A Roadmap to Full Funding for Public Pension Plans

What being fully funded means

When a pension plan’s actuarial value of assets exceeds actuarial liabilities, a funded ratio above 100 percent, it is considered to be fully funded. A funded ratio above 100 percent results in a surplus. Importantly, in this context, the word “surplus” does not suggest the plan has excess assets available for discretionary use.

Being fully funded means legacy unfunded liabilities have been eliminated. However, the plan’s Normal Cost (the value of benefits earned by active members in the coming year) continues indefinitely as long as members can accrue benefits, so the plan must still be funded with contributions. Full-funded status merely means a plan is on track to meet its obligations to provide promised benefits. Risks related to investment volatility, demographic changes and economic shocks still must be managed.

Misunderstanding a public sector plan’s surplus as extra assets creates risk. The plan may face pressure for contribution holidays, benefit enhancements and aggressive assumption changes.

Why full funding is within reach for many plans

At the turn of the century, when many public sector pension plans were fully funded, benefits improvements were common. That practice put plans in a vulnerable position during the sharp market downturn that occurred both in 2000–2002 and more acutely during the 2007–2009 global financial crisis (GFC).

Certain headwinds subsequently worked to increase pension plan liabilities and decrease funding levels. One result of the GFC was a lowering of prevailing interest rates, which reduced assumed investment returns for public pension plans, from an average of 8.0 percent in 2001 to under 7.0 percent currently. Lowering the assumed investment return increases liabilities. Over the same time frame, generational mortality adjustments were added to mortality assumptions to reflect the fact that people were living longer. This also worked to increase the liability side of the funding level equation.

In the wake of that experience, public sector pension plans’ contributions rose for years, accompanied by assumption updates. More recent improvements in funded status are primarily attributable to these factors: tightened benefit levels, contribution discipline and strong investment returns.

The aggregate funded ratio for all state pension plans was 78.8 percent for fiscal 2025, up from 76.7 percent one year earlier, according to the National Association of State Retirement Administrators (NASRA). However, funded ratios by state public pension systems vary widely, as illustrated by the map graph.

A surplus-management strategy is the foundation for long-term stability

Having a surplus-management strategy in place before reaching full funding helps plan sponsors prepare for a surplus by establishing clear guidelines for how the surplus will be used. It can also help sponsors reduce the risk of future funded status and contribution volatility, manage stakeholder expectations and preserve financial stability over time.

A surplus-management strategy should be part of the plan’s funding policy, which should align with funding policy best practices established by the Government Finance Officers Association (GFOA). This allows stakeholders to understand there is a specified, measured process to be followed in the occurrence of a surplus funding position.

Historically, surpluses have been used to enhance benefits and reduce contributions. Funding policies should start by considering using their surpluses to manage or reduce risks to the plan, as well to consider benefit modification, if circumstances permit within risk tolerances.

Consider including these key, interrelated elements in your surplus-management strategy: actuarial assumptions, contribution volatility management, benefit adequacy and investment strategy.

Ask your actuary to examine plan assumptions and methods with long-term stability in mind

The plan’s actuary should be proactive rather than reactive in making sure assumptions and methods are in a good place for the long term.

Outdated or overly optimistic actuarial assumptions can inflate a plan’s surplus and encourage premature actions that undermine long-term funding progress. Moreover, assumptions that are too aggressive may need to be adjusted quickly.

In a fully funded plan, the assets and liabilities are roughly similar. Therefore, getting the liability right or wrong by some percentage is going to create a huge change in the funded status relative to the Normal Cost and the contribution rate.

There are several options for revisiting assumptions and methods, including these:

• Update the plan’s funding policy on amortization methods and periods to pay down unfunded liabilities more rapidly when/if they occur and amortize surpluses over longer periods.
• Do not utilize surplus too quickly. Consider a buffer, such as being 120 percent funded before utilizing any surplus, for example.
• Add a margin to certain assumptions (e.g., expected return or anticipated cost-of-living adjustments) to account for adverse deviation to improve the long-term likelihood of achieving those expectations.
• Revisit the discount rate that’s used to set the expected investment return.
• Use a glide path on the current contribution rate (down to the normal cost) to reduce volatility of future rate declines and prevent abrupt increases due to market losses.

Manage contribution volatility

Before a public pension plan reaches full funding, the contribution is typically used for both the Normal Cost and amortization payments towards the plan’s Unfunded Actuarial Accrued Liability (UAAL) if the plan is funding in an actuarially determined manner (fixed rate or statutory plans often do not necessarily contribute on normal cost and UAAL explicitly). At full funding, the UAAL portion drops off, meaning the contribution rate can drop dramatically. That cliff can cause several problems, including a sudden increase in the contribution rate if the plan has adverse investment experience.

