New research confirms what pension experts have warned about for years: state pension funds across the United States face a staggering $1.3 trillion funding gap. This means that state government retirement plans collectively have promised $1.3 trillion more in benefits than they currently have set aside to pay them. To put this in perspective, Illinois alone carries nearly $200 billion in unfunded liabilities—more than many states’ entire annual budgets. This underfunding crisis affects not just retirees awaiting their pension checks, but also current workers and taxpayers who bear the financial burden as states struggle to close the gap. The crisis became visible during the 2024-2025 pension year when independent research revealed the true depth of the problem.
States have funded only 72 cents for every dollar of pension benefits they’ve promised to their workers. For example, a teacher who was promised a $40,000 annual pension at age 65 might find that the state has only set aside $28,800 worth of assets to eventually pay that benefit. This 28 percent shortfall represents one of the most pressing fiscal challenges facing state governments today. The good news is that the situation is beginning to improve. Funded status rose to 82.5% in 2025, up from 78.0% in 2024, and unfunded liabilities declined to $1.27 trillion from $1.54 trillion in the prior year. However, this improvement masks persistent problems in specific states and highlights why long-term solutions remain elusive.
Table of Contents
- How Did State Pension Plans Accumulate Such Massive Underfunding?
- Why Are Some States Deeply Underfunded While Others Are Fully Funded?
- Which States Face the Largest Dollar Underfunding?
- What Are the Most Significant Contributing Factors to Pension Underfunding?
- What Are the Real-World Consequences of Pension Underfunding?
- How Are States Beginning to Address the Underfunding Crisis?
- Looking Forward: Can Pension Underfunding Be Solved?
- Frequently Asked Questions
How Did State Pension Plans Accumulate Such Massive Underfunding?
The underfunding crisis didn’t happen overnight. It accumulated gradually over decades through a combination of policy decisions, economic shocks, and faulty financial assumptions. When state legislatures approved generous pension benefits in the 1990s and 2000s, they often assumed that investment markets would reliably return 7.5% to 8.5% annually. This assumption meant they could contribute less money today because they believed market returns would do the heavy lifting. When the 2008 financial crisis hit, investment returns collapsed, and states found themselves far behind on contributions.
Some states compounded the problem by skipping or reducing their required contributions during budget crises. When state tax revenues dropped during economic downturns, legislatures cut pension funding to balance budgets, borrowing against future obligations. This is roughly equivalent to a homeowner deciding not to make a mortgage payment during a rough year—the debt doesn’t disappear; it grows with interest. Connecticut and Illinois exemplify this approach: both states have made inadequate contributions for decades, and now face pension obligations that consume an outsized share of their annual budgets. Illinois, in particular, has unfunded liabilities representing nearly 200% of its annual income—a situation that simply cannot be sustained without major structural reforms.
Why Are Some States Deeply Underfunded While Others Are Fully Funded?
The variation in pension funding across states reveals how dramatically outcomes diverge based on plan design and contribution discipline. Six states—Washington, Wisconsin, Oklahoma, Nebraska, Utah, and South Dakota—have either fully funded or overfunded their pension plans. These states achieved this through a combination of consistent contributions, realistic investment return assumptions, and in some cases, more modest benefit formulas. Wisconsin, for example, has maintained strong contribution practices and uses conservative return assumptions that help ensure funding targets are met. Conversely, states like Illinois, New Jersey, Mississippi, Connecticut, and Kentucky struggle with severe underfunding.
Illinois faces the worst situation by far, with unfunded liabilities equal to 197% of its annual revenue. New Jersey sits at 162%, Mississippi at 149%, Connecticut at 147%, and Kentucky at 135%. These percentages mean that even if these states dedicated their entire annual revenue to pensions—and nothing else—they still couldn’t eliminate the underfunding in a reasonable timeframe. A critical warning: the most underfunded states face a genuine policy trilemma. They cannot simultaneously maintain promised benefits at current levels, keep tax rates politically acceptable, and allocate sufficient funds to other essential services like education and infrastructure. Some combination of benefit reductions, tax increases, or benefit restructuring is mathematically inevitable.
Which States Face the Largest Dollar Underfunding?
When measured in raw dollars rather than percentages, a different picture emerges. California, Illinois, Texas, and New Jersey collectively hold the largest unfunded liabilities by dollar amount. California’s unfunded liability alone exceeds $400 billion, reflecting both the size of its economy and the scale of benefits promised to public employees. These four states represent a significant portion of the national $1.3 trillion crisis.
California’s situation illustrates a nuance often missed in pension discussions: a state can have both a large unfunded liability and a reasonably healthy funded ratio. California’s pension system is approximately 85% funded—better than the national average—but because the system is so large, the remaining 15% gap translates to hundreds of billions of dollars. Conversely, a state like Illinois might have a smaller absolute underfunding than California but face greater financial stress because the underfunding represents a much larger percentage of the state’s available resources. This distinction matters for retirees and current workers, who should understand both the local severity of underfunding and how it compares to other states.
What Are the Most Significant Contributing Factors to Pension Underfunding?
