The United States public pension system faces a documented shortfall of approximately $1.32 to $1.48 trillion—meaning the gap between what has been promised to public employees and what has been set aside to pay those promises. This is not theoretical worry. When a state or local government falls short on pension obligations, the consequences ripple outward to current retirees, workers nearing retirement, and taxpayers picking up the bill through benefit cuts, tax increases, or both. Illinois alone carries $147.5 billion in unfunded liabilities, while California’s state and local pension systems combined face over $265 billion in debt—more than the entire annual budget of many states. What makes this crisis difficult to pin down is that multiple measurement methodologies exist, and the actual number shifts depending on market performance, policy changes, and which entities are counted.
The verified data shows the total underfunding gap stands between $1.32 trillion (Pew Charitable Trusts, July 2025) and $1.48 trillion (Reason Foundation, 2024), with the difference reflecting different methodologies and timing of measurements. While some projections invoke a $1.9 trillion figure, that typically represents a stress-test scenario for what could happen under adverse conditions—not the current reality. The median funding ratio across all public pension systems is 78 percent, meaning that for every dollar of promised benefits, only 78 cents has been saved and invested. This leaves a substantial margin of vulnerability. When markets perform well, as they did in 2025 with a 9.5 percent average return, the situation improves. When markets struggle, or during recessions, the gap can widen dramatically—potentially reaching $2.74 trillion by 2026 under adverse economic conditions.
Table of Contents
- How Large Is the Actual Funding Gap Across U.S. Public Pensions?
- What Does a 78 Percent Funding Ratio Mean in Practice?
- California and Illinois—Where the Crisis Is Deepest
- How 2025 Market Performance and Recent Reforms Are Affecting the Outlook
- Risk Scenarios—What Happens If Markets Decline?
- Why Accounting Standards Make the Problem Harder to See
- What Comes Next for Public Pensions?
- Conclusion
How Large Is the Actual Funding Gap Across U.S. Public Pensions?
The $1.32 to $1.48 trillion underfunding gap breaks down clearly across the country. States carry approximately $1.29 trillion in unfunded liabilities, while local governments add another $187 billion. This distinction matters because states and localities have different revenue sources, borrowing capacities, and political constraints. A state cannot file for bankruptcy the way a city might, but a municipality facing severe pension obligations has fewer options for raising revenue. The gap exists because public pension obligations were often made with overly optimistic assumptions about investment returns, life expectancy, and salary growth. When those assumptions did not materialize—particularly after the 2008 financial crisis—the shortfall accumulated.
Some systems assumed investment returns of 7.5 percent or higher when average returns have proven lower over longer periods. Others underestimated how long retirees would live. These compounding errors created the current shortfall. Consider that a 28 percent funding gap exists in conservative estimates across all 50 states. That means roughly three of every ten dollars of promised benefits remain unfunded. Some systems are in much worse shape: Illinois, new Jersey, Kentucky, and Connecticut are among the worst-funded, with ratios below 60 percent. Others, like South Dakota and Wisconsin, maintain ratios above 100 percent through consistent contributions and disciplined management.
What Does a 78 Percent Funding Ratio Mean in Practice?
A median funded ratio of 78 percent tells us that public pension systems have covered only three-quarters of their obligations through assets and contributions. The remaining quarter depends on future investment returns and continued taxpayer contributions. This creates a bet on the future: if markets perform as expected, and contributions remain stable, the systems theoretically reach their goals. If they do not, the shortfall grows. The danger lies in the assumptions embedded in these projections. Pension systems typically assume annual investment returns of 6.87 to 7.5 percent, yet average returns over the past decade have often fallen short.
In 2025, public pension funds did achieve a 9.5 percent average return, which exceeded assumptions and improved funding ratios for that year—but one strong year does not eliminate years of accumulated shortfalls. A single poor year, or a market shock, can reverse gains quickly. When funding ratios dip below 80 percent, the system enters a state of vulnerability. A 20 percent market downturn could lower the average funding level to 63 percent, according to Reason Foundation stress tests. At that point, even with contributions held constant, the system loses the margin to absorb shocks. Retirees have limited flexibility to accept benefit cuts, and states face pressure to raise taxes or reduce services elsewhere. This is the reality of underfunding: it concentrates risk on future payers.
California and Illinois—Where the Crisis Is Deepest
California’s situation demonstrates the scale of the problem in the largest state. The California Public Employees’ retirement System (CalPERS) and California Teachers’ Retirement System (CalSTRS), combined with local pension systems, carry over $265 billion in unfunded liabilities. CalPERS alone serves nearly two million members and has made headlines repeatedly as its funding ratio fluctuated in recent years. The system expects to receive nearly $50 billion in employer contributions annually—a burden that grows as a percentage of state and local budgets. Illinois faces an even more severe crisis relative to its population and budget. The state carries $147.5 billion in unfunded liabilities across multiple pension systems serving state workers, teachers, judges, and other public employees. Illinois has a constitutional protection for pensions that makes it nearly impossible to cut benefits, so the solution must come from higher contributions or taxes.
In 2023, the state was already dedicating about 30 percent of its budget to pensions, crowding out education, infrastructure, and other services. Illinois has raised contribution rates multiple times but continues to face annual shortfalls. These examples matter because they show the practical consequence of underfunding. Benefits cannot be cut easily due to constitutional protections, laws, and moral obligations. That leaves states with three choices: raise taxes on current taxpayers, reduce services in education and infrastructure, or allow the debt to compound. Illinois has largely chosen the first path, imposing higher income taxes and property tax increases. This creates a cycle where residents and businesses leave, reducing the tax base further. California has different challenges but faces similar pressure on its budget.
