Pensions are funded from three sources: contributions from the employer, payroll deductions from the employee, and investment returns on the money already in the fund. Of those three, investment earnings do most of the work. In public plans, roughly 60 to 65 percent of every dollar eventually paid to a retiree comes from investment returns, with employer and employee contributions splitting the remaining 35 to 40 percent.1National Association of State Retirement Administrators. Investment That ratio surprises most people. The markets, not the payroll department, are the primary engine behind a pension check.
Investment Returns Do Most of the Work
Contributions are the seed money. Investment returns are what grow the fund into something large enough to pay decades of monthly checks. Pension portfolios are spread across domestic and international stocks, government and corporate bonds, real estate, and private equity. The exact mix depends on the plan’s time horizon and risk tolerance. A plan with a young workforce and decades before peak payouts can lean heavier into equities. A plan already paying out more than it takes in needs more stable, income-producing assets like bonds.
As plans mature and more participants reach retirement, many funds shift toward liability-driven investing. Rather than chasing the highest possible return, the strategy matches the timing of investment income to the timing of benefit payments. That might mean loading up on long-duration bonds whose cash flows line up with projected retiree checks over the next 20 years. The trade-off is lower overall returns in exchange for less risk that a market crash will leave the fund unable to meet immediate obligations. Too aggressive and a downturn can crater the funded ratio; too conservative and the fund slowly falls behind its liabilities.
Where Employer Money Comes From
Private-sector employers that sponsor defined benefit pension plans are legally required to contribute enough money each year to meet minimum funding standards. Under 26 U.S.C. § 412, the employer must put in at least the minimum required contribution that actuaries calculate for that plan year—the amount needed to keep the plan on track to pay every promised benefit.2Office of the Law Revision Counsel. 26 USC 412 – Minimum Funding Standards Those contributions are tax-deductible under 26 U.S.C. § 404, which lets the company reduce its taxable income by what it puts into the pension trust.3Office of the Law Revision Counsel. 26 USC 404 – Deduction for Contributions of an Employer to an Employees Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan
Federal law also requires that pension assets be held in a separate trust, never mingled with the company’s general accounts. Under 29 U.S.C. § 1103, those assets must be held exclusively to pay benefits and cover reasonable administrative costs, and can never benefit the employer.4Office of the Law Revision Counsel. 29 USC 1103 – Establishment of Trust That separation is what protects retirees if the sponsoring company goes bankrupt. The pension money sits in its own legally shielded pool, out of reach of the company’s general creditors.
Multiemployer plans, sometimes called Taft-Hartley plans, work a little differently. Instead of a single company funding the plan, multiple employers in the same industry contribute based on collective bargaining agreements. A typical formula might require a fixed dollar amount per hour worked by each covered employee, with payments due monthly.5Pension Benefit Guaranty Corporation. Introduction to Multiemployer Plans
Public Sector: Taxes and Appropriations
Government pensions draw from different wells. The employer contribution comes from the public treasury, which means it ultimately flows from tax revenue: income taxes, sales taxes, property taxes, or some combination. Some jurisdictions dedicate a specific revenue stream to pension funding by statute, such as a fraction of a sales tax earmarked solely for reducing unfunded liabilities.6National Association of State Retirement Administrators. Funding Policies Others fund pensions through annual legislative appropriations that compete with every other budget priority.
That budget competition is where things get politically difficult. Unlike a private employer facing IRS excise taxes for underfunding, a state legislature can simply appropriate less than the actuary recommends and face no immediate federal penalty. The long-term cost of that decision shows up years later as a ballooning unfunded liability that future taxpayers inherit. This dynamic is why some public plans sit well above 90 percent funded while others hover below 50 percent.
Pension Obligation Bonds
Some governments have turned to borrowing as a funding strategy, issuing taxable bonds and investing the proceeds in the pension fund. The bet is straightforward: if the pension fund earns a higher return than the interest rate on the bonds, the government comes out ahead. When it works, it can meaningfully reduce unfunded liabilities. When it doesn’t, because the bonds were issued just before a market downturn, the government is stuck making fixed debt payments on bonds while facing a pension fund that has lost value. A study of bonds issued between 1992 and 2014 found an average real return of just 1.5 percent across the full period, with results swinging wildly depending on market timing. Bonds issued at stock market peaks frequently produced negative returns.
