By Evan Powers :

Last week, I wrote a lengthy piece about the various impacts that the Fed's ultra-low interest rate policies (which, of course, continue unabated ) have had on life insurance strategies and assumptions. In setting the stage for that piece, I briefly mentioned the precarious state of many public pension funds, which have felt the pinch of our extended period of low rates, especially given most funds' still-lofty investment return assumptions .

The headlines on the increasing vulnerability of public pensions have been coming fast and furious of late (see here , here , here , and here , for example), but those headlines can also obscure as much information as they reveal. Importantly, no two pension funds are created exactly alike, and laws regarding protections of pension benefits (or a lack thereof) vary widely from state to state .

And since not every dollar is backed by exactly the same "guarantee," it makes little sense to consider all public pension funds in aggregate (at a national level), since there is no organized or centralized national pension fund or guarantor. (Social Security can and will be left to another conversation.)

In essence, each state's funds should be considered exclusively on their own merits, and only in the context of that state's demographics, overall fiscal position and legal framework surrounding pension benefits.

Yes, if a number of public pensions all fail en masse due to an economic or other financial crisis, it stands to reason that there would be a flow-through impact to the national budget, and most likely some sort of federal government bailout. But such an outcome is still several steps away from actually occurring in any meaningful way, and as such, still currently remains in the realm of tinfoil hat conjecture, not realistic analysis.

So, that said, given the headlines, which states are in the most dire straits today, and how can we tell? Is the current public pension situation as bad as some of the statistics say? We'll take a look at a few key metrics to see which states are the most exposed.

Funding ratios

The first step in determining a pension fund's health is to take a look at its funding ratio , or the simple ratio of a fund's assets to its liabilities. Note that a pension does not necessarily have to have a 100% funding ratio in order to be "fully funded" - since a pension is constantly invested in the market, it is actuarially acceptable for a fund to rely upon future investment returns in order to meet its projected liabilities.

Of course, as investment returns have come under pressure in recent years (particularly on lower-risk investments that are historically favored by pension funds), the math and conventional wisdom with respect to appropriate funding ratios have changed somewhat. Traditionally, a funding ratio of 80% or greater was considered reasonable, inasmuch as it generally represented a gap that could plausibly be closed either via investment returns or future excess contributions.

But in current times, the 80% rule of thumb has become a bit like the old 4% withdrawal rate for personal retirement assets - antiquated if not completely obsolete given the historically low levels of interest rates and other investment returns. In our brave new world of persistently low (if not negative ) real interest rates, it's likely that a ratio of closer to 90% should be the new target number, although time will of course tell.

That said, even using the old 80% threshold, a number of public pensions still remain "underfunded," even after the stock market's strong seven-year rally. Indeed, the national average funding ratio for public pensions stands only at about 75% (as of the end of fiscal 2014), and only 19 states reported ratios in excess of 80% (similarly, another 19 states had ratios of 70% or lower).

That Illinois "leads" the list here may come as little surprise - the sorry state of Chicago's pension funds has become a major political issue in recent months, and a consistent news item as a result. In the case of Illinois, the gap is so vast and persistent that increasing contributions to the fund via new taxes is the only realistic option to consider. But for other states, gradual shifts in investment approach have also come into the picture.

Asset allocation

Even as investment return assumptions for pension funds have gradually declined (albeit by only about a half a percent on average), the amount of investment risk accepted by these funds has steadily increased. According to a recent Forbes analysis , the portion of pension fund assets that are devoted to "risky" investments (defined there as equities, real estate, and alternatives like hedge funds and private equity) has grown from 63.9% to 72.3% over the last 15 years, now standing at an all-time high.

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In looking at more granular data from the Census Survey of Public Pensions , I somewhat surprisingly found that there was no clear correlation between funding ratio and investment risk - the portion of assets devoted to "risky" assets was no higher for the 20 states with the largest funding gaps than it was for the 20 states with the best funding ratios (in fact, the "fiscally fit" pension funds had a slightly higher allocation to riskier assets).

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That information could be interpreted in a number of ways: One potential option is that at least a few of those funds that are in the "best" current shape are there because they have embraced risk over the last several years, and have not (yet) been as heavily impacted by the low interest-rate environment. The more conservative funds, on the other hand, may have suffered disproportionately as a result.

Regardless, it's probably important to know where your state stands on the asset allocation spectrum, especially if your state is also in an underfunded state. While an embrace of investment risk may have been a saving grace over the last several years, it could also introduce a massive new vulnerability in a future economic downturn. For funds that are both underfunded and overexposed, any underperformance by risk assets could prove devastating.

Anyone surprised to see Illinois make the naughty list again? Me either. Let's move on.

Number of beneficiaries

Finally, some measure of demographics and scale needs to be considered. Even if a state's pension funds are severely underfunded, it may not matter, as long as the state's tax base is wide and strong enough to easily cover any potential shortfall.

In order to have some idea of demographics, I went back to the census data to determine the percentage of residents of each state that were covered by a public pension. Naturally, the higher the number, the fewer people there will be to help cover any potential gap, so the lower the percentage, the better. This is essentially just another version of the Social Security demographic issue that we're currently facing as the baby boomers retire.

With more people drawing benefits and fewer paying into the system, the fund may have trouble meeting its promised benefits. Similarly, in a state where too many people are on the public dole, there may not be enough non-pension workers to help overcome any funding gap, and a haircut on pension income might be the only viable solution.

So, which states have the highest (and lowest) percentages of individuals covered by a public pension?

For once, Illinois doesn't find itself among the most vulnerable (although at 7.5%, it's still worse than the national average of 6.5%). Among the 10 worst states on this metric, exactly half are above the national average funding ratio (3 are at 80% or better), and half are below-average. Of the 10, only Mississippi was previously listed on my "most vulnerable" list.

Ultimately, every state's pension fund has its advantages and disadvantages. Very few funds are in such dire straits that they have no prayer of working their way out - many of those with low funding ratios have manageable investment risk, or manageable numbers of pensioners, or both. This sort of context is vital to consider when evaluating the strength or weakness of our nation's public pensions.

Are things perfect? Far from it. But with the possible exception of a few outlier states (Illinois, Mississippi, Kentucky and Colorado come to mind), most states' pension funds are in better shape than the litany of breathless headlines would have us believe. Each pension fund has its own pros and cons and potential vulnerabilities, and a more complete understanding of the broader picture is necessary in order to properly assess our so-called "pension crisis."

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