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

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.

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