Robust market valuations in recent years have supported funding progress for U.S. state and local defined benefit pension plans. However, public pensions remain underfunded and fundamentally exposed to market volatility. A market shock could increase the burden of state and local pension liabilities and drive contributions higher, says Fitch Ratings. Governments with weaker liability metrics and high carrying cost burdens could be most vulnerable to rating pressure.

Post-global financial crisis, plan sponsors took various policy actions such as reducing benefits to new employees, using more conservative actuarial assumptions and discount rates, and increasing contributions. This helped stabilize plans and support funding improvement. But other trends, including higher allocations to alternative investments and steady demographic weakening, could amplify the effects of a market shock.

According to the Public Plan Database, alternative investments outside of traditional equity, fixed income and cash were 34% of pension portfolios in fiscal 2024, double the fiscal 2008 level. Allocations to increasingly complex categories of alternatives can include leverage or variable rate strategies that expose investors, including pensions, to greater losses. Many of these alternatives have not yet been tested in a downturn. The illiquidity of many alternative investments could also force plans with tighter cash flows to sell marketable assets at a loss to meet benefit or other obligations, such as capital calls.

Private credit makes up a rapidly growing share of alternative investments, driven by strong performance relative to traditional fixed income. Many public pensions are raising their private credit exposure to drive returns and help address still-substantial liabilities. CalPERS, the gigantic California system covering most state and local workers, recently raised its allocation target to 8% from 5%, as part of a shift to 40% alternatives. Other pensions have pulled back due to unease about the sector’s rapid growth amid macroeconomic and credit quality concerns.

Many plans’ demographic trends continue to weaken, which could exacerbate the effects of a market shock on pension contributions. The median ratio of active employees to retirees in state plans dropped to 1.2x in fiscal 2024 from 1.7x in fiscal 2010, putting more pressure on plans to generate asset growth. Increasingly lopsided demographics play out in plan cash flows, with benefit outflows rising faster than contribution inflows. After a downturn, participating governments would be subject to bigger contribution increases to restore market losses. Risk-sharing with members through hybrid structures, variable benefits, shared contributions or other features has become more common since the GFC. But it remains far from universal, leaving governments principally responsible for absorbing plan losses.

A major pension asset drawdown would depress portfolio values, raise unfunded liabilities, and lead to higher employer contributions. This would take place just as governments would likely be grappling with economic and budgetary fallout from a downturn. Fitch believes most governments have sufficient flexibility to increase pension contributions, aided by built‑in lags such as asset smoothing that phase in losses over time. However, those with weaker liability metrics and higher carrying costs relative to total spending (e.g., exceeding 20%) could be most vulnerable due to budgetary pressure from increased pension contribution demands.

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