Over the past decade, policy reforms and increased financial contributions have dramatically improved the cash flow situation of some of the nation’s most troubled state pension plans. Thanks to these changes, which include reforms to benefit designs, a commitment to fiscal discipline, and greater monitoring of the financial health of public retirement systems, no state is at risk of pension plan insolvency. Nevertheless, many states still have more to do to ensure the long-term sustainability of pension promises.

As recently as 2016, seven states still had gaps between outgoing benefit payments and incoming contributions that were large enough to cause insolvency if investments fell short of expectations and policymakers failed to react quickly. But by 2018, the number of plans at serious risk of insolvency had dropped to two. And in 2021, no state was below that dangerous threshold, a sign of the significant turnarounds achieved by states such as Colorado, Kentucky, and New Jersey.

However, sustainable pension policy requires more than just paying the bills due today. If a pension plan is meeting current needs but pension debt is steadily growing, future generations of policymakers might have to make unaffordable contribution increases or reduce benefits. From 2002 to 2018, states fell short of minimum funding thresholds by a combined $220 billion, which caused the funding gap to grow in good economic times as well as bad. But after more than a decade of increasing pension contributions—which have risen by 7% annually since 2008—by 2021, states collectively were contributing enough to keep pension debt stable (though not enough to make progress in paying down pension debt). Most states met or exceeded Pew’s contribution benchmarks in 2021, but 21 still had negative amortization, meaning that contributions were insufficient to keep the funding gap from growing.

Although the improvements in states’ fiscal discipline related to pension liabilities are apparent in the cash flow and net amortization data, whether that progress will be enough to ensure long-term sustainability is not yet clear. In 2021, once-in-a-generation investment returns raised the overall state pension “funded ratio” (the share of pension liabilities matched by assets) to its highest level in more than a decade. Recent investment shortfalls and economic uncertainty, however, have erased most of those gains. Successful states with a long track record of stable costs and full funding have demonstrated policies that can weather ups and downs in financial markets. States that have had to play catch-up and still face significant underfunding might have more work to do.

After more than a decade of reform, policymakers have a wide array of proven practices at their disposal to ensure that public pensions are sustainable. Successful states have shown that sound policy can deliver well-funded retirement promises and stable costs using policies and practices such as contributing more than the minimum when times are good to build a buffer against future downturns, having benefits automatically adjust based on the plan’s funding level, and reducing exposure to investment risk.

In addition, stress testing—modeling what will happen under various economic and investment conditions—can help policymakers know whether further reforms are needed and plan for the budget impact of the next economic downturn. States have the tools to prevent runaway pension costs or unfunded liabilities, so should those problems emerge and strain public budgets and balance sheets during a future recession, it will be the result of poor policy choices rather than bad luck.

State pension plans’ cash flow has improved

While successful pension policy must achieve several goals, the most important, clearly, is to avoid running out of money. State and local pension plans are typically pre-funded, with the state and other public employers setting money aside for current public employees and letting it grow in order to pay the promised benefits when those workers retire. In 2021, state pension plans received $128 billion in contributions from state and local governments, school districts, and other plan sponsors (public employers with workers in state pension plans), plus $45 billion from employee contributions. But those pension plans also paid out $260 billion in benefits, resulting in a negative operating cash flow of $87 billion.

State pension plans are able to pay out more than they receive through contributions because they benefit from returns on invested assets that have been set aside to pay for benefits. In 2021, the negative operating cash flow was more than matched by $819 billion in investment returns, thanks to once-in-a-generation investment performance, with the typical pension plan generating a 27% return. Most states assume a 7% return from financial markets, which likewise would have more than offset the negative cash flow with $220 billion in expected gains.

Across the 50 states, the negative operating cash flow in 2021 equaled 2.8% of the assets state pension plans had at the start of the year. Thus, at a minimum, investment returns on those assets had to equal 2.8% or higher to ensure plan assets would have risen. But that’s not the entire story, as liabilities also increase from year to year: Rising assets alone are no guarantee that a pension’s funding is sustainable. And for underfunded pension plans, declining assets can quickly lead to insolvency, forcing either a significant increase in employer contributions to provide benefits on a pay-as-you-go basis or even the inability to send out retirement checks.

Pew began calculating and using operating cash flow (OCF) as a key metric for assessing the health of state pension plans in 2014, relying on data that was newly available as a result of changes in government accounting standards. As shown in Figure 1, the overall operating cash flow ratio for states in 2014 was -3%. That ratio has stayed largely stable in subsequent years.

Pew has identified an OCF ratio below -5% as an early warning sign of potential insolvency, based on the assumption that there is a reasonable likelihood of a plan experiencing a period of lower-than-expected investment performance over a 20-year period in which average returns fall below 5%. In 2014, six states fell below that -5% threshold. By 2021, every one of the 50 states had a cash flow ratio above −5%. This improvement was thanks largely to a significant increase in employer contributions from 2014 to 2021, with an average 6.7% annual growth over this seven-year period. Likewise, benefit reforms, including limits to cost-of-living adjustments in many states, have helped reduce growth in benefit payments, further improving cash flow.

Tracking cash flow on an annual basis can help policymakers detect early warning signs of distress for public pension plans and identify potential near-term worries. As Pew’s data shows, the efforts of state policymakers and fiscal discipline have resulted in real improvements to the cash flow of state pension plans.

