Funded Ratio

The funded ratio for a defined benefit plan is a useful snapshot of financial health because it measures the percentage of assets that a pension plan has available to meet its promises. When trying to assess whether a funded ratio is healthy or not, we generally categorize government sponsored defined benefit pension plans in three groups:

 

  • Resilient: A resilient pension system has a funded ratio of 90% or more for at least three years in a row. These plans are generally in a strong position to recover from financial downturns, as funding policy improvements are easier to make when the plan’s finances are stable. There isn’t particular magic to this needing to be three years in a row, a range from two to four years consistently is reasonable. The important aspect is that the funded ratio is around 100% funded consistently. A plan that has one year with a 90% funded ratio could be considered “Robust”— not entirely fragile, but not proven resilient.
  • Fragile: A fragile pension fund is consistently between 60% and 90% funded. While these plans aren’t going insolvent any time soon, they will be building up unfunded liabilities that will gradually become a strain on budgets and government revenues. A plan that is 85% funded for several years in a row is healthier than one 65% funded but is still exposed to risk. One or two asset shocks could send the plan into a downward spiral.
  • Distressed: Pension systems with funding levels below 60% should be looking to make immediate steps toward fixing their problems. It shouldn’t matter how many years they are below this threshold because they either suffered a massive shock or they’ve been in a fragile condition for a number of years already. While the specific causes of problems may vary across plans, at a certain point it is considerably much harder for a plan to return to fiscal health because of how low the funded status has become.

 

While the funded ratio is helpful as an initial measure, it isn’t a perfect tool on its own because it can be influenced by underlying accounting factors (rules for measuring assets or actuarial assumptions) and it doesn’t give a sense of the measured pension plan’s scale relative to the size of government’s resources. The funded ratio might go down due to problems (such as investment losses) or good governance decisions (such as updating mortality tables to more accurately reflect changes to demographic norms).

For a more complete consideration of our three-part categorization of funded ratio health, read our article on Retirement Plan Resilience.

 

Funded Ratio History

Click here to read more about the funded ratio one of the many tools for measuring “funded status,” why 80% funded ratios are not good enough, and about funded status is an indicator, not a destination.

 

Share of Required Contributions Paid

The Society of Actuaries, American Academy of Actuaries, and a substantial amount of academic research strongly recommends that the sponsors of any defined benefit plan — whether a state, city, or private company — should pay 100% of actuarially determined contribution rates every year.

Valuation Risk

State and local pension funds manage tens of billions — in a few cases hundreds of billions — of dollars on behalf of public employees and taxpayers. In some ways, they are “institutional investors” (like private wealth managers), but in other ways they are “sovereign wealth funds” (like national pension funds or national investment corporations). But in all cases an important aspect of public pension funds is that they are managing money in the public trust.

Since taxpayer money finances pension funds (and is responsible for resolving shortfalls), public pension funds are effectively managing money on behalf of public employees/retirees and taxpayers. This means there are at least three reasons why transparency of public pension fund investments is important:

 

  • Accountability — fiduciaries and trustees managing pension funds aren’t hedge fund managers, they are managing money in the public trust, which requires public lines of sight on assessing fees, overall investment performance, conflicts of interest, and quality of decision making.
  • Mitigating Risk — without clarity on how public pension funds are being invested, local governments, public employees, and taxpayers don’t have the capacity to reign in excessive risks (whether those are related to principal risk, budgetary effects of underperformance risk, or others).
  • Public Understanding — In moments where a company collapses, an industry is destabilized, or financial crisis hits there are members of public retirement systems who feel a particular kind of concern: personal fear for their financial security. Investment transparency for public awareness also provides a safeguard against politically driven interference, such as fiduciaries adjusting investment strategy based on public policy goals rather than fiduciary duty.

 

In addition to having transparency on what pension funds are invested in, it is important for public employees and taxpayer representatives to understand the scope of “valuation risk” that a public pension fund faces.

Valuation Risk is the risk to pension funds that the value of their assets as reported to them is inaccurate (e.g., understating or overstating the actual value) because the asset pricing method used is based on valuation models, as opposed to market-based prices.

If asset values are overstated today, then that means reported funding levels are overstated. This in turn can lead to lower than appropriate contribution rates, which will mean larger unfunded liabilities in the future than if assets were more accurately priced. Overstated pension asset values can also lead to other policy decisions that could influence future funded status — such as raising the value of benefits or having lower political priority for supplemental funding to pay down unfunded liabilities faster than planned.

