Debt woes: Can Illinois (or your state) avoid becoming the next Greece?

Illinois ranks at the bottom of a new listing of states ranked by fiscal difficulties, as its governor and lawmakers grapple over how to balance the state’s budget and manage pension reform.  

America may not be the financial equivalent of Greece, but states including Illinois and New Jersey are on a path that may justifiably evoke that incendiary comparison.

And their troubles may be merely the leading edge of larger challenges: Six years after the recession’s end, many US states are still in fiscal trouble, according to a new report released Tuesday by the Mercatus Center at George Mason University in Arlington, Va. In many cases, pension liabilities are a significant burden that could force a reckoning – not this year but in the not-so-distant future.

The report’s 50-state ranking, coupled with parallel headlines of distress out of Springfield, Ill., and Athens, raises a question: What must US states do to avoid becoming the next Greece?

The comforting side of the answer is that not all US states are in deep fiscal trouble. Experts differ on how deep the problems are, but not even Illinois is facing the kind of bond-market turmoil that surrounds Greece, amid uncertainty over whether that nation will slide into a chaotic debt default and exit from the euro currency union.

Still, Illinois stands as a poster child for risks that could arise over time in numerous US states and localities that have promised more than they have funded in public pensions. In Springfield, Gov. Bruce Rauner (R) is in a standoff with the Democratic legislature over how to balance the state’s budget while reforming public pensions. Talk of a possible state-government “shutdown” has risen as the state entered a new fiscal year on July 1 without a budget.

Illinois ranks at the bottom of the new ranking of states in the Mercatus Center report. And its path toward long-term fiscal solutions looks rougher than that of most states, because Illinois has unusually strong constitutional protections for state workers against pension cuts. (Governor Rauner has proposed a constitutional amendment to pave the way for reforms.)

Whether in Illinois or in other states, the basic options to deal with pension shortfalls are similar: find ways to reduce pension obligations (for future or in some cases current retirees), ask public workers to fund more of their benefits out of their own pockets, or bolster funding from the outside through new tax revenues or general-budget cuts.

“The solution to this issue is going to have to be some kind of shared pain,” predicts Joshua Rauh, a Stanford University finance expert. The answers, he says, will vary by state based on “what is legal and what is palatable.”

Fiscal experts don’t all agree on the scale of the problem. Where Mr. Rauh says the magnitude of the pension problem alone is enormous – a nationwide challenge much larger than states acknowledge in their official reports – some others argue that pensions and long-term finances more generally are manageable for the vast majority of states. (Even Illinois can borrow money at high but not astronomical rates of interest.)

Still, both camps in this debate see a need for action and for shared sacrifice to put states on a sound footing.

“You need a balanced solution” on pensions, which could mean part from current employees, part in benefit adjustments, and part from a state’s general fund, says Liz McNichol, a senior fellow at the liberal Center on Budget and Policy Priorities in Washington.

The Mercatus Center report seeks to make state fiscal challenges visible in one ranking. In general, states with low debts and a natural-resource base, such as public revenue from the oil industry, rank high in fiscal health (the top five are Alaska, North Dakota, South Dakota, Nebraska, and Florida).

At the bottom of the list is Illinois, followed by New Jersey, Massachusetts, Connecticut, and New York. California joins Kentucky in narrowly escaping bottom-five status.

The ranking merges several gauges of state health, from pension liabilities, public debt, and other long-term obligations to the extent to which states are already tapping much of their potential tax base.

Is the overall outlook alarming?

The answer may hinge on whether states are making realistic accounting assumptions. On the more pessimistic side, analysts like Rauh say a fundamental flaw in state budgeting is to assume roughly 7.5 percent returns on money invested in pension funds.

“We've had a remarkable period” during which such returns have materialized, he says. But looking forward, Rauh doubts such returns are reasonable to bank on.

If his view is correct, the unfunded pension liabilities for states now total about $4 trillion, compared with an officially acknowledged total of roughly $1 trillion.

“There are more states than you would expect that need to do something” to fix their finances, says Eileen Norcross, the Mercatus senior research fellow who wrote the new report.

Others are more optimistic about the current state of pension funds – and hence of state budgets overall.

“On average, the pension contributions are a fairly small piece of state budgets,” about 4 percent of total state and local government spending, says Ms. McNichol. Even if funding payments need to go up, pensions are “generally not the thing that makes or breaks state budgets.”

By the commonly used accounting methods, state and local public pensions had an assets-to-liabilities ratio of 74 percent in 2014, up from 72 percent in 2013, according to data tracked by Boston College’s Center for Retirement Research.

Still, the pension shortfall comes at a time of overall uncertainty for state budgets.

Tax revenues have recovered since the recession, but some 27 states have less purchasing power (adjusted for inflation) than they had six years ago, says Barb Rosewicz, a state fiscal expert at the Pew Charitable Trusts in Washington.

This leaves states struggling as they look toward future needs, with the number of retirement-age Americans on the rise.

Demand for spending on pensions and health care is rising even as “you need to be investing in education and transportation and other things that states care about in order to grow their economies,” McNichol says.

Some analysts say more states may feel impelled to consider changing from a “defined benefit”-style pension toward the “defined contribution” or 401(k)-style plans that have become common in the private sector. Another option is some hybrid of the two systems.

US states, for the most part, aren’t in Greece-style chaos. But they aren’t on easy street, either.