How Can We Avoid the Looming State Pension Avalanche?

"States across the nation will be paralyzed for the rest of our lives because they face unfunded pension obligations," David Brooks wrote yesterday. Echoing his concerns south down I-95, the Washington Post reported that the nation's local retirement plan face half a trillion dollars in unfunded promises. Are state and local governments sleep-walking toward a retirement crisis?

Maybe. But let's slow down to understand why these pensions are in crisis. In the private sector, most people are familiar with a 401(k) retirement plan, where your employer promises to pay a certain amount of money every year into your investment account. Many public sector pensions are different. The government doesn't promise a yearly contribution. Instead, it promises a certain return on investment to pay its retirees.

Promising high returns is a high risk business. It's especially risky when you're promising high returns in a recession. Low tax revenues and troubled markets could smash the solvency of some states' pension funds. What should we do?

To find out, I spoke with Andrew Biggs at the American Enterprise Institute. An edited transcript follows:

For people who are just joining, can you explain what a state retirement program looks like?

Most state and local governments offer a defined benefit pension which is different from a 401(k). With 401(k), you and your employer accept risk and reward. Defined benefit has fixed benefit at retirement. It's a given percentage of final salary multiplied by years on the job. Let's say it's two percent of final pay, and you've spent 40 years working. You'd get 80 percent of final pay in your first year, and then most public pensions grow that over the course of your retirement with inflation.

What's the problem with these state and local pension programs?

There are two problems. First, they're underfunded. They only have about 75% of the money needed to pay liabilities. They need more money from either employee contributions or general taxes [employer contributions].

Second, states' accounting standards are inappropriate. They assume they can earn high returns on stocks and private equity investment without market risk. If the risky assets fail, the taxpayers have to pay the difference.

But public sector pensions have paid out their obligations for the last few decades. Are we overreacting by calling for dramatic change now?

Public sector pension plans have done well over the last few decades because stocks have done well and pension plans have gone more toward stocks. And even the worst pensions plans have assets on hand to meet their current obligations. But the current recession has showed that pensions are underfunded. The next recession will require a pension bailout. Pensions are investing in stocks that will fall with the economy. So the state will need taxpayers to bail out their promised payments to retirees. But we'll ask for this taxpayer funded bailout just at the moment when taxpayers have no money on account of the recession.

Why are state and municipal pensions guarantees so high, in the first place? Is it part of a classic union compromise: higher benefits for lower wages?

It's not clear. If you go back 25, 30 years, state and local employees had lower salaries and higher benefits. At this point, state and local employees receive salaries that are slightly lower, but when you account for pension benefits and retiree health benefits, that more than makes up the difference.

What should we do?

I don't have a hard preference for defined contribution or defined benefit, but defined contribution plans are more transparent. Employers say they're matching 50 cents on the dollar, and you can check every month to see if they're meeting their obligations. If the benefits are guaranteed years away, and the taxpayers and lawmakers don't understand the accounting, the government get away with doing less than they should to meet those obgliations.