States cap workers benefits to reduce shortfalls: Is your pension fund at risk?

States' pension fund holdings are short $1 trillion. Illinois's answer: Cut benefits for state workers. But even that might not be enough.

The funding crisis that will eventually hit Social Security is coming much sooner to a state near you.

The ravages of the recession combined with chronic underfunding have created a $1 trillion shortfall, by one estimate, and threaten to undermine the pensions of state workers around the United States within the next 15 to 20 years. The probable results in many states: fewer guaranteed benefits for new state workers and either more taxes or fewer services.

"These are not politically attractive options and not necessarily economically attractive options, but for the last 30 years state governments have been more than happy to pay money for stuff they don't have, and someone has to foot that bill," says Jeff Brown, a former economic adviser in the Bush administration and a finance professor at the University of Illinois at Urbana-Champaign. "There's no way to get around it."

With the worst-funded pension system in the nation, according to the Pew Center on the States, Illinois is a now a testing ground for how to fix the problem.

The challenge is large. In June 2009, accrued liabilities reached $126 billion, $62 billion of which was underfunded. In December, a state commission put the underfunded amount at $77.8 billion.

In April, Illinois Gov. Pat Quinn signed a reform bill that he said would stabilize pensions and save taxpayers $200 billion over almost 35 years. The measure hikes the retirement age to 67 and caps pension benefits. Anything state workers earn above $106,800 won't be included in pension calculations.

But there's a catch: The reforms only apply to new hires starting January 2011. It's a dilemma for states around the country. How much will state governments really cut and how much of the problem will they merely push onto the shoulders of the next generation of workers?

Illinois reforms too tepid?

In Illinois, critics say the reform doesn't go far enough.

The bill offers steps in the right direction but does "nothing to address the immediate crisis for how the state is going to pay for the pension funds this year," says Laurence Msall, president of the Civic Federation, a nonpartisan tax policy think tank in Chicago. He says the state needs to increase the contribution requirements for existing employees to help steady a problem that, if not addressed seriously within the next decade, may lead the state into bankruptcy.

"At the end of the day, the size of the liability is so large it is only going to be major structural changes in the existing funding structures that can help stabilize Illinois's finances," Mr. Msall says.

Changing the pension rules on existing state employees is a political risk, which is why it is hardly broached by legislators who are also beneficiaries of the system. For some states, the solution is not tenable because the pensions are guaranteed by state law.

Veteran employees have the most protections, either because they live in a state where their pensions have a constitutional guarantee or because state courts have established them as a right under common law. Either way, says Professor Brown of the University of Illinois, the courts have legally bound states to keep those pensions intact. So if state money dries up, lawmakers will be forced to make draconian cuts or order big tax hikes to make up the difference. Lawmakers would likely turn to retiree healthcare next, which is not constitutionally protected.

"There are a lot of ways to do this without simply saying, 'Hey, your pension's gone.' Legally or politically, I can't see [a pension cut] happening," he says.

One way around state constitutions

State constitutions do provide one emergency option for governments to back out of their pension obligations, according to Amy Monahan, a professor at the University of Minnesota Law School who specializes in employee benefits. States have "police powers," she points out, which give them fundamental rights to protect the welfare of their citizens in a crisis, which in this case would allow a legal "out" in providing benefits. But when and how they could be applied is still in question because they have yet to be tested in court. "It's a big unknown," Ms. Monahan says.

The public sector workers under the most threat are new hires at the lower end of the pay scale, such as road crews or janitors, who have less mobility than higher-paid professionals.

"If you're a state worker, you don't have much recourse if your pension is reduced. They're in a worse situation," says J. Fred Giertz, an economics professor at the University of Illinois at Urbana-Champaign and an elected member of the State Universities Retirement System board of trustees.

Past reform measures have not kept pension funds from losing value, especially when state lawmakers don't follow through on promises to make up for previous shortfalls. In 2000, over half of states fully funded their pension systems, according to a 2010 study by the Pew Center on the States. By 2008, only four states had: Florida, New York, Washington, and Wisconsin. That's why the pension shortfall now stands at an estimated $1 trillion nationwide and is growing, Pew says.

One answer: a 401(k) for state workers

A possible solution may be to make the same change in public pensions that the private sector has largely already made. Instead of traditional pensions, which guarantee a fixed payment, states could fund 401(k) type retirement plans that only guarantee the level of pension contributions. In this scenario, the investment risk shifts to the employees.

Despite resistance from public-sector unions, more states will be looking at this type of system as state economies worsen, says Peter Zaleski, a professor of economics and statistics at the Villanova School of Business, outside Philadelphia. "I'm all for [pensions] if states are responsible enough to fund them. But the problem is they haven't been."

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