund are invested in financial assets. Assuming those assets will appreciate over time, that means current contributions can be less than the dollar amount of the future promise. But how much less?

To determine that, administrators discount the future sum by a percentage reflecting the rate of return they expect to earn on that money in the meantime. The higher the discount rate, the smaller the present value of the liability on the books, and the less they need to sock away.

As you might expect, cash-strapped states and municipalities are inclined to optimism. In 2022, the average discount rate used by funds was 6.7 percent. That choice was based on recent investment results, but it reflected yields on risky assets during a market boom — which are anything but certain over the long term. (The actual return on fund assets that year was negative 3.2 percent.)

Pension obligations, on the other hand, are effectively ironclad commitments — often guaranteed by law and almost certainly by political considerations. “It’s a total mismatch,” Rauh says. “You have risky assets backing up risk-free liabilities.”

The current system ignores that disconnect. “Those high-targeted returns may or may not be achieved in any year, but public sector accounting and budgeting proceed under the assumption that they will be achieved with certainty,” Rauh says.

To be sure of having enough money to pay retirees, funds would have to stick to risk-free securities like U.S. Treasury bonds, which averaged just 2.1 percent over the past decade. That doesn’t mean they should, he says. (They’d be worse off if they’d missed the recent stock market boom.)

But that low, default-free 2.1 percent rate is the one that markets would use to measure the true value of future pension obligations, say Rauh and Giesecke. Doing so greatly increases the present value of existing pension promises and increases total unfunded liabilities from $1.6 trillion to $5.1 trillion.

The resulting market-value funding ratios vary widely among plans. In 2022, Wisconsin’s plan was 74 percent funded; New York’s was nearly 65 percent funded. At the other end of the list, New Jersey’s plan was just 29 percent funded. The nation’s biggest public pension fund, California’s CalPERS, had a market-value funding ratio of around 48 percent — significantly below the 77 percent it reported. (Rauh and Giesecke’s data on state and local pension plans are available on this dashboard.)

“The method used by public pension systems makes no sense,” Rauh says. “It’s just basic finance: The present value of a stream of payments is determined by the risk properties of those payments. It has nothing to do with the assets used to back them.”

Betting on bull markets

Pension sponsors say none of this will matter if their asset portfolios hit their targets — as they often have. “And if not?” Rauh asks. “I don’t think people realize their governments are gambling on endless bull markets, and those bets are being underwritten by taxpayers.”

The data shows that public pensions have increased their risk exposure over the past 30 years, investing not just in publicly traded stocks but also more speculative assets like private equity. And those with lower funding ratios, in particular, were more aggressive in their investments.

That’s partly an effort to make up ground. But it also results from a perverse incentive in the current system, Rauh says. More risk means higher expected returns. And since funds use target returns to discount their liabilities, that higher discount rate makes their balance sheet look healthier, even if the assets underperform.

This accounting creates a false picture of the cost of public employment, Rauh says. “You’re paying employees a salary, but you’re also accruing new pension obligations each year, which is essentially deferred compensation. Aggressive discounting makes that deferred amount look smaller.” It also gives the impression that governments are contributing enough to pension funds. That’s pretty remarkable, considering that annual pension contributions as a percentage of government payroll have increased from 22 percent to 28 percent in the past decade.

With proper discounting, even those contributions fall short of the true cost in every single state, the researchers found. “Really, they should be putting in much more, closer to around 40 percent of payroll, to keep these plans solvent,” Rauh says.

Time for a change of plan?

The biggest takeaway from this research, Rauh says, is how expensive defined-benefit pension plans really are. In the private sector, an employer might contribute 3 percent of payroll to a retirement account, maybe 5 percent if you’re lucky.

By using an inappropriate discount rate, public employers have obscured the real long-term costs. “That’s enabled politicians to kick the can down the road for a long time, and that tab will ultimately have to be paid by future generations,” Rauh says. “Without reform, state and local governments will increasingly have to draw on tax revenue to meet their obligations, crowding out spending on things like education and public safety.” Cities could go bankrupt, and states like California could see a continued exodus of high-income taxpayers as government services are squeezed by the financial demands of keeping pension systems afloat.

Yet that future isn’t inevitable. “It would take a lot of courage under our political system,” Rauh says. “But if governments would open up and be transparent about the precarious state of their pension systems, they might be surprised to find that their employees are open to changes.”

For example, states and cities could move to defined contribution plans similar to those offered by private employers. Employer contributions could still be quite generous, but the plans would be much less expensive to run because they would not guarantee a preset lifetime benefit.

Rauh and Giesecke recently surveyed more than 7,500 public employees and found them surprisingly receptive to this model. Nearly 90 percent said they’d be willing to switch to a 401(k)-type plan under some circumstances. More than half said an employer contribution of 10 percent of their salary would be sufficient.

“Public-sector workers care about good government like anyone else. And they know a fiscal collapse is not in their interest as citizens or employees,” Rauh says. “Moving to a system that preserves benefits and stabilizes public finances would make their own futures more secure.”

This story was originally published on Feb. 1 by Stanford Graduate School of Business Insights.

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