Nice little briefing from Douglas Elliot at Brookings on the scope of the state and local pension problem:
Unfortunately, pension deficits are closely correlated with the overall economy, principally because of the high level of investments in the stock market. Thus, pension deficits turn out to be worst when the economy is in bad shape, such as today, making it particularly hard for taxpayers to absorb the cost of the required additional pension contributions. If they had been luckier and both the economy and the markets had done well, they would face lower than expected pension contributions at a time when this savings would not matter so much. In this respect, risk-taking in pension funds is the opposite of hedging - it is more like gambling the grocery money. Winning would be nice, but losing would be very painful.And how likely is this gamble to pay off? Not very.
Deficits at state and local pension funds constitute a serious problem, with economic values of these deficits aggregating to approximately $3 trillion or more than 2 years worth of tax revenue. There are no easy answers either, unless very favorable stock markets intervene to save the day. However, the stock market would have to almost triple in a short period from today's level to eliminate the current pension deficits as measured using risk-free discount rates.
This problem has been building for a long time. That's the problem with retiree benefits--they can accumulate for quite a while before you notice that, oops, they're budget killers. Unfortunately for us, as with Medicare and Social Security, now is when these problems have gotten too big to ignore. We have a triple-whammy of rising health care costs, a demographic bulge, and the historical legacy of a major expansion of government. In the early years, as government expanded, generous pensions and retiree benefits were easily expandable; the previous generations of workers were relatively small, while the large new class was relatively young. Now those generations of workers are piling up in the retirement system, and the current group of workers is not big enough to absorb the cost out of their paychecks.
This mirrors a debate happening in Europe, and I think it is the end game of the arguments about the welfare state. The vision has hit its practical (and demographic) limits. The convulsions will continue for some time, as we try to settle what, and how much, the state will pay for. But in the end we'll probably emerge with something roughly stable, and the sweeping, century-long conflicts will no longer be about growing or shrinking the safety net.
What will replace those debates? No idea. But as the state hits its fiscal limits, I predict that debating what more it should spend money on will come to seem a lot like arguing over how many angels can dance on the head of a pin.