States short $1 trillion to fund retiree benefits

NEW YORK (CNNMoney.com) -- Just as they are contending with massive gaps in their operating budgets, states and localities must also deal with a $1 trillion deficit in public employees' retirement benefits' funds, a new report found.

The shortfall amounts to more than $8,800 for every household in the nation, according to the Pew Center on the States, which published its findings Thursday.

States largely got themselves into this mess by failing to make annual contributions while also enhancing benefits, the study found. Now, they are behind by a total $452 billion in their pension accounts and $555 billion in their retiree health funds, as of the end of fiscal 2008, which ended June 30 for most states.

The deficit is likely even more severe because the report did not take into account the crumbling of the stock market in the latter half of 2008. The typical pension plan lost 25% of its value in 2008.

States must find ways to make up these gaps because retiree benefits for public workers are largely guaranteed by union contract. And they are funded through contributions from both employees and state employers, as well as investment returns.

So when gaps appear, states must ask their residents to make up the difference, usually through property tax or income tax hikes.

"Ultimately, taxpayers could face higher taxes and cuts in services," said Stephen Fehr, one of the report's authors. "You can't ignore the problem. It's just going to be more serious budget trouble for states down the road."

To be sure, the bill isn't due all at once and no state is in danger of default. These benefits are paid out over decades. Still, the deficits must be addressed sooner than later or the gaps will simply balloon more.

The consequences of the shortfall could be severe. It comes at a time when states are wrestling with a cumulative $180 billion budget gap for fiscal 2011.

Eight states are in the most dire shape, according to the Pew report. These include: Alaska, Colorado, Illinois, Kansas, Kentucky, Maryland, New Jersey and Oklahoma.

Two of these states -- Illinois and Kansas -- have less than 60% of the necessary assets on hand to meet their long-term pension obligations.

Only four states -- Florida, New York, Washington and Wisconsin -- had a fully funded system in 2008, down from just over half at the beginning of the decade.

Overall, state pension systems are 84% funded.

Many states have been lax about funding their pension systems, even during more prosperous times earlier this decade. Some 21 states failed to contribute at least 90% of the required amount during the past five years.

Retiree health care and other non-pension benefit accounts are in even worse condition. Only about 5% of their total liabilities are funded. States generally paying these bills as they come due, rather than setting aside money in advance.

Also, some states sweetened their retiree benefits during the 1990s and earlier this decade, reducing employee contributions or providing cost-of-living increases. But they didn't allocate money to pay for these changes.

Recognizing the seriousness of the situation, states have begun to act. Fifteen states passed legislation reforming their pension systems in 2009 and 16 are looking at making changes this year.

Since it's tough to make changes to union contracts, most states apply the new rules to incoming employees only.

Several states, including Kentucky, Nevada, New Jersey, New York, Rhode Island and Texas, have reduced benefits offered to new employees or raised the retirement age. Some are also asking workers to contribute more to their pension accounts or retiree health benefits. And a few have created 401(k) style plans to go alongside their traditional pensions.

In Nevada, for instance, those hired in 2010 and beyond will have to wait until age 62 to retire, instead of age 60. They will also have a less generous funding formula: Their years of service will be multiplied by 2.5, rather than 2.67, to derive the percentage of salary being replaced by pension benefits.

In New York, new hires can't retire until age 62, instead of age 55, and they will have to work for 10 years instead of five.

"A growing number of policy makers recognize that their states' fiscal health depends on how well they manage the bill coming due for public sector retirement benefits," said Susan Urahn, the center's managing director. "We are seeing more and more states explore policy reforms aimed at putting their systems on stronger fiscal footing."

The study looked at 231 state-administered pension plans and 159 state-administered retiree health care and other non-pension benefit plans, which include some localities' and teacher plans.