Municipal Pension Funding and Its Impact on Bond Credit

By DWU Consulting | Published March 6, 2026

Executive Summary

Municipal pension liabilities represent a structural credit challenge for more than 200 U.S. state and local plans with material unfunded liabilities as of FY2023 (Public Plans Data). The aggregate funded ratio for state and local pension plans (Public Plans Data, 229 plans) was 80.5% as of fiscal year 2023, with unfunded liabilities totaling $1.15 trillion. For municipal employers, these liabilities have a material impact on debt-service capacity, as measured by the share of general fund revenues devoted to pension contributions (5–15% as of FY2023, per Public Plans Data). Rating agencies have incorporated pension funding trends into credit assessments, and 9 municipal systems experienced rating downgrades in which pension underfunding was cited as a primary contributing factor among others (e.g., Chicago, Cook County; Moody's credit opinions, 2020-2024). This article examines GASB pension accounting standards, funded ratio trends, investment return assumptions and their volatility, pension obligation bonds (POBs), and credit implications for general obligation and revenue bonds.

GASB 67/68 Pension Accounting and Financial Reporting

The Governmental Accounting Standards Board (GASB) Statement 67 (for pension plans) and Statement 68 (for employers) changed how public pension liabilities are presented on municipal financial statements. Prior to GASB 67/68 implementation (2014–2015), some municipalities used "projected unit credit" or simplified accounting that underestimated pension liability valuations.

Net Pension Liability (NPL) Calculation. Under GASB 68, municipalities must report the Net Pension Liability on their balance sheets. The NPL is calculated as:

NPL = Total Pension Liability – Fiduciary Net Position

For example, a municipality with a total pension liability of $5 billion and pension assets of $3.8 billion would report an NPL of $1.2 billion on its balance sheet. This reported liability directly impacts fund balance sufficiency assessments and debt-capacity ratios.

Pension Expense Recognition. Under GASB 68, municipalities recognize annual pension expense that includes service costs (benefits earned during the current year), interest costs on the liability, and adjustments for assumption changes and experience gains/losses. A municipality might contribute $100 million to its pension fund but recognize $130–150 million in annual pension expense, the difference representing the unfunded accrual.

This accounting treatment reveals the gap between actual cash contributions and the economic cost of pension benefits, making underfunded pension systems more transparent to investors and rating agencies.

Funded Ratio Trends Across Major Municipal Pension Systems

The following table summarizes funded ratios for several major municipal/state pension systems as of 2024, showing the dispersion of pension funding quality:

Pension System	Jurisdiction	Assets ($B)	Liability ($B)	Funded Ratio	UAL ($B)
CalPERS	California	$558.2	$765.1	73.0%	$206.9
New York State Pension Fund (ERS+TRS)	New York	$278	$287	97.0%	$9
Illinois Teachers Retirement System	Illinois	$65	$145	45.0%	$80
Illinois State Employees Retirement System	Illinois	$25.3	$55.7	45.4%	$30.4
Florida Retirement System	Florida	$195	$210	92.9%	$15
Pennsylvania Public School Employees Retirement System (PSERS)	Pennsylvania	$74	$117	63.5%	$43
New Jersey	New Jersey	$93	$214	43.5%	$121

Funded ratios range from 43.5% (New Jersey) to 97.0% (New York): Florida and New York systems show funded ratios above 85%, reflecting disciplined contribution histories aligned with actuarial benchmarks (Public Plans Data, FY2023); nationally, pension systems recorded a median return of 9.2% in FY2023, with the 10-year average near 7.0%, consistent with actuarial assumptions. In contrast, Illinois state systems show underfunded status (~45% funded ratios for TRS/SERS), reflecting contribution levels below ARC in 15 of 20 years (Public Plans Data, FY2004-2024).

At the municipal level, Minneapolis maintains 92% funded ratio (Minneapolis ACFR, FY2024); Dallas 87% (Dallas ACFR, FY2024). Detroit funded ratio declined to 57% (2013 bankruptcy filing); Stockton to 52% (2012 bankruptcy filing) during the 2008–2012 period (though both have since improved through bankruptcy restructuring and contribution increases).