How 2025 Market Performance and Recent Reforms Are Affecting the Outlook
The 9.5 percent average return achieved by public pension funds in 2025 provided meaningful relief from the underfunding crisis—at least temporarily. This performance exceeded the typical 6.87 percent assumed rate of return, allowing many systems to improve their funded ratios and reduce contribution requirements. For states struggling under pension obligations, a strong market year buys time and reduces the immediate pressure to raise taxes or cut services. However, relying on market performance to solve the problem has proven risky. After strong years, inevitable down years erase gains. Public pensions should not depend on beating return assumptions every year to remain solvent. Instead, some states have moved toward structural reforms.
Minnesota adopted pension funding improvements in November 2025, including adjustments to contribution rates and benefit formulas. These changes are relatively modest but signal recognition that the current path is unsustainable. The tradeoff with reforms is always the same: changes either reduce promised benefits for current and future employees, increase contributions from employers (taxpayers), reduce other government services, or some combination of all three. No solution is painless. States that act early, like Wisconsin, have maintained better funding ratios through consistent contributions and periodic adjustments. States that delayed, like Illinois and California, face larger and more disruptive changes down the road. The longer a state waits to address underfunding, the steeper the required changes become.
Risk Scenarios—What Happens If Markets Decline?
The Reason Foundation stress tests show vulnerability clearly. A 20 percent market downturn could lower the average funding level to 63 percent across all systems. At that point, many individual systems would dip below 60 percent funded—levels at which plan solvency becomes genuinely uncertain without immediate intervention. Sixty percent funded means four of every ten dollars of promised benefits lack dedicated assets to cover them. A deeper recession scenario presents an even more troubling projection: total state and local pension debt could rise to $2.74 trillion by 2026 under adverse economic conditions. This figure assumes a significant market decline, slower growth, and higher-than-expected inflation.
While such a scenario is not inevitable, it is plausible—and it shows how quickly the crisis could escalate under stress. A 2008-level financial crisis, combined with recession, would test every system’s ability to pay benefits. The warning here is structural: public pension systems have become increasingly sensitive to market performance because they rely on investment returns to bridge the gap between contributions and obligations. The higher the underfunding ratio, the larger the required return to avoid insolvency. This creates a dangerous dynamic where underfunded systems take on more risk by shifting to alternative investments—like private equity, hedge funds, and real estate—hoping for higher returns. These investments often involve higher fees and less liquidity, which can amplify losses during downturns.
Why Accounting Standards Make the Problem Harder to See
Public pension systems use fundamentally different accounting standards than private pensions regulated under ERISA (the Employee Retirement Income Security Act). Private sector pensions must use conservative assumptions and are insured by the Pension Benefit Guaranty Corporation. If a private company underfunds its pension, the PBGC steps in to protect benefits—at least up to a limit. Public pensions have no such backstop. When they underfund, the burden falls on taxpayers or future benefit recipients. Public pensions are allowed to use higher discount rates for calculating liability, which makes liabilities appear smaller than they truly are.
They can also assume higher investment returns, further reducing the apparent shortfall. This accounting difference means the “official” underfunding figures used by pension systems themselves may understate the problem compared to how private pensions would calculate it. Truth in Accounting and other watchdog groups have repeatedly highlighted this discrepancy, estimating that using consistent accounting standards would show significantly larger unfunded liabilities. Additionally, many public pension systems have shifted toward alternative investments based on optimistic return assumptions. Stanford’s SIEPR research has documented that increasing reliance on alternatives—rather than traditional stocks and bonds—does not necessarily improve returns and often increases fees and volatility. This compounds the underfunding problem because the systems need higher returns to justify their current contribution levels, so they take on more risk. If those bets fail, the underfunding worsens rapidly.
What Comes Next for Public Pensions?
The trajectory is clear: public pension systems cannot remain on their current path without significant change. Some form of adjustment is inevitable—whether through higher contributions, benefit modifications, tax increases, or service cuts. The question is not whether change will happen, but how soon and in what form. States that begin the adjustment now, while markets are relatively stable, can spread the burden over time. States that delay face sharper, more disruptive changes later.
Looking forward, several developments will shape outcomes. First, market performance in 2026 and beyond will either improve or worsen the underfunding gap. A recession could push the problem to $2.74 trillion in a few months. Second, legislative reforms in individual states—like Minnesota’s recent changes—may gradually improve funding. Third, demographic shifts as more boomer retirees leave the workforce could increase pressure on contribution rates. The 2025 strong market performance was helpful, but it should be viewed as one year in a longer cycle, not the beginning of a sustained solution.
Conclusion
The underfunding gap in U.S. public pensions ranges from $1.32 to $1.48 trillion in current verified estimates, with median funding ratios of just 78 percent. This means that roughly one of every four dollars of promised benefits lacks dedicated assets to cover it. The problem is concentrated in states like Illinois and California, but it affects every state to some degree.
While 2025 market performance provided temporary relief, the underlying vulnerability remains: public pension systems depend on consistent market returns and contributions they may struggle to sustain, while facing constitutional and legal constraints that limit benefit reductions. For workers, retirees, and taxpayers, the practical implication is straightforward: do not assume public pensions will deliver their full promised benefits without change, and do not assume tax burdens will remain stable. The underfunding crisis will be resolved through some combination of higher taxes, service cuts, benefit changes, and improved investment returns. Those resolutions will unfold over the next decade, affecting virtually everyone with ties to public employment or the states that employ them. Understanding the scale of the problem, and the timing of potential changes, is the first step in planning accordingly.