Three primary factors have driven state pension underfunding: investment underperformance, contribution shortfalls, and unrealistic return assumptions. The first factor is market-driven and beyond states’ direct control, though it’s predictable. When states assumed 8% average annual returns and markets delivered 6%, the compounding effect over decades creates substantial gaps. A system that assumes 8% returns will significantly underestimate the contributions needed if actual returns are only 6%—a seemingly small difference that creates enormous long-term consequences. The second factor—contribution shortfalls—stems from legislative choices.
During the 2008-2010 recession and again during the 2020 pandemic, many states reduced pension contributions to manage budget deficits. This borrowing against the future proved costly. The third factor involves overly optimistic assumptions about investment returns. Some pension systems continue to assume returns of 7.5% or higher despite decades of evidence that such returns are unrealistic in the current economic environment. Stanford’s research on this issue revealed that many public pension systems blend together real estate, hedge funds, and other illiquid investments in ways that might not deliver promised returns, yet the systems still assume they will. When return assumptions are too optimistic, pension plans systematically undercontribute, slowly accumulating shortfalls.
What Are the Real-World Consequences of Pension Underfunding?
Underfunding creates cascading consequences that extend far beyond pension managers’ offices. When a state’s pension fund is underfunded, the state government must contribute more money each year to cover the gap. As contributions grow, they crowd out funding for schools, transportation, public health, and other services. Some states now dedicate 15% to 20% of their general fund revenue to pensions—essentially choosing between paying retirees and funding current operations. Illinois spends nearly $10 billion annually on pension contributions, limiting its ability to invest in schools and infrastructure. The second major consequence is risk exposure for current workers and future retirees.
When a pension system is deeply underfunded, it creates temptation to take greater investment risks in hopes of achieving higher returns. If riskier investments pay off, the state benefits. If they don’t, workers and retirees bear the cost through benefit reductions or delayed funding. This represents a fundamental shift of risk from the state to individuals. A warning: underfunded systems often contemplate benefit restructuring, including reducing future cost-of-living adjustments, raising retirement ages, or switching from defined-benefit to defined-contribution plans. Current workers in underfunded systems face greater uncertainty about their retirement income than counterparts in well-funded systems.
How Are States Beginning to Address the Underfunding Crisis?
Several states have adopted reforms aimed at gradually improving funded status. Some have increased contribution rates, while others have modified benefit formulas for new employees. A handful of states have implemented hybrid plans that combine a traditional pension with a 401(k)-style component, reducing long-term liability. Washington State’s approach—maintaining consistent contributions and conservative assumptions—offers a replicable model that other states have studied.
The 2025 improvement in funded status, with national funding rising from 78% to 82.5%, reflects both these reforms and favorable investment market conditions in 2024. However, this improvement demonstrates a limitation: pension funding is volatile and sensitive to market performance. A significant market downturn in 2026 or 2027 could erase much of this progress. States that rely on market returns to solve underfunding rather than increasing contributions are essentially betting on favorable markets—a strategy that has repeatedly backfired.
Looking Forward: Can Pension Underfunding Be Solved?
The path forward requires acknowledging that the underfunding problem cannot be solved through investment returns alone. States need a three-part strategy: increasing contributions to realistic levels, adjusting benefit structures for new employees, and using conservative financial assumptions that don’t rely on optimistic market forecasts. The improvement from $1.54 trillion to $1.27 trillion in unfunded liabilities between 2024 and 2025 proves that improvement is possible, but it also underscores that backward steps are equally possible if policy discipline falters. The stakes extend beyond pension managers and retirees.
This $1.3 trillion underfunding represents real future claims on state budgets. If states continue the pattern of increasing pension contributions, other state services and taxpayers will bear the burden. For workers currently in pension plans, the challenge is monitoring their own plan’s funded status and understanding how their state’s pension solvency might affect their benefits. Those nearing retirement should verify with their pension plan administrators what their specific benefit amounts are, rather than assuming the state will deliver every promised dollar.
Frequently Asked Questions
If my state has underfunded pensions, will my pension be cut?
Pension cuts are possible but not automatic. It depends on how your state addresses underfunding. Some states increase contributions, others adjust benefits for future employees while protecting current retirees, and still others pursue a combination of reforms. Check your state’s pension plan announcements for specific information.
What’s the difference between being 72% funded and 82.5% funded?
It represents the portion of promised benefits that the pension system currently has assets to cover. At 72% funded, the system has $0.72 set aside for every $1.00 of promised benefits. At 82.5%, it has $0.825. Improvement is occurring, but substantial underfunding remains across many systems.
Why do some states have fully funded pensions while others have $200 billion underfunding?
The difference reflects decades of policy choices. States with fully funded pensions typically made consistent contributions, used realistic return assumptions, and sometimes offered more modest benefits. Underfunded states often reduced contributions during budget crises or assumed overly optimistic investment returns.
Should I be concerned if my state’s pension system is underfunded?
You should be informed and attentive. Underfunded systems sometimes restructure benefits or increase contribution rates. If you’re a current worker, understand your plan’s status and consider whether additional retirement savings might be prudent. If you’re a retiree, your benefits are typically more protected, but follow your plan’s communications about funding status.
Which states have the most serious pension underfunding?
Illinois faces the most severe crisis relative to state resources, with unfunded liabilities representing 197% of annual state revenue. New Jersey, Mississippi, Connecticut, and Kentucky also face significant challenges. Conversely, Washington, Wisconsin, Oklahoma, Nebraska, Utah, and South Dakota have fully funded or overfunded systems.