Unfunded liabilities for U.S. state and local pension plans fell for a fourth year in a row to around $2.5 trillion as of June 30, a plunge of almost 60% from a historic high of $6 trillion in 2020, according to a July 9 report from Moody’s Ratings.

Strong market returns for the latest year contributed to that progress, with investment gains of almost 11% topping public fund target returns of between 6.75% and 7.25%.

But higher interest rates did the heavy lifting over the four-year span, pushing down the present value of accrued benefits.

“Interest rates on high-quality fixed-income securities with a duration similar to governments’ pension liabilities surpassed 5% as of June 30, 2024, the first such June 30 occurrence since 2011,” the report said.

For the latest year, public funds’ steady allocations to risk assets paid off, with double-digit returns for their allocations of roughly 60% to publicly traded domestic and overseas equities more than offsetting a 12% decline on their roughly 10% exposure to real estate.

By asset class, Moody’s estimates showed a 22.1% return on a 36% allocation to large-cap domestic equities; an 8.4% return on a 4% allocation to small-cap domestic equities; an 11.2% return on a 15% allocation to international equities; a 12.5% return on a 5% allocation to emerging markets equity, a 6.5% return on a 10% allocation to private equity; a 2.7% return on a 20% allocation to fixed income and a 12% loss on a 10% allocation to real estate, for a portfolio gain of 10.6%.

While a host of metrics continued moving in the right direction over the past year, heavy exposure to volatile risk assets remains the top pension risk facing governments, the report said.

In contrast to corporate pension plans, which have taken advantage of higher rates to trim exposure to equities in favor of bonds, public funds haven’t moved to insulate themselves, noted Thomas Aaron, a vice president and senior credit officer with Moody’s Ratings, who helped author the July 9 report.

As such, a market decline remains the biggest pension risk facing governments, even if — all other things being equal — a rate cut would add to pressures as well, he said.

Elsewhere, high levels of government contributions to public pension plans now could leave those governments more vulnerable to upward pressure on liabilities from salary increases for active public employees, the report said.

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