Pension funding risk has evolved into a structural debt obligation — akin to an obligor’s bonded indebtedness from a secondary credit consideration — having minimal impact on yield levels. Public pension fund risk assessment stands at the intersection of investment management practices and a municipal credit evaluation process for governments and revenue enterprises that prioritizes funding discipline and fiscal capacity.

While funded ratios remain a key barometer of pension funding risk, they do not tell the full story. Beyond simply stating what the pension owns, investors should have a clear sense of risks owned by the pension. A well-crafted pension funding and investment strategy should not trigger higher government pension contributions and disproportionate risk-taking by the pension plan.

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. Pension plan disclosure has greatly improved over the past three and a half decades, but the analytical complexities have expanded. This necessitates a more modernized presentation of disclosure standards and requirements, and there needs to be a fresh reasoning of what constitutes a material pension development.

It is advisable to make a complete assessment of the underlying assumptions and investment selections applied to the pension fund asset allocation strategy with a focus on concentration and liquidity risk exposures. 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. A greater allocation into counter-cyclical strategies, when appropriate, could be helpful.

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.

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