Paying Down a Trillion Dollar Bill

Imagine getting a bill for $1 trillion, or maybe one that is over $3 trillion, with a due date of something in the next 30 years.

Even if you don't need to pay it right now, it will overshadow every financial decision you will make for the next 10, 20, or even 30 years. This is a situation faced by the 50 states whose pension funds are underfunded by $1 to $3 trillion, depending on whose estimates you believe.

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Underfunded pensions are one-half of the fiscal crisis facing so many of the states. The other half is shorter-term in nature.

Many states face huge budget gaps for the upcoming fiscal year because tax receipts have declined, costs are up and federal aid is winding down. States have responded to the near-term crisis primarily by cutting costs and raising taxes, and in some cases, like New Jersey, not making annual contributions to their pension funds, choosing instead to use the money to cover near term expenses.

Deciding not to make an annual contribution to a state pension fund is one reasons so many state pension funds now have a shortfall, the others being aggressive estimates on investment returns, and a flat performance by the stock market over the last ten years.

"States need to put together a sustainable, rational, well-thought out, affordable pension program," says Chris Mier, a managing director and municipal strategist at Chicago's Loop Capital.

Municipal Bond Maze - See Complete Coverage
Municipal Bond Maze - See Complete Coverage

According to a February, 2010 report titled "The Trillion Dollar Gap", the Pew Center on States said as of fiscal 2008, states had promised $3.35 trillion dollars in pension, health care and other retirement benefits to their current and retired workers, but had only $2.35 trillion dollars on hand to pay for these obligations.

The $1 trillion gap sounds bad enough, but others say it is even larger. Northwestern University Associate Professor Joshua Rauh estimates the underfunded pension liabilities for state and local employees are closer to $3 trillion. Whatever enormous number you believe, it's not immediately threatening to state finances, according to municipal analyst Matt Fabian.

"The pension funding issue is a long term problem," said Fabian, a managing director at Municipal Market Advisors. "You know it's something that will be handled in the long term, so more gradual movements over the next twenty years should be more than enough to handle the funding of retiree benefits."

According the the Center for Budget and Policy Priorities (CBPP), only 3.8 percent of a state or locality's operating budget goes to funding pension funds. One solution to bridging the gap between future benefits and current contributions would be to raise the states' contributions.

Many see this move as unlikely as it would take funds from other services provided by the municipalities. So states are taking or considering other steps raising the retirement age, cutting future benefits for current employees, or asking employees to contribute more of their own money to their pensions.

States have little choice but to put more of a burden on current employees, says Don Boyd, a senior fellow at the Rockefeller Institute of Government. Cutting benefits for future employees has little immediate impact on the funding problem and cutting pension payments to retirees is almost impossible given pension payments are protected by states' constitutions.

"In the broad middle, raising employee contribution rates is going to be a significant part of the solution," Boyd says.

As for giving less to current retirees, it's an option that's been legally explored, but has yielded little success. When it comes to retireess, states can cut benefits other than pensions, whether it be eliminating cost of living increases or asking the retirees to shoulder a bigger share of their health care costs.

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States can also hope for improving investment returns. They account for 60 percent of public pension funds' sources of revenue. The other two sources are employer contributions (27 percent) and employee contributions (13 percent), according to the CBPP.

Stronger returns would mean more money in the pool, but many experts argue one of the reasons pensions are underfunded right now is because states overestimated how much these pensions investments would return. They advocate lowering the estimates from what is typically an 8 percent expected return.

The sooner states take action to address this, the better off their future residents will be. pension payments and payments on a states' general obligation bonds have first priority in any state budget. Having to dip into an annual budget to meet future pension payments would likely result in higher tax rates for state residents, or lower ratings and higher interest rates on a state's debt.

Watch special coverage of the municipal bond crisis, "Muni Maze,"all day Monday, February 14 on CNBC.