State and local pension funds are short approximately $1.3 trillion nationally, a figure that represents a critical funding gap between what governments have promised to retirees and what they actually have saved. This $1.3 trillion unfunded liability—reported for fiscal year 2022 by major research institutions—translates into a structural problem affecting millions of current and future retirees across the country. To put this in perspective, the entire pension systems of the 50 states collectively owe more than they’ve funded, meaning taxpayers will eventually need to cover the shortfall through contributions, benefit cuts, or a combination of both. The gap has evolved as markets have fluctuated and investment returns have missed expectations. More recent projections suggest the unfunded liability has improved slightly to $1.27 trillion as of 2025, down from prior estimates, largely due to better market performance in recent years.
However, this remains a substantial and persistent challenge. For example, Illinois faces roughly $137 billion in unfunded liabilities alone—nearly three times what the state collects annually in all taxes—while New Jersey, Mississippi, Connecticut, and Kentucky also carry disproportionately large shortfalls. These states illustrate how the national $1.3 trillion problem is unevenly distributed across the country. Understanding how we reached this point requires examining the intersection of demographic shifts, investment returns, and policy decisions made decades ago. The pension funding crisis isn’t new, but recent market volatility has brought it back into sharper focus for policymakers, taxpayers, and workers who depend on these benefits.
Table of Contents
- Why Does a $1.3 Trillion Pension Funding Gap Exist?
- How the Unfunded Liability Breaks Down Across States
- What Does a Funded Ratio Actually Tell You?
- What Happens if the Economy Sours? Recession Scenarios and Stress Tests
- The Risk of Pension Obligation Increases Amid Market Uncertainty
- State Policy Responses and Contribution Trends
- What the Future Holds for Public Pensions
Why Does a $1.3 Trillion Pension Funding Gap Exist?
The $1.3 trillion shortfall stems from a combination of structural factors that have accumulated over the past two decades. When pension systems were designed, they assumed steady investment returns of 7 to 8 percent annually. Reality has often fallen short of those expectations. The 2008 financial crisis, the 2020 pandemic downturn, and other market disruptions have periodically delivered negative returns or returns below the assumed rate, forcing funds to play catch-up on contributions. Meanwhile, states and localities in many cases failed to make their full required contributions to pension funds during economic downturns, deferring payments that should have been made immediately.
Demographic trends have worsened the problem. Life expectancy has increased, meaning retirees collect benefits for longer than pension actuaries predicted when many systems were established. At the same time, many public sector workforces have shrunk or stagnated, reducing the number of active workers contributing to the system relative to the number of retirees drawing benefits. This unfavorable ratio—fewer workers supporting each retiree—pushes required contribution rates higher. In some states, pension contributions now consume 10 to 15 percent of all tax revenue, crowding out funding for schools, infrastructure, and other services. A pension fund that promised too much in benefits decades ago, combined with missed investment targets and demographic headwinds, creates precisely the conditions that produced the $1.3 trillion gap.
How the Unfunded Liability Breaks Down Across States
The $1.3 trillion figure masks significant variation. State pension plans carry roughly $1.29 trillion of the unfunded liability, while local government plans (city, county, and special districts) account for approximately $187 billion. This distinction matters because state plans are typically larger and more heavily scrutinized, while local pension shortfalls often receive less public attention despite directly affecting local property taxes and municipal services. Not all states are equally burdened.
Illinois, which has the worst-funded major state pension system, exemplifies how a single state’s dysfunction can drive national statistics. With a funded ratio near 40 percent in recent years, Illinois’s pension system requires roughly 30 percent of all state revenue just to keep the system solvent—an unsustainable burden that crowds out education, healthcare, and other needs. new Jersey, Mississippi, Connecticut, and Kentucky round out the most underfunded systems, each facing unfunded liabilities exceeding $50 billion. Meanwhile, some states like Wisconsin and Florida maintain funded ratios above 90 percent, demonstrating that better outcomes are achievable through disciplined contributions and prudent governance. The wide disparity means that retirees and taxpayers in well-funded states like Wisconsin benefit from sounder pension management, while those in severely underfunded states face greater risk of benefit reductions or tax increases.
What Does a Funded Ratio Actually Tell You?
A funded ratio measures how much a pension system has saved relative to what it owes. The national average funded ratio improved to 82.5 percent in 2025, meaning pension systems collectively have set aside 82.5 cents for every dollar of promised benefits. The median funded ratio across all plans stood at 78 percent at the end of 2024. These improvements from 2024’s lower levels reflect recent market gains, but they also reveal how sensitive pension funding remains to investment performance. A funded ratio below 80 percent is generally considered underfunded, carrying higher risk that the system will struggle to meet all obligations without contribution increases or benefit adjustments.
