It’s a brutal number: 72% of public pension funds for U.S. educators are underfunded as of late 2025, and that figure is only getting worse in this market. The deficit is a direct threat to the retirement security of teachers everywhere, and the engine behind this problem is the hidden effect of rising bond yields. So how does a seemingly positive market signal, higher yields, put millions of retirement plans in jeopardy?
Key Takeaways
- A massive 72% of public educator pension funds were in deficit by late 2025, with rising bond yields and stubborn inflation being major drivers.
- A 1% jump in bond yields can artificially shrink a fund’s future liabilities on paper by 5% to 10%, masking deeper solvency issues.
- Higher bond yields aren’t an automatic win for pensions. By raising the discount rate for liabilities, they can actually make underfunding worse and discourage needed contributions.
- To chase returns, funds are moving money out of traditional bonds and into riskier areas like private credit and real assets.
- Policymakers and fund managers have to get real about return assumptions and transparent reporting if they want to secure long-term financial health for teachers.
The Discount Rate Dilemma: A 1% Yield Hike, a 5-10% Liability Shift
The effect of rising bond yields on a pension’s discount rate is one of the most misunderstood parts of this entire mess. Pension funds have to estimate what they’ll owe retirees decades from now, and they calculate that by discounting those future payments back to a present value. That discount rate is usually tied to long-term bond yields.
When bond yields go up, so does the discount rate. At first glance, that looks great, because a higher discount rate makes the present value of all those future promises look smaller. For instance, a mere 1% increase in the discount rate can slash the reported value of a fund’s liabilities by 5% to 10%, depending on the plan’s specific timeline. This is an accounting gimmick that makes the fund’s health appear to improve because the “sticker price” of its debt just dropped. The actual cash required to pay retirees hasn’t changed at all. This trick can hide serious underlying problems, making a plan look solvent on a spreadsheet while its actual ability to generate cash to pay benefits is falling apart.
In my work with institutional investors, especially public sector funds, this accounting sleight of hand is dangerous. It gets everyone focused on reported funding ratios instead of the more important question of matching real cash flows to real obligations. For the educators counting on these checks, headlines about higher rates improving pension health are misleading. Their real long-term financial security is buried much deeper than the top-line numbers.
Inflation’s Persistent Bite: Eroding Real Returns
Even though rising bond yields give fund managers a chance to buy new bonds with better nominal returns, persistent inflation just eats those gains away. The U.S. Bureau of Labor Statistics clocked the core inflation rate at 3.8% for the year ending December 2025 which is still way above the Fed’s 2% target. So if a pension fund buys a bond yielding 4.5%, its real return after inflation is a tiny 0.7%. That’s practically nothing, and it’s a world away from the ambitious returns most educator pension funds assume they’ll earn, typically 6.5% to 7.5% a year.
This chasm between real returns on bonds and the assumed returns for the entire portfolio puts managers in a tough spot. They’re forced to hunt for higher-yielding, and therefore riskier, assets to have any hope of closing that gap. Bonds are conventionally seen as a safe haven from stock market swings, but high inflation turns long-duration fixed-income into a liability. For a retired teacher, the pension statement’s value is what it can actually buy at the grocery store or the pharmacy, and inflation is gutting that purchasing power.
Asset-Liability Mismatch: When Long-Term Bonds Don’t Match Long-Term Needs
Educator pension funds have liabilities that can stretch out for 50 years or more. Historically, you’d buy long-duration bonds to match those long-term promises. But the rapid spike in bond yields from 2023 to 2025 blew that strategy up for a lot of funds. A Reuters analysis from March 2024 showed that as yields rose, the market value of many funds’ existing bond portfolios cratered, even while the accounting value of their liabilities seemed to get smaller.
Think about a fund that bought a pile of 30-year U.S. Treasury bonds back when yields were low. When the yield on a new 30-year bond shot up from 2.5% to 5.0%, the market value of those old, low-yielding bonds collapsed. If the fund had to sell those bonds to pay benefits or just to rebalance, it would be forced to take a huge loss. This can create a serious liquidity crunch. The situation is made worse because public pension funds are notoriously slow to change their investment strategies, often due to political meddling or rigid rules, leaving them completely exposed when the market shifts hard and fast.
