* Funding gap in 109 state pensions swells to $834.2 bln * 95 percent of plans underfunded * Average plan has funding ration of 68 pct * Managers up exposure to alternative assets By Edward Krudy NEW YORK, March 3 (Reuters) - The recovery in the U.S. state pension system suffered a setback in 2012 as the huge funding shortfall in a large swath of state pensions swelled more than 20 percent, interrupting two years of improvement following the devastation of the financial crisis. The shortfall in 109 of the nation's state pension plans, which guarantee retirement for millions of public workers such as police, firefighters, and teachers rose to $834.2 billion in 2012, up from $690.3 billion the previous year, according to a new report by Wilshire Consulting, a unit of independent investment management firm Wilshire Associates. The report highlights the uphill struggle faced by many of the state pension plans nationwide and is a reminder that financially strained state governments will have to make some tough choices in order to make up the shortfall. It also shows state pension fund managers are continuing to up their exposure to less conventional assets such as real estate, private equity, hedge funds and commodities as they try to boost their returns and diversify away from over exposure to volatile equities. "The hit that was taken through the global financial crisis was significant and now they are on the road to looking at recouping that over the long term," said Steven Foresti, head of investment research at Wilshire. "But it will require without question significant contributions and adequate investment returns." Collating timely data on state pension systems is hard as they report with different time frames. Wilshire's report focuses on 109 funds that reported data as of June 30 last year, and uses prior data for another 25 plans that reported earlier. Wilshire notes that in the use of any sample there is the chance of statistical error and although the 109 funds with 2012 data are a sizable majority of the state plans in the survey, there will be a degree of variance from the entire plan cohort. Sticking with the 109 plans, in 2007 before the financial crisis struck, state pension plans were 93 percent funded, up from being 81 percent funded in 2002 as stock markets rallied. In 2012 the total market value of their assets amounted to 69 percent of their liabilities, down from 73 percent in 2011. Although that is much better than during the aftermath of the financial crisis when the funding ratio plummeted to 61 percent in 2009, the move in the wrong direction is a concern with levels still way below where they need to be. A healthy funding ratio is considered 80 percent or above. ARE MANAGERS TOO OPTIMISTIC? The length of time it takes pensions to report means Wilshire's analysis is necessarily backward looking. The authors point out that the swelling shortfall is due to market volatility in the 12 months leading up to June 30 last year when most funds reported data. That was when the euro zone crisis was at its worst. Following strong performance in markets since then the pension are probably in better shape now, they said. Still, given the bumpy ride that appears to be a feature of today's markets, the report is likely to reignite debate about whether managers are too optimistic when forecasting returns. Wilshire estimates that the median state pension fund can expect an annual return of 6.9 percent. That is much less than the current median rate of 7.8 percent that pension use as long-run expected returns. The report's authors acknowledge that their more modest assumptions assume risk-adjusted market returns and do not allow for higher returns that could be added by active money management. They also use a time horizon of 10 years rather than the 30-year time horizon that pension forecasters often use. Even so, a closer look at the number reveals the scale of the task that many state pensions face. Of 109 state plans, 95 percent are underfunded, with asset values less than their liabilities. The average underfunded plan has a ratio of assets to liabilities of just 68 percent. The problem varies greatly across plans. Nine have assets with a market value less than 50 percent of their liabilities, 62 plans have less than 70 percent of liabilities and 81 plans have assets less than 80 percent. Wilshire's report does not list individual plans although that data is publicly available. The report shows managers continued to ditch U.S. equities last year in search of yield and diversification. Exposure to the asset class fell 13 percent through the middle of last year and total U.S. equity exposure across the plans stood at 28 percent, down from 41 percent since 2007. The money coming out of U.S. equities has been flowing into non-U.S. equities, real estate, private equity, and other investments such as hedge funds and commodities. This may be an attempt by fund managers to increase their exposure to more leveraged investments in an effort to meet return targets or reduce volatility across the fund by diversifying assets, according to the report. "They all recognize that there will be short periods of time when that risk works against them but if they have the liquidity to stay in those positions and returns are adequate over the long run that will have the most emphasis in terms of what level of contributions will be required," said Foresti.