What Does Inflation’s New Normal Mean for Public Pension Funds?

September’s Federal Reserve interest rate cut was meant to signal a win in the battle against inflation. With the highest inflationary peak in decades behind us, there was palpable relief at the idea of rates coming down.

That may be especially true for public pension plan participants and plan sponsors. Over the past few years, more retiree groups have pushed for cost-of-living adjustments for their retirement benefits, as inflation eroded pension benefits. Some have been successful at getting ad hoc increases, but those wins have not been widespread, and they are not likely to be enough to contend with a future in which inflation rates hover within the 2% to 4% target range.

According to data from the Equable Institute’s State of Pensions 2024, 878 state and local pension benefit classes lack inflation protection. Some of them have received recent ad hoc COLAs to help deal with this, but without government action, participants in these plans will see their benefits erode over time.

That reality is pushing some governments to reconsider how benefits are structured. But making a change to COLAs or plan structures in general—especially for public plans—is not easy. Underfunded plans may not have the money to institute a COLA, which is paid up front, and they may be wary of creating additional unfunded liabilities.

Calculated Guessing

What makes COLAs so challenging to implement?

If a plan is integrated with Social Security, the Social Security portion is fully indexed to inflation so plan participants get something, as seen last week, when the Social Security Administration announced a 2.5% COLA for beneficiaries in 2025. But when it comes to the plan itself, plan sponsors and actuaries are essentially making calculated guesses about what inflation is likely to be in the future. Once those estimates are acted upon, they are hard to correct.

“I started doing actuarial work in the late ’90s, and we just kept getting more and more good news,” says Dan Doonan, executive director of the National Institute on Retirement Security. “The market was going up, my plan’s funding ratio kept going up, and it felt like we were on the right track. But then the Great Recession hit and caused a reevaluation. Many plans cut their COLAs in response to the drop in [interest] rates because it was an immediate cost savings, and now they are discovering that there are problems with that in today’s environment.”

Todd Tauzer, a senior vice president and actuary at Segal, says some pensions have accounted for this by using a strategy called COLA banking, whereby the COLA tracks inflation up to a cap, and anything over the cap gets banked. When inflation drops, the plan can draw from the bank to offer a COLA in lower-inflation years as a means of catching up.

Other plans have a COLA that was locked in at a lower rate and may not be fully indexed to current inflation levels. Some plans offer participants the option to self-fund a COLA via an annuity during retirement—but that can be expensive.

“Broadly speaking, the takeaway here is that plan sponsors generally look at COLAs as a means of helping to maintain purchasing power, but few of them offer a COLA that is going to keep that purchasing power at 100%, no matter what,” Tauzer says.

Ad Hoc Options

Over the past few years, more plans have offered ad hoc COLAs in response to the spike in inflation. Ad hoc COLAs are typically one-time increases, although they can be repeated.

Retiree groups have had some measure of success with pressure campaigns to get an ad hoc COLA, but they have to be paid when they are issued, which means funding either needs to be set aside or a funding strategy must be put in place to cover the cost.

Alex Brown, a research manager at the National Association of State Retirement Administrators, says plans are getting better at doing these; they had a history of creating unfunded future liabilities. Still, they are not easy to issue during high-inflation periods.

“An ad hoc COLA typically requires legislative approval or investment board approval, and that can be hard to do,” he says.

Curves Ahead

Looking ahead, if the U.S. settles into a 2% to 4% annual inflation rate, plan participants that do not have much in the way of inflation protection could see a material difference in the level of purchasing power provided by their benefits over time. This could be compounded for participants in newer classes of a pension plan, especially if that plan has taken steps to cut costs in the past.

Brown says many states have rules, laws or constitutional protections in place that any changes made to a retirement system can only be applied prospectively, rather than retroactively. That means there can be discrepancies between the benefits available to participants, depending on when they joined the plan. This helps the plan cut costs over time by accruing lower liabilities, but it can create headaches going forward.

Illinois is one example. A 2010 pension reform law cut the benefits for new classes so low that some participant advocacy groups say they are now below fiduciary suitability standards. Illinois Governor J.B. Pritzker has said that these rules need to change, but the system is underfunded, and changing those classes now would be a retroactive change. It is unclear where funding would come from or how any changes would be structured.

Other states, including Wyoming and Kentucky, have announced they will not add COLAs until the plan reaches a designated funding threshold. Brown notes that those plans are underfunded to such a level that “participants are unlikely to see much, if any, inflation protection for the foreseeable future.”

COLAs are also at the center of an ongoing fight within the State Teachers Retirement System of Ohio. As CIO recently reported, STRS Ohio has been rocked by pressure from reformers to move many investments to index funds and increase the COLA. The fund had suspended COLAs between 2017 and 2022 as a result of significant unfunded liabilities. At the end of fiscal 2022, the pension funding ratio stood at 78.9%, and the plan reinstated the COLA without applying it to the years it was suspended. Both the governor and state supreme court have stepped in at various times during the fight, removing and reinstating trustees, and Aon, the retirement system’s investment consultant, dropped the system as a client. The permanence of the COLA and the structure of the investment portfolio going forward are still very much in question.

Participants in all of these plans will have to lean on their investments and Social Security to maintain purchasing power. Doonan says that leaving it up to the participant ends up being the solution all too often.

“There’s a lot of talk about plan sponsors reducing their risk, but the risk doesn’t really get reduced—it just gets transferred,” Doonan says.