Where Employee Money Comes From
Many pension plans, especially in the public sector, require employees to contribute a percentage of each paycheck. Those mandatory deductions typically run between 4 and 8 percent of pay, though some plans sit outside that range.7National Association of State Retirement Administrators. Employee Contributions to Public Pension Plans Nearly all state and local government workers share in the cost of their pension. That contrasts sharply with most private-sector defined benefit plans, where the employer funds the entire benefit.
The steady payroll stream does more than accumulate savings. Because deductions arrive every pay period, fund managers can rely on that cash flow to pay current retirees without selling long-term investments at bad moments. A pension fund that has to liquidate stock during a market downturn to cover monthly checks erodes value for everyone still in the system.
In many government plans, employee contributions receive favorable tax treatment through what’s called an “employer pick-up” arrangement under IRC § 414(h)(2). The government employer formally designates the employee’s contribution as an employer contribution, which means the money goes in pre-tax and reduces the worker’s taxable income for the year.8Internal Revenue Service. Employer Pick-Up Contributions to Benefit Plans For the pick-up to apply, employees cannot have the option to take the money as cash, and the arrangement must cover all employees in the same class.
The Rules That Keep Contributions Honest
Behind every contribution schedule is an actuary running projections: how long participants will live, when they’ll retire, what investment returns the fund can realistically expect, and what all of that means for the money needed today. The result is the plan’s funded ratio, calculated as current assets divided by projected liabilities. A plan at 100 percent has enough on hand to cover every dollar it has promised. The national aggregate funded ratio for public plans was about 77 percent as of 2024.
Federal law sets the floor for how much must go in each year. Under ERISA, 29 U.S.C. § 1082 requires defined benefit plans to satisfy minimum funding standards. Single-employer plans must contribute at least the minimum required amount calculated under statutory formulas. Multiemployer plans must contribute enough to prevent an accumulated funding deficiency.9Office of the Law Revision Counsel. 29 USC 1082 – Minimum Funding Standards
If an employer falls short, the consequences escalate quickly. The IRS imposes an excise tax of 10 percent of the unpaid minimum required contribution for single-employer plans. Multiemployer plans face a 5 percent tax on the accumulated funding deficiency.10Office of the Law Revision Counsel. 26 USC 4971 – Taxes on Failure to Meet Minimum Funding Standards Those penalties are designed to hurt enough that employers treat pension funding as a non-negotiable expense rather than something to defer when cash is tight.
The Pension Protection Act of 2006 tightened the rules further. It required single-employer plans to reach a 100 percent funding target over time, meaning the present value of plan assets should equal the present value of all accrued benefits.11Pension Benefit Guaranty Corporation. FAQs – Plan Funding Plans that fall below certain thresholds face restrictions: they may lose the ability to pay lump-sum distributions, and the sponsor may be barred from increasing benefits until funding improves.
The Federal Backstop for Private Plans
When a private-sector pension plan fails, the Pension Benefit Guaranty Corporation steps in. PBGC funds itself through insurance premiums paid by plan sponsors, investment income on those premiums, and recoveries from the assets of failed plans. It does not use taxpayer money for its single-employer or multiemployer insurance programs under normal operations.12Pension Benefit Guaranty Corporation. How We Operate Every single-employer plan pays a flat per-participant premium, and underfunded plans pay an additional variable-rate premium tied to the size of their unfunded vested benefits.13Pension Benefit Guaranty Corporation. Premium Rates That variable rate creates a direct financial incentive for employers to keep their plans well funded.
When a plan terminates without enough money, PBGC pays benefits up to a legal maximum that varies by retirement age. Workers with benefits above that cap lose the excess. PBGC covers private-sector plans only. State and local government pensions have no federal insurance backstop, which is why their funded status matters more directly to participants.
How to Check Your Own Plan’s Funding
You don’t have to take anyone’s word for how well your pension is funded. Private-sector plans must send participants an annual funding notice within 120 days of the plan year’s end. The notice includes the plan’s asset value, its liabilities, the funding percentage, and a breakdown of how assets are invested. Under updated SECURE 2.0 rules, these notices now show what percentage of promised benefits could be covered by current assets.14U.S. Department of Labor. Field Assistance Bulletin 2025-02
Plan sponsors also file Form 5500 with the Department of Labor annually, including a Schedule SB with detailed actuarial data: assets, liabilities, interest rate assumptions, contribution amounts, and funded status compared to the prior year. These filings are public records. If your annual notice looks thin on detail, the Form 5500 gives you the full picture. For public-sector employees, equivalent data is usually published in your retirement system’s annual financial report, often available on the system’s website.