Public Sector Pension Inflexibility and Its Impact on Workforce Retention

The U.S. public sector pension crisis has evolved into a systemic risk that transcends retirement security, threatening municipal financial planning and infrastructure investment. As of 2025, unfunded liabilities for public pensions and retiree healthcare have surged to $1.3 trillion, representing 66% of states' own-source revenue in fiscal year 2022, according to a Pew analysis. This underfunding, driven by insufficient contributions, underperforming investments, and optimistic return assumptions, has created a fiscal drag that constrains municipalities' ability to fund critical infrastructure projects and retain skilled workers.

Workforce Retention: A Double-Edged Sword

Public sector pension inflexibility has become a key driver of workforce instability. States experimenting with hybrid pension models-combining defined benefit (DB) and defined contribution (DC) components-have seen mixed results. For instance, Tennessee's shift to a hybrid plan reduced mid-career retention by 4.2% but increased late-career retention by 20.9%, according to Pew research. Conversely, states like South Carolina, which transitioned entirely to DC plans, faced an 8.9% decline in teacher years of service and a 28.5% drop for state workers, findings the study attributed to the DC transition. These trends underscore the fragility of public sector employment in an era of fiscal uncertainty.

The problem is compounded by workforce reductions. Cities like Los Angeles and states such as Louisiana have implemented hiring freezes and layoffs, disrupting payroll growth assumptions used in pension funding calculations, according to a Reason commentary. This mismatch between projected and actual liabilities exacerbates underfunding, creating a vicious cycle where strained pension systems deter recruitment and retention.

Infrastructure Investment: A Casualty of Fiscal Priorities

The fiscal strain of underfunded pensions has directly impacted infrastructure spending. With states allocating larger shares of budgets to pension obligations, projects like wastewater treatment plant upgrades and transportation network repairs face delays or reduced funding, as noted in a Pew analysis. Illinois, New Jersey, and Connecticut-states with unfunded liabilities exceeding 130% of own-source revenue-exemplify this dilemma. For example, Chicago's recent $28 million loan to its Firemen's Annuity & Benefit Fund, reported by The Real Deal, highlights the immediate pressures on municipal liquidity.

The shift toward alternative investments by pension funds, such as private equity and real estate, further complicates matters. While these assets aim to generate higher returns, they introduce volatility and liquidity constraints. California's CalPERS, for instance, has allocated $30 billion to private markets, betting on 12% annual returns compared to 8.9% from public equities, according to a Stanford GSB analysis. However, the complexity and fees associated with managing such portfolios risk deepening underfunding if returns fall short.

Systemic Risks and the Path Forward

The interplay between pension inflexibility, workforce retention, and infrastructure underinvestment creates a systemic risk that extends beyond municipal budgets. As public pensions increasingly rely on private capital markets, concerns about overleveraging and underinvestment in key industries emerge, according to a CFA Institute blog post. For example, the high-interest-rate environment of 2025 offers an opportunity for states to adopt more sustainable funding practices, such as revising accounting standards to reflect true liabilities. Yet, political resistance and the cost of higher contributions or interest rates pose significant barriers.

Cities like Houston face additional pressures from climate-related infrastructure costs, compounding the strain of pension obligations. This convergence of challenges underscores the urgency for holistic reform-balancing pension sustainability with workforce stability and infrastructure resilience.

Conclusion

Public sector pension inflexibility is no longer a siloed issue but a systemic threat to municipal financial health. Addressing it requires rethinking pension funding models, workforce incentives, and infrastructure financing. Without urgent action, the fiscal crisis will deepen, with cascading effects on public services, economic growth, and long-term stability.