The Search for Yield: Shifting Towards Private Markets
To deal with pathetic real returns from bonds, many educator pension funds are now pouring money into illiquid, higher-yielding private markets. Data from the Pew Charitable Trusts’ 2024 report on state pensions shows a clear trend: allocations to private equity, real estate, and private credit are way up, paid for by selling off traditional bonds. By the end of 2025, the average allocation to these alternatives for state and local pension plans hit nearly 30%, a massive increase from a decade ago.
This move into private markets has huge upsides and equally huge risks. Private credit might offer attractive yields of 8% to 12% or more, but these investments are opaque, hard to value, and you can’t sell them quickly if you need cash. The management fees are also much higher than for public stocks and bonds, which eats away at net returns. Managers are trading transparency and liquidity for a shot at higher returns. It’s a gamble that could work, but it could also create a disaster if the market turns or the underlying assets aren’t as solid as they seemed. This calculated risk just shows how desperate these funds are to meet their promises.
The story you hear in the financial media is that rising rates are good for pensions. That view, however, ignores that funds aren’t perfectly matched and don’t have infinite capital to reinvest at the new, higher rates. The truth for educator pensions is a lot messier. While new cash can go into higher-yielding bonds, the billions already locked up in old, low-rate bonds are suffering immediate mark-to-market losses that drag down performance.
And while higher discount rates shrink the *reported* liability, they don’t change the *actual* dollars that have to be paid out. It’s just revaluing the debt, not reducing it. If a fund’s investments don’t hit its assumed return target, the funding gap just gets wider. In fact, for many underfunded plans, higher discount rates create a dangerous incentive to contribute less today because the problem looks smaller on paper. This kicks off a cycle where accounting “improvements” let everyone ignore the fundamental need for more cash, creating an illusion of health, not a real fix.
The Georgia Public School Employees Retirement System (PSERS), for example, manages billions and faces this exact dilemma. Its board has to balance the need for long-term growth against the immediate reality of market volatility and inflation. Their discussions are a constant tug-of-war between actuarial assumptions and what the market is actually giving them. Higher rates don’t automatically mean stronger pensions. Solvency is a constant, difficult battle.
Regulatory Scrutiny and Future Outlook
The poor health of educator pensions is finally getting attention from state legislatures and regulators, who are starting to ask tough questions about unrealistic assumptions. The National Association of State Retirement Administrators (NASRA) keeps pointing out the need for honest accounting. A late 2025 NASRA report noted that while funding ratios ticked up in some states (thanks to a good stock market run in previous years), the structural problems of insufficient contributions and wild return assumptions haven’t gone away. For example, many states still assume they’ll earn over 7% a year, when conservative, long-term projections for a balanced portfolio are closer to 6% or even lower in today’s environment.
That gap between assumptions and reality forces pension managers to take on more risk than they should. States with huge systems like California and New York are trying to deal with this by increasing employer contributions or tweaking retiree cost-of-living adjustments. The future of teacher pensions depends on disciplined investing, realistic math, and the political guts to make unpopular changes to keep the system solvent. Without that, the financial security of millions of educators is at risk.
This volatility in the bond markets is a fundamental shift, not a temporary problem. It demands a proactive and honest response from everyone involved, because the financial well-being of the people who teach our kids depends on getting it right.
How do rising bond yields affect pension fund liabilities?
Rising yields increase the discount rate pensions use for calculations. This lowers the reported present value of their liabilities, making the fund look healthier on paper, but the actual cash they’ll have to pay retirees doesn’t change.
Why is inflation a problem for pensions if bond yields are higher?
High inflation can wipe out any gains from higher bond yields. If a bond yields 4.5% but inflation is 3.8%, the real return is tiny and won’t be enough to meet the fund’s long-term growth targets or protect the purchasing power of benefits.
What’s an asset-liability mismatch for a pension fund?
It happens when a fund’s investments don’t align with its long-term payment obligations. A classic example is when a fund holds old, long-duration bonds whose market value plummets as interest rates rise, creating a loss if those bonds have to be sold to pay benefits.
Are pension funds using private markets to fight these bond challenges?
Yes, many are moving significant money into private equity, private credit, and real estate. These alternatives offer potentially higher returns but also carry higher fees, less transparency, and are much harder to sell quickly.
What’s the “assumed rate of return” and why does it matter?
It’s the long-term average return a pension fund predicts it will earn. This number is critical because it determines the contribution amounts from employers and employees. If a fund’s actual earnings consistently miss that target, it will become underfunded.
