Policy and Budget Outlook: What’s Ahead for Public Pensions in 2026

Pensions at a Turning Point

Public pension systems in the United States, which provide retirement security for millions of state and local government employees such as teachers, firefighters, and police officers, have seen their financial health improve markedly in recent years. Driven by robust investment returns, the average funded ratio—the share of promised benefits covered by assets—reached over 80% in fiscal 2025, a level not seen since before the 2008 financial crisis and up nearly 10 percentage points since fiscal 2022.

This upward trajectory is expected to persist into fiscal 2026, with market performance suggesting sustainable gains toward 81% funded status when audited results for periods ending June 30, 2025, are reported. Strong equity markets and returns exceeding the typical 7% assumed rate have generated actuarial gains, reducing the need for immediate contribution hikes from employers.

Yet the improvement masks vulnerabilities. Public plans have increasingly shifted toward alternative investments, particularly private equity and private debt, to chase higher yields in a low-return environment. While these assets can boost long-term performance, they introduce greater volatility and liquidity risks, making required contributions harder to predict and potentially amplifying budget strain during downturns.

Another underappreciated pressure comes from rising workplace disabilities since 2020, a trend showing no signs of abating. Higher disability claims directly increase pension liabilities and costs, adding to fiscal burdens at a time when many states still grapple with legacy underfunding.

The most politically charged risk lies in the temptation to unwind reforms enacted after the 2008 recession and subsequent market shocks. Those changes—higher employee contributions, reduced benefit formulas for new hires, and shifted retirement ages—helped stabilize systems but imposed sacrifices on workers. With funded ratios improving and employees bearing the costs of past shortfalls, unions and affected members are gaining influence on pension boards and in legislatures, raising the prospect of benefit expansions or reform rollbacks. If acted upon prematurely, such moves could quickly erode gains and return governments to the cycle of rising pension costs crowding out other priorities.

Federal fiscal dynamics add another layer. The Congressional Budget Office projects a $1.9 trillion deficit in fiscal 2026, with debt climbing to 120% of GDP by 2036, limiting room for new federal support to states and heightening scrutiny on all mandatory spending, including indirect effects on public retirement systems.