Markets have experienced a historically bad year opening. (Richard Drew/Associated Press)

For a year and a half, state and local pensions were improving.

The gap between how much they were presently worth and how much they would someday owe was closing. Fears of a looming crisis were easing. But, in just three months last year, those gains were erased.

An analysis released Wednesday now shows that about  one-and-a-half year's worth of improvements to state and local government pensions were undone in the third quarter of 2015, driven in large part by a stock market slide that summer. The historically bad market start to this year suggests that pension conditions could worsen even more.

[Is the stock market telling us we’re headed for a recession?]

State and local pension fund investments are heavily tied to stocks. So when the market tanks, the gap between a pension's present value and its expected future obligations grows. When that gap — known as the unfunded liability — increases, lawmakers are pressured to get involved.

"When pension investments fall short, government contributions rise, leading to tax increases or spending cuts and sometimes even to cuts in promised benefits for workers and retirees," Don Boyd and Yimeng Yin write in their analysis from the Rockefeller Institute of Government at the State University of New York.

In light of the third-quarter decline, the historically bad market start to the year — the Dow, S&P 500 and Nasdaq are each down more than 9 percent — does not bode well for pensions. Sure, markets can rebound by the end of the first quarter, but the slide means they're starting from behind.

[Markets close rocky trading day down 1 percent as oil prices plummet]

"It's better to be sitting on a pile of money than sitting in a hole trying to dig your way out," Boyd said in an email.

As he and Yin lay out, investment shortfalls over the third quarter of 2015 caused unfunded pension liabilities — that gap between current value and future obligations — to grow by $268 billion, to $1.7 trillion, according to Federal Reserve Board data. In other words, unfunded liabilities ended the third quarter about equal to 9.5 percent of economic output (otherwise known as gross domestic product) for that quarter. That's a 1.4 percentage point rise from the quarter before.


Unfunded liabilities rose in the third quarter of 2015. (Rockefeller Institute of Government)

"It is always possible that good returns will balance out bad returns, and vice versa, but there is no guarantee of that," Boyd and Yin write.

In fact, as they point out, there were more stretches like the third quarter of 2015 than not. Over the past 25 years, unfunded liabilities rose by 1.4 percentage points as a share of GDP in 13 quarters. They shrank by that much in just two quarters, as the Rockefeller chart below shows.


Over the past quarter-century, the biggest changes in unfunded liabilities tended to be for the worse. (Rockefeller Institute of Government)

Quarter-to-quarter changes don't necessarily drive policy, but they do add up.

"If the July-September shortfall were spread over 30 years, it would be roughly equivalent in size to a 3.9 percent surcharge on state and local income taxes for thirty years, or a 15 percent cut in highway capital outlays for the same period," Boyd and Yin write.

The only way to reduce the risk, they argue, is to pay more into the pension funds in the first place — a policy taxpayers may not be able to get behind.

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