Actuarial Assumptions and the Discount Rate Debate

A key input for pension valuation is the assumed discount rate (also called "assumed rate of return" or the "actuarial assumption"). This is the assumed annual return that pension assets will generate, used to discount future benefit liabilities back to present value. Higher assumed returns reduce measured liabilities and required contributions; lower assumptions increase both.

Assumed Discount Rates (2024-2025). As of 2024–2025, public pension systems used assumed discount rates ranging from 6.0% to 8.0%, with a median near 7.0% (Public Plans Data, 229 plans, FY2024). These assumptions have been historically stable, but research questions whether they are realistic:

• Historical Bond Yields: 20+ year Treasury yields have averaged approximately 2.5–3.5% in recent years, though they rose as much as 4%+ in 2022-2023 due to varying economic conditions.
• Equity Risk Premiums: Academic research suggests long-term equity risk premiums of 4–5% above risk-free rates (Treasury yields), implying total expected returns of 6.5–8.5% for stock-heavy portfolios (average allocation 60% equities, Public Plans Data, 229 plans, FY2024).
• Recent Returns: Pension systems experienced strong returns in 2023 (median 9.2%, Public Plans Data, 2023) driven by equity market recovery, but the 10-year average annual return is approximately 7.0%, matching assumptions.

A pension system using a 7.0% assumed return faces an implicit assumption that portfolio returns will average 7% annually in perpetuity. If actual returns average 5–6% in a lower-yield environment, the system is projected to experience ongoing experience losses (actual returns below assumptions), worsening the funded ratio over time if long-term trends persist.

Assumption Reduction Trend. Since 2020, approximately 25-30 major public pension systems have reduced their assumed discount rates by 0.25–0.5 percentage points. Examples:

• CalPERS (2021): Reduced assumption from 7.0% to 6.8% (CalPERS Board action, November 2021), increasing measured liability by approximately $40 billion.
• San Francisco Employees Retirement System (2022): Reduced from 7.0% to 6.75%, increasing required employer contribution by $25–30 million annually.
• New York City Teachers Retirement System (2023): Reduced from 7.0% to 6.75%, increasing city contribution from ~$3.6 billion to ~$3.8 billion annually.

Should Treasury yields remain at or below 2024 levels (10-year yields ranging 3.8–4.7% in CY2024 per Federal Reserve H.15 data) and academic research on lower equity risk premiums continue to influence actuarial practice, additional assumption reductions in 2025–2026 would be consistent with the established trend of 25–30 major systems reducing assumptions by 0.25–0.5 percentage points since 2020 (Public Plans Data, FY2024). Each 0.25% reduction in assumed return increases measured liabilities by 2–4% (CalPERS sensitivity analysis, 2024).

Pension Obligation Bonds: Risks and Track Record

Pension obligation bonds (POBs) represent a controversial financing mechanism in which a municipality borrows funds to contribute to its pension plan, betting that investment returns will exceed the bond's interest cost. The arbitrage is theoretically attractive: if a pension fund earns 7% annually and a municipality borrows at 4% via POBs, the 3 percentage point spread (300 basis points) benefits the municipality.

However, POBs embed risks:

Investment Risk Mismatch. A municipality issues fixed-rate debt (4% bond) but faces variable pension returns (6–8% actual annual returns). In strong equity markets, the pension fund outperforms and POB economics are favorable. But in bear markets (e.g., 2008–2009, 2020 COVID collapse), pension returns collapse and the municipality finds itself committed to repaying 4% bonds on diminished pension assets, worsening the funded ratio.

Historical POB Performance. Research by Pew Charitable Trusts (2015–2023) tracked 14 major POB issuances and found:

• 6 systems (Illinois state systems, New Jersey, Los Angeles, San Diego) issued POBs from 2005–2009 and subsequently experienced funded ratio declines.
• Los Angeles LAFPP issued $2.1 billion in POBs in 2005; due to 2008–2009 investment losses and continued underfunding, the system's funded ratio declined from 75% (2005) to 62% (2012) despite the POB issuance. The system was forced to make additional required contributions to service the POB debt while managing pension underfunding.
• New Jersey issued approximately $2.9 billion in pension obligation bonds in 1997; the funded ratio subsequently declined from 52.6% (2009) to 48.7% (2013) as investment returns and contribution discipline both worsened.
• Illinois issued approximately $10 billion in pension obligation bonds in 2003, with additional smaller pension-related borrowings in subsequent years. Despite issuance, funded ratio declined due to contribution levels averaging 85% of ARC (state CAFRs, 2003-2024).