This is in contrast to “opportunity risk” (the risk that a specific use of capital doesn’t justify the risk adjusted returns relative to other opportunities), “asset risk” (the risk of losing money on an investment), or “management risk” (the risk that trustees will inefficiently allocate capital).

Assumed Rate of Return

The most important actuarial assumption is the assumed rate of return (or discount rate) used to determine contribution rates for a retirement plan.

The assumed rate of return is typically based on the asset allocation of a public pension fund, and the probability of returns for the various asset classes selected by a pension fund. The assumption is used to calculate the value of promised benefits and an actuarially appropriate contribution rate sufficient to ensure a pension plan reaches 100% funded within the timeframe targeted by trustees for that pension plan (formally, this is based on the plan’s “funding policy”).

The reasonableness of an assumed rate of return can be thought of through two prisms: (1) the probability that a pension fund might achieve that assumed return, based on capital market forecasts; (2) the level of risk that a pension fund would develop unfunded liabilities due to missing the assumed return, which would subsequently require additional contribution rates from taxpayers and/or public employees.

Generally public sector pension actuaries recommend an assumed rate of return that is around the 50th percentile of a distribution of probable rates of return for a given pension fund’s asset allocation. The reasonableness and quality of the capital market forecasts used for those assessment are critical, though.

If the 50th percentile is the desired target, capital market forecasts for the year 2026 suggest that the assumed rate of return should be between 6% and 7% for an average public pension fund asset allocation. If stakeholders want less risk than a 50/50 chance of meeting their assumed rate of return, then targeting something between 5.5% and 6.5% would be more appropriate.

This rate is important with respect to resilience because it signals the reasonableness of a plan’s measured funded ratio and unfunded liabilities. Retirement plans that report 90%+ funded ratios consistently but that use 8% assumed returns are not appropriately measuring their liabilities and are likely not accurately reflecting the resilience or fragility of their system. So, while the assumed return on its own is no more a perfect measure of resilience than any other, it is a particularly good signal.

Based on this framework, we argue the following metrics are reasonable categorizations of resilience for 2025 and 2026:

 

  • Resilient: 6.9% or below
  • Fragile: Between 7% and 7.25%
  • Distressed: 7.25% or higher

 

These measures are higher than they were a few years ago due to changes in the interest rate environment. The rate targets may increase or decrease again in the coming years. For a more complete consideration of our perspective on the assumed rate of return, read our article on Retirement Plan Resilience.

Unfunded Liabilities as a Share of GDP

It is important to consider how good or bad a public pension plan’s funded status is relative to the size of the government that sponsors and manages it. Understanding the size of unfunded liabilities relative to the size of a state’s economy gives a sense of what scale of resources will be needed from a local tax base to improve the plan’s funded status.

For example, a low funded ratio may signal problems for the health of a retirement system. But if the pension fund itself is relatively small compared to the budget of the government sponsor, then the situation may not be as dire as it appears on paper. The following benchmarks provide a general framework for considering whether a pension fund’s unfunded liabilities are creating excessive pressure on state finances.

 

  • Resilient: Plans with unfunded liabilities that are less than 5% of state GDP and a resilient funded ratio
  • Robust: Plans with unfunded liabilities that are less than 5% of state GDP but a fragile or worse funded ratio
  • Fragile: Plans with unfunded liabilities that are 5% to 9.9% of state GDP
  • Distressed: Plans with unfunded liabilities that are over 10% of state GDP

 

Another similar metric is actuarially determined employer contributions as a percentage of state budgets (or own-source revenue).

A state’s capacity to pay for retirement benefits out of existing revenues is not necessarily a key metric when measuring resilience, as there are many policy reasons why the value of benefits might be set at high levels (translating to high normal cost prices). If a government wants to provide large benefits that require large portions of their budget and these costs are known and accounted for, that could be an appropriately stable situation. However, a state’s — or sponsoring local government’s — capacity to pay for growing unfunded liability amortization payments is an important part of resilience because when contribution rates are pushed up due to funding shortfalls and this puts pressure on government budgets it makes it less likely that retirement systems will continue to receive necessary funds. Such potential underfunding of contributions can be both explicit skipping out on required payments, or implicit behavior — such as not adopting a reasonable investment assumption in order to avoid how that might trigger a higher required contribution rate.

Click here to read more about how to think about this metric of unfunded liabilities as a share of state economic activity.