States contributed enough in 2021 to keep pension debt stable

Pew’s research into public pension plans dates back to 2007, with the publication of Pew’s first report, “Promises With a Price.” From the beginning, Pew’s research has emphasized the importance of adequately funding pension promises. Although policymakers can and should pay attention to questions of plan design, investment practices, and governance, the lack of consistent, adequate funding will make any pension policy unsustainable. States with a track record of fully funding their pension promises going back to 2003 were 94% funded in 2021 (the average funded ratio among the 18 states that made the full pension contribution, on average, from 2003 to 2021). States that fell short over that period were just 79% funded. As mentioned above, the “funded ratio” describes the amount of money set aside by a state in the past to pay for its current pension liabilities. Thus, if a state previously saved 94 cents for every $1 of current pension liability, it is said to be 94% funded—leaving a 6% gap, which must be funded by future employer contributions to cover benefits already owed.

Pew’s primary benchmark for assessing the adequacy of a state’s pension contributions is called net amortization. Net amortization is calculated as the total amount of money needed to pay for new benefits earned by current employees in a given year and to cover interest on pension debt on the plan’s balance sheet at the start of the year. States where pension contributions exceed this benchmark can expect to see pension debt decline year over year if investments meet expectations and other assumptions hold true. States that fall short of this benchmark can expect to see funding gaps grow over time. For states where contributions hover around the benchmark, pension debt should stay stable over time, neither growing nor shrinking.

Together, the 50 states had positive amortization for the first time in 2020. While not quite able to replicate this success in 2021, contributions remained sufficient to stabilize pension debt. Even so, 21 states had negative amortization in 2021, meaning they can expect their funding gap to grow over time, absent an increase in contributions. The net amortization benchmark relies on data that states began reporting consistently in 2014; when Pew first calculated and reported this benchmark that year, only 17 states had stable or positive amortization, as shown in Figure 2 below. In previous years, Pew had examined whether states were contributing enough to meet their self-reported actuarial funding targets; most were likewise falling short of that benchmark.

In fact, prior to 2020, the most recent year in which states collectively met contribution targets was 2001. Although other factors contributed to the pension problems facing states, nearly 20 years of inadequate funding of pension plans has led to hundreds of billions of dollars in additional pension debt.

The 24 states with positive amortization can expect their funding level to improve over time with the policies they have in place as long as investment returns hit their targets and other economic and demographic assumptions hold true. However, the volatility of investment markets and uncertainty about whether the future will match other assumptions mean that policymakers still need to pay careful attention to measuring and managing risk. Pension plans with stable amortization and full funding may likewise be in a sustainable situation, but stable states that have unfunded liabilities will need a plan to address that shortfall. For the 21 states with negative amortization, maintaining current policies and contribution levels will lead to increasing unfunded liabilities, push the cost of current and past benefits onto future budgets, and create the risk of unsustainable growth in minimum contributions.

What does it mean for a state to have positive amortization? And how can a state end up with negative amortization? Looking at the example of four states—Kentucky, Pennsylvania, South Carolina, and West Virginia—can offer a helpful illustration. As shown in Table 1, below, three of the four had negative amortization in 2014. The state of Kentucky and participating employers would have had to contribute 50% of payroll in 2014 to cover the cost of newly earned benefits (service cost) and interest on $32 billion of pension debt that was on the state’s books when that fiscal year began. Employer contributions instead totaled just 18% of payroll; if not for good investment returns, pension debt would have grown by $1.7 billion in a single year.

Pennsylvania and South Carolina were in a similar position. Pennsylvania would have had to increase pension contributions by 14% of payroll to pay for service cost and interest on pension debt. And South Carolina was falling short by 5% of payroll. But while Kentucky and Pennsylvania faced problems because they were not making the actuarially determined employer contribution in 2014, South Carolina fell short even as it made the calculated contributions, since actuarial calculations can still allow for negative amortization when the actuarial policy is built to push costs off into the future. South Carolina’s new funding policies, put into effect in 2017, will address this problem over time. Kentucky and Pennsylvania have spent the last decade raising contributions to reflect actuarially determined funding, and both are starting to make progress paying down pension debt.

Although Kentucky, Pennsylvania, and South Carolina show how states can stop making problems worse by meeting minimum contribution benchmarks, West Virginia’s situation shows how consistently achieving positive amortization can actually fix past pension challenges. West Virginia’s pension plans have been historically underfunded, with the lowest funded ratio of any state at the turn of the 21st century. But thanks to funding policies designed to pay down debt, its funding gap has been steadily shrinking. In 2014, West Virginia started with $5.2 billion of unfunded pension liability; the state finished 2021 with a funding gap of less than $500 million. West Virginia thus managed to close 90% of its funding gap in just seven years.

Policymakers in many states have committed to making actuarially determined employer contributions to state pension plans and, in states such as South Carolina, have improved how actuarial calculations are made to ensure that pension funds are sufficient to pay for pension benefits. In addition, some states have adjusted benefit provisions and employee contributions to make sure that state and local budgets can sustain the resulting costs. As a result, many states have made substantial progress in moving toward sustainable pension policy. Now most states are on track to meet their pension obligations—if everything goes as planned. But what happens if unexpected problems arise?

States need tools to manage risk from volatile markets

States reported that their pension plans were 82% funded in 2021, meaning 82 cents had been set aside for every dollar that actuaries calculated state plans should have had on hand to pay for promised benefits. This was the highest ratio since prior to the 2007-09 recession. The funding gap closed to approximately $836 billion in 2021, compared with the nearly $1.4 trillion of unfunded liability reported in 2020. Although the reforms and policy changes described above helped states turn a corner and move toward stable or shrinking unfunded liabilities, the scale of the change was driven by financial market gains: The typical public pension plan enjoyed a 27% increase in the value of its assets. Thanks to that boost, pension assets climbed from $3.1 trillion in 2020 to $3.9 trillion in 2021, even as liabilities rose from $4.5 trillion to $4.7 trillion.