Why state pension funds may need a $1 trillion bailout

NEW YORK (CNNMoney.com) -- Ready for another government bailout? Taxpayers could be on the hook within the decade if current state pension system isn't reformed.

Even if they continue to rake in the projected 8% in annual returns, pension funds in at least seven states -- Illinois, Louisiana, New Jersey, Connecticut, Indiana, Oklahoma, and Hawaii -- could dry up by 2020, and 31 states could be in trouble by 2030, according to a recent study by Northwestern University economist Joshua Rauh.

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What'll they tax next?

Some states have already slapped taxes on blueberries, illegal drugs and fur clothing. But as budget shortfalls grow, state legislators are looking for even more creative ways to earn revenue.

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Promised benefit payments are so astronomical that raising taxes would still fall short. The only solution would be to call on the federal government for a bailout, according to the study.

"This is a problem of monumental proportion," said Rauh, an assistant professor of finance at the Kellogg School of Management. "Given that we see the same issue in many states, the total size of a federal rescue plan could exceed the seriousness of the recent economic crisis and potentially cost more than $1 trillion total."

In Illinois, Rauh says the pension funds could be insolvent by 2018 at the current rate. And in the following years, the state will owe government workers $14 billion -- more than half of the state's projected revenue for 2010.

To dodge a bailout, Rauh says the state pension system needs an overhaul that includes allowing states to issue tax-subsidized pension funding bonds for the next 15 years if they consent to other reform measures.

For starters, states must agree to close defined benefit plans to the 1 million new workers who start state jobs annually, and instead offer defined contribution plans and guaranteed access to Social Security, to which only a quarter of public workers currently contribute. Rauh estimates the total cost to the federal government would be about $75 billion.

"Existing pensions would become more secure and new workers would get more than an empty promise, while the country would avoid another massive taxpayer-financed bailout," Rauh said.