In conversations concerning America’s retirement system, one figure is not given nearly enough consideration. According to the most recent estimates, state and local pension funds have unfunded liabilities of about $1.35 trillion, which means they have made far more promises than they actually have. Due in large part to record-high contribution rates, that gap has been gradually closing. However, the size of the hole isn’t the more intriguing—and perhaps more concerning—question. Fund managers have been attempting to fill it in this way.
Leverage is becoming a more important part of the solution. borrowed funds. derivatives. The investment portfolios of pension systems that provide retirement benefits to firefighters in California and teachers in Ohio are now using strategies that were previously exclusive to hedge funds and proprietary trading desks on Wall Street. The Financial Times reported that funds totaling an estimated $1.5 trillion have been increasing risk through these mechanisms. By most accounts, regulators have only partially mapped the exact scope of that exposure, including the amount of synthetic leverage embedded in these portfolios through derivatives and the amount of private equity being carried at valuations that haven’t been stress-tested.
The issue was brought to light in a 2023 report by the Financial Stability Board, a Geneva-based organization that oversees financial supervision in major economies and warned about “hidden leverage” accumulating among non-bank institutions worldwide. The FSB observed that hedge funds were using derivatives to increase exposure without the borrowing appearing as a traditional loan on any balance sheet, resulting in high levels of synthetic leverage. This type of leverage is problematic because it is more difficult to observe and quantify, making it more difficult to control when circumstances worsen. The same dynamic may be at work, albeit more subtly, in pension systems that the majority of Americans believe to be conservatively run.
The discrepancy between the obligation and the assets is what makes this especially uncomfortable. Investors lose money when a hedge fund blows up. Retired firefighters are destroyed by a pension fund that assumes excessive risk. This asymmetry is important, but it appears to be overlooked in the haste to use return-chasing tactics to fill funding gaps. The editorial board of Bloomberg stated unequivocally that borrowing to increase returns is not a means of guaranteeing public employees a comfortable retirement. Reading the available research gives the impression that some fund managers have persuaded themselves that the math is sound. The cooperation of the market is the only factor that determines whether it does.
| Category | Details |
|---|---|
| Topic | Hidden leverage and systemic risk inside U.S. public pension funds |
| Funds Affected | State and local public pension plans across the United States |
| Total Unfunded Liabilities (2025 est.) | $1.35 trillion (down from $1.51 trillion prior year) |
| Average Funded Ratio (2025) | 81.4% |
| Average 2025 Investment Return | 5.41% vs. 6.87% assumed rate |
| Pension Assets Using Leverage | Funds worth approximately $1.5 trillion adding risk through leverage strategies |
| Regulatory Body Raising Alarms | Financial Stability Board (FSB), global financial regulators |
| Key Risk | Synthetic leverage via derivatives, overvalued private equity holdings, undisclosed exposure |
| Notable Commentators | Equable Institute (Anthony Randazzo); Bloomberg Editorial Board; Financial Stability Board Chair Klaas Knot |
| Reference Links | Bloomberg — Public Pensions Should Be Safe, Not Levered Up · Equable Institute — The Persistent Fragility of Public Pension Systems |
They frequently don’t. April 2025 served as a sobering reminder of that. The markets plummeted quickly after the Trump administration unveiled its most aggressive tariff proposals, and public pension funds suffered hundreds of billions in paper losses in a matter of days. According to Anthony Randazzo of the Equable Institute, the majority of managers advised patience. They claimed that long-term investors don’t respond to noise from the short term. Pension funds do have long time horizons, so that argument isn’t totally incorrect. However, it overlooks something crucial. The immediate result of investment losses is increased contribution requirements, which fall on state and local governments already strapped for budgetary space, even if the fund survives a drawdown. In April, the markets did eventually rebound. They might not recover as smoothly or quickly the next time.
The issue of private equity should be given more consideration than it usually is. Private equity, private credit, and real assets make up a sizable portion of many pension portfolios; unlike public stocks, these positions are not repriced on a daily basis. They are valued on a regular basis using methods that may be months or even years behind reality. Funding ratios may appear better than they actually are if these holdings are significantly overvalued in current portfolio reports, as Equable has made clear. It’s hard not to notice the uncomfortable parallel with 2007, when certain mortgage-backed securities were being carried at values that bore increasingly little relationship to their actual market worth.
As I’ve watched this develop over the past few years, a pattern begins to emerge. Systems that fell behind after the 2008 crisis — many still haven’t fully recovered, with an average funded ratio sitting at just 81.4% — gradually shifted into higher-risk strategies to chase the return assumptions they needed to justify their funding projections. The annual average of those assumptions is about 6.87%. The actual returns for the previous year were 5.41%. The shortfall gets quietly absorbed into the balance sheet and the cycle continues.
Regulation has struggled to keep pace, partly because the leverage in question isn’t always visible in standard disclosures. Derivatives-based exposure doesn’t show up the same way a bank loan does. A stock price is updated more frequently than private valuations. Although Bloomberg can write editorials and the FSB can issue warnings, the actual supervisory infrastructure for comprehending systemic risk within the pension sector is still lacking. It’s still unclear if any regulator has a complete, up-to-date picture of the amount of synthetic leverage embedded in the $5+ trillion held by public pension systems in the United States.
The people whose retirement security depends on these funds — the teachers grading papers in Springfield, the paramedics working overnight shifts in Phoenix — are generally not aware that their retirement assets are being deployed in strategies that carry real tail risk. That does not necessarily mean that all investment risk should be removed from pension management. Returns are important. But there’s a meaningful difference between a well-diversified portfolio that accepts market volatility and a portfolio that amplifies risk through borrowed money in pursuit of numbers that may be unrealistic in the first place. That distinction seems worth making, loudly and often, before the next shock arrives and patience is once again the only answer offered.