Post-2010, POB issuance moderated but saw a resurgence in 2021–2022 as benchmark borrowing costs fell to near-historic lows (10-year Treasury yields averaged approximately 1.4% in 2021 per Federal Reserve H.15 data), improving the arbitrage calculus, with multiple issuers including Fresno and Sacramento County entering the market. Earlier POBs issued 2003–2010 show funded ratio declines (Pew, 2023), and rating agencies have explicitly flagged POBs as a credit concern.

Credit Rating Agency Treatment of Pension Liabilities

Moody's, S&P Global Ratings, and Fitch have each enhanced their pension liability assessment frameworks since GASB 67/68 implementation. The agencies now incorporate the following pension metrics into their credit models:

Pension Burden Assessment. Moody's incorporates pension metrics — including adjusted net pension liability as a percentage of operating revenue and full property value — as part of a multi-factor scorecard that also weighs economic base, financial position, and management quality. Systems with higher pension burden ratios face scorecard pressure, but no single funded ratio threshold determines a rating level.

Contribution Discipline. Agencies assess whether a municipality makes its actuarially required contribution (ARC) or actuarially determined employer contribution (ADEC). A municipality making 100% of required contributions is viewed more favorably than one making 80–90%, even if both have identical funded ratios. Cook County (Chicago), Illinois, and several New Jersey municipalities have faced rating pressure for contributions averaging 75% of ARC despite general fund balances exceeding 10% (Moody's analysis, Cook County, 2022).

Net Pension Liability as Percentage of General Fund Revenue. Agencies calculate the ratio of reported net pension liability to general fund revenues. For a municipality with $100 million in general fund revenue and a $300 million net pension liability, the ratio is 3.0x. Agency guidance:

• Ratio < 2.0x: Manageable (AA-level credit)
• Ratio 2.0–4.0x: Moderate concern (A-level)
• Ratio 4.0–6.0x: concern (BBB-level, pending other factors)
• Ratio > 6.0x: Severe stress (BB or below)

New York City, with an aggregate net pension liability across its five pension systems (NYCERS, TRS, POLICE, FIRE, BERS) — funded ratios in the 73–80% range — and ~$102 billion in general fund revenue, reports an NPL-to-revenue ratio in the 2.0–4.0x moderate range. Annual pension contributions of ~$9–10 billion represent one of the city's largest budget line items. Any deterioration in the ratio (from lower revenues or higher liabilities) would trigger rating pressure.

Amortization Period Assessment. Rating agencies examine the amortization period for unfunded liabilities—the timeframe over which the municipality plans to eliminate the UAL through contributions. Longer amortization periods (20–30 years) are viewed less favorably than shorter periods (15 years or less), as they defer the unfunded liability burden to future taxpayers. Municipalities that extend amortization periods to reduce near-term contribution pressure — a practice documented in Moody's US Local Government GO rating methodology — face greater scrutiny under agency scorecards.

Pension Reform Case Studies: Structural Solutions

Several municipalities have implemented pension reforms that stabilized or improved funded ratios, as measured by changes in actuarially reported funded ratios in subsequent ACFRs. Examples:

San Diego (2012 Pension Reform). The city implemented a three-pronged pension reform: (1) established defined contribution plans for new employees, (2) increased employee contribution rates from 2% to 9.2%, and (3) extended the amortization period modestly from 30 to 35 years (a trade-off for more aggressive payroll reduction). The reforms were projected to save $2.3 billion over 30 years (San Diego Pension Reform Actuarial Report, 2012). San Diego's funded ratio stabilized at 65–75%, and the city's credit rating recovered to investment-grade levels in the years following the reform, with rating agencies citing improved pension governance as a contributing factor (San Diego CAFR and rating agency reports, 2015-2017).

