Here's a study from Northwestern University's Kellogg School of Management that ties in nicely with the muni bond collapse / federal bailout of the states thread.

State pension funds headed for crisis of national proportion
According to new research from the Kellogg School of Management, taxpayers, public workers and state and federal officials alike have cause for serious concern about an issue that often falls under the radar but poses serious risk to the future health of the national economy: state pension liabilities.

Data presented today in Washington, DC, at a conference called "New Retirement Realities: Pensions at a Crossroads" demonstrates that several state pension funds will not last the decade, a situation that will place tremendous pressure on the federal government to bail out financially insolvent states at a price tag likely to match or exceed the recent bailout of the U.S. financial system.

In his presentation, Joshua Rauh, associate professor of finance of the Kellogg School of Management at Northwestern University, predicts that without basic reform to the current pension system, many large state pension funds will run out, even if they achieve predicted 8 percent annual returns. As a result, Rauh warns that promised benefit payments would be so substantial that raising state taxes to make the payments would be infeasible, offering no other choice than to call on the federal government to bail out the failing states.

As an example, Rauh points to Illinois. If the state's three main pension funds earn 8 percent returns and the state makes contributions accordingly, the funds will run out of money in 2018. In the following years, benefit payments owed to existing state workers would be an estimated $14 billion - more than half of the revenue Illinois is projected to receive in 2010 - and states are under legal obligation to make these payments.

"This is a problem of monumental proportion," said Rauh. "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. Plus, this scenario could happen sooner if taxpayers flee to other states with lower taxes and higher services, if contributions are deferred or not made, or if returns are lower than expected," he said.While Illinois is currently at the highest risk, pension funds in other troubled states could dry up by the end of 2020: Louisiana, New Jersey, Connecticut, Indiana, Oklahoma, and Hawaii. And, by 2030, as many as 31 states could be affected.

To counter this problem, Rauh has outlined an innovative plan, issued today. It notes that fundamental state reform is essential, and underscores the urgent need for a federal program that offers incentives to stop the growth of unfunded liabilities. He recommends that states be allowed to issue tax-subsidized pension funding bonds for the next 15 years if they agree to a specific program of major pension reforms. To get the subsidy, states must agree to close defined benefit (DB) plans to the approximately one million new workers who take state jobs every year, and instead to offer the new hires a defined contribution plan (DC) similar to the federal Thrift Savings Program, as well as guaranteed access to Social Security.

"Right now only a quarter of all public workers contribute to Social Security," said Rauh. "While the cost for the Pension Security Bonds over 15 years would be about $250 billion, under this plan the Social Security system would see a net gain of over $175 billion. All told, the cost to the federal government for such a program would be around $75 billion, far less than the minimum $1 trillion it could risk if the state pension fund system is left in disrepair."

Rauh's plan offers a cogent solution for the tens of millions of police officers, firefighters, teachers and other public service and state employees that will enter the workforce over the next decade, while maintaining consistency for workers already in the system.

"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," he concluded. "It is imperative that we act today to give states the incentives they need to put themselves back on a path to fiscal sustainability."

Some thoughts:

• The assumptions are, um, a tad optimistic: "As an example, Rauh points to Illinois. If the state's three main pension funds earn 8 percent returns and the state makes contributions accordingly, the funds will run out of money in 2018." But how is a pension fund going to generate 8% returns with bonds yielding less than 5%? To make up the difference in a 50-50 stocks/bonds portfolio, stocks would have to average 11%. Since negative 11% is a lot more likely, it's a very safe bet that Illinois' pension fund runs out of money well before 2018.

• Who exactly would buy these bonds? Somehow it seems unlikely that the Chinese or Saudis will find them compelling. But what about other state pension funds? The prospect of California and Illinois bailing each other out at least has some entertainment value.

• For such a "monumental" problem, the proposed solution seems both tame (no cuts in existing benefits) and ultimately destructive (massive issuance of new debt). This kind of structural change might have worked back in the 1980s or 90s when the problem was relatively small, but is too little too late with the collapse of many systems imminent. A direct federal bailout would seem to be unavoidable.