Illinois’s 40 percent funded ratio means the state has only set aside 40 cents for every dollar owed—a precarious situation. Conversely, a 90 percent funded ratio doesn’t mean a system is fully secure; actuaries generally recommend ratios above 90 percent to provide a safety cushion for market volatility. The problem is that even with improvements, most public pension systems remain below that threshold, leaving little room for economic downturns. For individual workers and retirees, funded ratios matter because they signal the likelihood of benefit security. In underfunded systems, there’s a meaningful risk that promised benefits will be reduced, either through changes to cost-of-living adjustments, delayed payments, or formal benefit cuts.
What Happens if the Economy Sours? Recession Scenarios and Stress Tests
Recent stress testing by pension research organizations reveals just how vulnerable current funding levels are to economic shocks. If a recession caused a 20 percent decline in investment returns—a decline that is well within the range of historical downturns—the average pension fund’s funded ratio would fall from today’s 82.5 percent to approximately 63 percent. Under the most pessimistic scenario, where a major economic recession combines with continued lower-than-expected returns, the total unfunded liability could balloon to as much as $2.74 trillion by 2026. This worst-case projection underscores a critical limitation of current funded ratios: they reflect a specific moment in time and provide limited protection against near-term market volatility.
The practical consequence is that pension systems have very little margin for error. Unlike private companies that can reduce operations or lay off workers during downturns, pension systems must continue paying retirees regardless of market performance. States would need to respond to a major funding shortfall through some combination of higher contributions, benefit reductions, or tax increases. A comparison illustrates the tension: during the 2008 financial crisis, which caused roughly a 30 percent decline in stock values, pension funds nationwide lost hundreds of billions in value, forcing many states to increase contributions while revenues were simultaneously declining due to recession. That painful period showed that the worst time to raise contributions—during a recession—is precisely when they’re most needed.
The Risk of Pension Obligation Increases Amid Market Uncertainty
While markets have recovered and funded ratios have improved since 2022 and 2023, pension obligations themselves continue to grow. As interest rates and bond yields rise, the present value of pension liabilities actually increases in accounting terms—meaning the bill for promised benefits grows even as markets improve. This counterintuitive dynamic means that recent positive market returns haven’t fully closed the $1.3 trillion gap because the obligations side of the equation has also shifted. Additionally, many states have added new benefits or expanded cost-of-living adjustments in recent years, further increasing long-term liabilities.
The limitation of relying on market returns to solve the pension problem becomes clear when examining this pattern. Even strong market gains of 10 percent annually can be offset by rising discount rates that increase measured liabilities. This means that states cannot simply wait for markets to recover; they need structural reforms that align contributions with realistic investment assumptions and reduce the gap between promised benefits and actual funded levels. Without changes, even years of good market performance may not be sufficient to bring major underfunded systems into secure territory.
State Policy Responses and Contribution Trends
States have responded to the $1.3 trillion shortfall through a combination of contribution increases, benefit modifications, and governance reforms. Many states have increased the employee contribution rate—the portion of paychecks that go to pensions—shifting more of the burden to current workers. Others have raised the employer contribution rate, increasing the taxpayer cost. Some have moved new employees into lower-benefit systems or hybrid plans that combine defined benefits with defined contribution elements, similar to a 401(k).
A handful of states have reduced cost-of-living adjustments or raised retirement ages. Illinois provides a cautionary example: despite significant contribution increases and modest benefit reforms, the state’s funded ratio has barely improved because the system’s long-term liabilities are so severe that normal contributions cannot catch up. In contrast, states like Florida and Wisconsin have maintained better funding by consistently making full contributions even during recessions, demonstrating that disciplined governance works. The comparison suggests that a state’s response to pension funding challenges must be comprehensive; contribution increases alone, if not accompanied by benefit adjustments or other reforms, may prove insufficient for the most underfunded systems.
What the Future Holds for Public Pensions
Looking ahead, the $1.3 trillion unfunded liability is unlikely to disappear quickly, even with favorable markets and disciplined contributions. Most pension experts project that it will take 20 to 30 years for many underfunded systems to reach acceptable funding levels through normal contribution increases and market gains. During that period, public employees will face the uncertainty of whether promised benefits will be fully honored, while taxpayers will bear the burden of elevated pension contributions that crowd out other spending. Policy reform remains the most consequential variable.
Some states are exploring changes to how they calculate pension liabilities or adjust discount rate assumptions, moves that are controversial but may reflect economic reality. Others are transitioning to different benefit structures for new employees. Nationally, there’s growing recognition that the defined benefit pension model—where governments guarantee specific retirement income—may be unsustainable in its current form without major changes. The path forward likely involves a mix of higher contributions, modest benefit adjustments, workforce reforms, and governance improvements. For those relying on public pensions—current employees, retirees, and taxpayers—understanding this $1.3 trillion challenge and the policy responses it’s generating is essential for evaluating financial security and planning accordingly.