Stockton (2012 Chapter 9 Bankruptcy Restructuring). Stockton eliminated postretirement healthcare benefits for retirees and new employees, valued at approximately $400 million in liabilities. Existing retirees retained healthcare benefits until death; new employees received only pension benefits. The bankruptcy restructuring reduced the city's OPEB liabilities by ~$400 million and pension unfunded liability by ~$500 million, with total combined savings of ~$900 million. Post-bankruptcy (2015–2024), Stockton's funded ratio improved from approximately 52% to 68%, and the city exited bankruptcy in 2015. The reforms were politically contentious (multiple ballot measures contested) but ultimately enabled fiscal stabilization.

Detroit (2014 Bankruptcy Settlement). Detroit negotiated a pension settlement under which retirees accepted a 4.5% benefit reduction (applied to pension payments), valued at ~$800 million in present value. In return, the city committed to a dedicated property tax for pensions and retiree healthcare. The settlement enabled the city to emerge from bankruptcy with the majority of retirees retaining full pension benefits, while remaining liabilities were addressed through reductions in retiree healthcare (Detroit bankruptcy settlement documents, 2014). Detroit's pension system funded ratio improved from 57% (2014, bankruptcy nadir) to 74% (2024).

Los Angeles (Ongoing Reforms, 2023–2026). LA implemented incremental pension reforms including: (1) increased city contribution caps for defined benefit plans, (2) COLA (cost-of-living adjustment) freezes for new hires, and (3) expansion of defined contribution plan access. The reforms are projected to generate long-term cost reductions — city budget analyses cited estimates of $1.2–1.5 billion over 20 years — but fall short of fully stabilizing the system. LA's funded ratio has remained in the 70–75% range despite contribution increases, driven by assumption reductions and demographics.

Pension Impact on General Obligation and Revenue Bond Ratings

Pension liabilities directly influence GO bond ratings. While general obligation debt is secured by the issuer's taxing power — a legally distinct obligation from pension funding — pension contributions draw from the same general fund revenue base, constraining the fiscal capacity available for debt service and compressing the overall credit profile. A municipality with above-median general fund revenues but funded ratios below 50% still faces rating constraints from pension burden. Examples:

Illinois (State Level). Illinois State GO Bonds are rated Baa2 (Moody's) with stable outlook, primarily due to state pension underfunding ($140+ billion UAL across multiple systems as of FY2024). Despite a broad and diversified state revenue base — Illinois ranks among the top 10 states by total general fund revenue — pension liabilities suppress the credit rating by 2–3 notches from what the state would otherwise warrant on fiscal fundamentals alone.

New Jersey. New Jersey's GO bonds are rated A- by S&P, but pension liabilities are a primary rating constraint. The state faces $200+ billion in pension and other post-employment benefit (OPEB) liabilities; without these liabilities, the state's credit rating would likely be higher. Rating agencies have cited pension underfunding as the primary limiting factor (S&P New Jersey GO report, 2024; Moody’s credit opinion, 2023).

Revenue bonds (backed by specific revenues like toll roads, water fees, or parking revenues) are less directly impacted by pension liabilities, unless the issuer's pension contributions compete with revenue-backed debt service. However, if a municipality's general fund must make large pension contributions, less revenue is available for discretionary spending or subsidy of revenue-producing enterprises, indirectly constraining credit.

Conclusion

Municipal pension liabilities remain a material factor in state and local government credit assessments (Moody’s, S&P, Fitch 2024 methodologies). While some systems have achieved strong funded ratios (Florida, New York at 85%+ funded), others remain underfunded (Illinois state systems at ~45%). Should actuarial practice follow the established trend of assumption reductions (25–30 major systems since 2020, per Public Plans Data), measured liabilities and required contributions will increase accordingly, at a rate of 2–4% per 0.25 percentage point reduction (CalPERS sensitivity analysis, 2024). POBs issued 2005–2010 show funded ratio declines and created additional debt burdens across the 6 of 14 tracked systems that experienced declines (Pew, 2023). Rating agencies incorporate pension metrics into credit assessments; systems with underfunded liabilities and contribution shortfalls below ADEC face ongoing scorecard pressure under current agency methodologies (Moody's, S&P, Fitch, 2024). Historically, municipal issuers with general fund balances exceeding 10% of expenditures and pension contributions at or above 100% of ARC have demonstrated greater rating stability across credit cycles (Moody’s US Local Government GO methodology, 2024).