To mitigate large movements in the contribution rate, allow for predictability and strengthen the plan funding position, consider a glide path that smooths the contribution rate reduction, bringing it down gradually over time. For example, if the newly calculated UAAL contribution rate is less than a set percentage of payroll, the prior year’s contribution rate could be maintained. Alternatively, the reduction could be limited to a predetermined percentage of payroll.

Finally, because a surplus may be temporary, carefully consider implementing a sudden, sharp reduction in contributions, as budgeting for pension plan contributions often can easily accommodate decreases but subsequent increases can be harder to implement, especially after recent contribution reductions.

Evaluate the impact of benefit enhancements being contemplated

Some stakeholders advocate for benefit enhancements as soon as a plan reaches full-funded status. Experience suggests it may be prudent to resist that pressure. Before the turn of century, many plans rode very strong asset returns to fully funded levels. Subsequent benefit increases (often on past service) that did not account for possible market downturns left some plans poorly funded and with legacy new higher benefit costs as the market corrected.

A surplus-management strategy might specify that certain conditions must be met before benefit enhancements can be considered. It might also recommend that, in addition to performing a cost analysis, the implications be assessed. For example, stress testing under multiple scenarios can help demonstrate the exposure various benefit enhancement scenarios might create for the plan.

Adjust investment strategy to mitigate negative cash flow

Most mature public pension plans, which have many retirees, have negative cash flows, which means they receive less in contributions than they pay out in benefits. When a plan reaches full funding and contributions are likely to fall due to the UAAL amortization component ending, negative cash flows suddenly increase significantly because benefit payments continue to rise. For example, they could increase from 2 percent to 5–10 percent of a plan’s portfolio.

As UAAL payments cease, plans start receiving fewer contributions; investment income becomes a larger share, as a percentage, of the inflow used to pay for benefits and funding. Plans with significant negative cash flow must maintain sufficient liquidity to pay benefits without being forced to sell assets at inopportune times, which could lead to suboptimal investment performance. Failure to plan for liquidity needs can amplify market losses and increase volatility in funded status. Changing the liquidity requirements of the portfolio has implications for strategic asset allocation, timing asset sales and expected long-term returns.

Decision-making tools for setting a surplus-management strategy

As plans move closer to full funding, sponsors should consider taking advantage of some or all of these decision-making tools:

• Stress testing is an analytical process for evaluating performance under various scenarios. As noted above, it can be used to evaluate proposed benefits enhancements. It can also help explore how economic volatility affects required contributions and funding levels as well as assess liquidity.
• Asset-liability modeling (ALM) is a risk-management technique that considers plan demographics, contributions and cash flow. ALM is considered a best practice for integrating decisions on plan assets and liabilities. Increasingly, public plans and their private sector counterparts are using ALM.
• Stochastic modeling uses simulations and probabilities to project a range of possible investment outcomes with estimates of the likelihood they will occur in order to test a wide range of scenarios. Potential ranges of funding results as well as contribution levels can help stakeholders assess how likely certain outcomes are.
• Liquidity tier analysis categorizes investments according to how quickly they can be converted to cash to pay benefits. As public pension plans have increased their allocations to alternative investment to continuously improve portfolio diversification in recent years, liquidity tier analyses and related cash-flow modeling have become important tools in a broadened risk-management framework.

To learn more about these decision-making tools, refer to the National Conference on Public Employee Retirement Systems (NCPERS) guide to Best Governance Practices for Public Retirement Systems, which NCPERS developed in collaboration with Segal Marco Advisors. The guide includes a model framework for risk management.

As plans approach full funding, coordination of governance responsibilities becomes more important

Often, plan sponsors consider the core aspects of plan management — funding, benefits and investments — separately because they require different technical expertise. Yet these areas of focus are intertwined, and as a plan approaches full funding, an integrated approach becomes more important. For example, reducing investment portfolio risk will likely lower the assumed investment return and discount rate, which then lowers the funded ratio.

That’s why coordination between the plan’s actuary and investment consultant is invaluable. Ideally, they will collaborate to ensure they have a shared understanding of the plan’s assumptions, cash-flow needs and risk tolerance.

Having a surplus-management strategy prepares a plan to be in a stable, strong funding position

Sponsors that create a surplus-management strategy covering governance, funding and investing will be well-positioned to sustain success once they reach full funding.

The surplus-management strategy should be reviewed regularly, as the plan’s funding level will fluctuate with investment performance.

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