State pension plans in crisis: underfunded by $1 trillion?

FORTUNE -- When the majority of the country's 225 state-sponsored pension plans release their annual reports this month, the numbers will paint a bleak picture. Unfortunately, the reality may be even worse.

According to the Manhattan Institute for Policy Research, pension plans for public school teachers, which comprise about half of states' total pension liabilities, were underfunded by $933 billion dollars in fiscal year 2008, almost three times the amount that the plans had reported.

Behind the discrepancy are accounting methods, sanctioned by the government and perpetuated by most fund administrators, that allow public plans to report future liabilities in today's dollars using an overly optimistic conversion rate, a process called "discounting." It also lets them spread out, or "smooth," losses over a four- to five-year period, effectively muting the havoc that 2007-2008 wreaked on pension fund portfolios.

Discounting and smoothing help reduce stock market volatility on employee and state contribution rates, but some experts say these methods mire the actual health of the pension system and encourage policymakers to ignore the growing problem.

The Pew Center on the States estimates that states' total unfunded liability is $452* billion, but according to Josh Barro, Walter B. Wriston fellow at them Manhattan Institute, it's somewhere in the range of $2 trillion to $3 trillion, which is about equal to the bond debt that states have outstanding. "It's likely states are twice as much in debt as we thought," he says.

As a consequence, state services such as public education, road repairs and daycare, will have to vie with retirees for scarce resources. But here the deck is loaded; once a retiree is promised a benefit, by law the state cannot renege.

Pension Holiday

The overwhelming majority of public pension plans operate under what is called "defined benefit" model, in which the state and public employees contribute varying amounts to a pooled fund. This amount is based on several factors, including a plan's funding ratio. After retirement, the employee receives a guaranteed payout, on average $22,000 a year, no matter how well or poorly the market performs, effectively placing all of the investment risk on the shoulders of the state.

Ironically, it's the states themselves, and not investment performance, that are primarily responsible for the growing deficit in pension funding. According to the Pew Center, only about one-third of states in fiscal year 2008 were consistently putting in 90% or more of what was required to get their plan to a fully funded status. That year, states and participating localities should have paid about $108 billion (a figure that includes funding for some other retiree benefits). Instead, they contributed just $72 billion.

This failure to pay is what is referred to as a "Pension Holiday" in official government parlance. In other circles it is known as fiscal delinquency.

"It would be just as though you or I were not making our payments on our credit cards," says Sue Urahn, managing director at the Pew Center. "The debt doesn't go away, and just like credit card debt, it keeps getting bigger."

How states could get away with this is simple: there are no federal regulations that require them to make their full contribution. Only a handful of states, notably Arizona and New York, have statutes or constitutional requirements that require them to make those payments. "Those that have tied their own hands to do that are the ones that have not found themselves in trouble despite the recession," Urahn says.

Bridging the Gap

Given the legal protection that pension benefits enjoy, remedies to close the gap are limited. Some states have reduced retirement benefits for new employees and increased the retirement age, but the effects of these measures won't be evident for decades. New York has made its pension fund essentially borrow from itself to temporarily close the funding gap. Others are taking a more drastic approach. Michigan and Alaska have closed their defined benefit plan and in its place adopted a "defined contribution," or 401(k), model.

Unlike defined benefit plans, a defined contribution scheme places all of the investment risk on the individual because it doesn't guarantee a certain payout. If the worker is ready to retire and the stock market just dropped the value of their account by 25%, well, tough luck.

Critics of the defined contribution model argue that it doesn't provide enough security. "There is no question that the nation's overall financial preparedness [for retirement] has diminished over the last generation and that is due in no small part to the movement away from the traditional pensions and toward 401(k) plans," says Keith Brainard, research director for the National Association of State Retirement Administrators. States will end up having to pay more in services later for individuals who go broke, he says.

Another alternative, proposed by the Manhattan Institute, is to reduce the 8% discount rate to better represent obligation risk. Private pension plans run by large corporations generally discount at a rate of 6%, equal to the blended annual average for a high-quality corporate bond, and smooth over a two-year period. In this sense, corporate plans prepare for the worst, but hope for the best, and are less likely to overestimate their future performance.

Finally, the Pew Center suggests that state lawmakers follow New York and Arizona's lead and pay their annual contributions in their entirety. "What you have is a situation in most states where if they take action today it's a manageable problem," Urahn says. "If they put it off and they do not take action, they will have an unmanageable crisis on their hands."

*Editor's note: An earlier version of this article stated unfunded liability was $533 billion, a figure that included certain non-pension benefits. The sentence has been corrected.