Pension Funding Explained: What the Numbers Mean

Updated Jun 2024

Pension funding numbers can seem opaque, but they follow a logic anyone can understand once you know the key concepts. PensionWatch tracks 151 plans with $5415.4B in total assets against $7379.0B in total liabilities. Here is what those numbers actually mean and why small changes in assumptions can shift billions.

The Basic Equation: Assets vs. Liabilities

Every pension plan has two sides of its balance sheet. On the asset side, you have the money the plan has accumulated through employer contributions, employee contributions (where applicable), and investment returns. On the liability side, you have the present value of all future benefits the plan has promised to pay. The funding ratio is simply assets divided by liabilities. If a plan has $80 billion in assets and $100 billion in liabilities, it is 80% funded with a $20 billion unfunded liability.

Across the plans PensionWatch tracks, the average funding ratio is 73.4%. The total unfunded liability — the aggregate gap between assets and obligations — is $1963.6B. This gap represents money that must come from somewhere: future employer contributions, better-than-expected investment returns, or in worst cases, benefit reductions.

How Liabilities Are Calculated

Pension liabilities are not simply the sum of future benefit payments. They are the present value of those payments — the amount of money that, if invested today at the discount rate, would grow to cover all future benefits. This is where the math gets consequential. A pension plan might promise to pay a retiree $3,000 per month for 25 years of retirement. The total nominal payments are $900,000. But the present value of those payments might be only $550,000 if discounted at 7%, or $650,000 if discounted at 5%. Same benefits, vastly different reported liability — and vastly different required contributions.

The Discount Rate Debate

The discount rate is the most contentious number in pension finance. Public pension plans typically use their assumed rate of investment return — usually 6.5-7.5% — as the discount rate. The logic is that the plan expects to earn this return on its investments, so future obligations are effectively "pre-funded" by expected gains. Financial economists argue this is circular reasoning and that pension obligations should be discounted at a risk-free rate (Treasury yields, around 4-5%), because the benefits are contractual obligations regardless of how investments perform.

The difference is enormous. Using a 7% discount rate, a plan might report $100 billion in liabilities and appear 80% funded. Using a 4% risk-free rate, the same plan's liabilities could be $150 billion, making it only 53% funded. Neither number is "wrong" — they answer different questions. The higher rate asks: "If investments perform as expected, do we have enough?" The lower rate asks: "If we had to settle these obligations today with safe investments, could we?"

The Assumed Rate of Return

The assumed rate of return directly determines how much a plan sponsor must contribute each year. A plan assuming a 7.5% return effectively says: "Our investments will generate most of the money needed to pay benefits, so the employer only needs to contribute the difference." If the plan lowers its assumption to 7.0%, the expected investment income drops and the required employer contribution rises immediately, often by tens or hundreds of millions of dollars for large plans.

This creates a political tension in public pension plans: lowering the assumed return is more financially honest but forces governments to allocate more budget to pensions and less to schools, roads, and other services. Over the past 15 years, the average assumed return for public plans has declined from about 8% to roughly 6.9%, but many experts believe even current assumptions are too optimistic given the interest rate environment and equity market valuations.

Actuarial Smoothing

Most pension plans use smoothing to spread investment gains and losses over 5-7 years. After a market crash, the full loss is not recognized immediately — instead, a portion is recognized each year. This reduces contribution volatility for sponsors but means reported funded status can lag reality by several years. After 2008, many plans continued to report funded ratios above 70% even when their actual asset values had dropped below 60% of liabilities. PensionWatch uses the actuarial values reported by plans but shows the 3-year trend to help reveal whether smoothing is masking a deteriorating position.

Normal Cost vs. Amortization Payments

The annual cost of a pension plan has two components. The normal cost is the price of benefits being earned in the current year by active employees — typically 10-25% of covered payroll. The amortization payment is the additional amount needed to pay down existing unfunded liabilities over a set period (usually 15-30 years). Together, these equal the annual required contribution. When employers pay less than this amount, the unfunded liability grows both by the shortfall and by interest on that shortfall, compounding the problem year after year.

Why Funded Status Changes Year to Year

A plan's funding ratio can swing significantly from year to year based on several factors: actual investment returns versus assumed returns, changes in actuarial assumptions (discount rate, mortality tables, salary growth), employer contribution levels, benefit payments to retirees, and demographic shifts (more retirees relative to active workers). A single year of 15% investment returns can improve a plan's funded status by 5-8 percentage points, while a year of negative returns can erase years of improvement. This is why the trend over multiple years provides a more reliable picture than any single valuation.