A pension war is brewing, and it's likely to pit state and municipal employees against citizens who foot the bill for government pension plans with their state tax dollars.

While employees of most companies have watched their 401(k) plans, and their retirement hopes, shrivel in the bear market, public employees have been smiling. They've been promised lucrative pensions, which have increased over the years as cities and states negotiated labor contracts. Now those public employees are about to find out they are not immune from the ravages of the stock market.

The Center for Retirement Research at Boston College

estimates that state pension plans have losses greater than $865 billion, a loss of nearly 40 percent in just the past year. Add those current losses to the fact that many municipalities have gotten away with under-funding those pension plans for years, and you have trouble brewing.

Now, the double-whammy of stock-market decline and lower tax revenue in this recession is causing state and local governments to take a second look at how they will fund those promises.

The options are few. Tax hikes, whether income or property or sales tax increases, will be hard to pass in this economic slowdown, as well as counterproductive. Will the voters stand for cutbacks in services, from snow removal to education funding? Or will cities ask public employees to make up the gap with a combination of benefit cutbacks or increased plan contributions?

All those choices are political dynamite, which may explain why state legislatures have been so slow to face reality.

State retirement promises:

The National Bureau of Economic Research

says the value of pension promises already made by U.S. state governments will grow to approximately $7.9 trillion in just 15 years.

And they're forecasting that states are unlikely to be able to keep those promises: "We conservatively predict a 50% chance of aggregate under-funding greater than $750 billion and a 25 percent chance of at least $1.75 trillion in under-funding."

They say it all adds up to a huge gap: "Insuring taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today."

Paying state pensions?

The looming issue of state and local pension deficits has been buried by our national financial issues, and by state politics. But there is one

Web site

that is tracking the pension pile-up. It started out as a watchdog for California pension issues, and now covers state budget and pension deficits across the nation.

The site has highlighted losses in California's public pension plan (CalPERS), which invested heavily in residential real estate, a mistake that wiped out nearly a third of the state employees' pension plan. Bad planning and huge promises helped force the city of Vallejo, California, into an unusual Chapter 9 bankruptcy last spring, partly to renegotiate labor contracts and pension promises.

Illinois has a nearly $50 billion gap in its public pension funds. It's trying to sell the state lottery to raise $10 billion, so far with no takers. The legislature hasn't appropriated pension funds, perhaps not recognizing that its own pension plan was only 32% funded, and that was


the stock-market crash last fall!

Chicago has balanced its budget, but only by selling the Skyway toll road, the city's major parking garages, Midway Airport. Now Chicago is in negotiations to sell the city's parking meters! Those one-time cash infusions are a tradeoff that will make it harder to pay tomorrow's pension promises.

It's a hot issue in every state. Kentucky reports a $30 billion gap in pension funding. Connecticut and Massachusetts have highly publicized state budget woes. And the stories keep coming. One of this week's PensionTsunami headlines: "Macomb County, Michigan, faces layoffs without $10 million in cuts to pensions and health benefits!"

Accounting legerdemain:

The magnitude of the state pension shortfall has been hidden by accounting rules that allow pension liabilities to be discounted based on the "expected rate of return." Obviously, the higher the expected return is set, the lower the current pension contributions required. Given recent returns, most pension plans will be even more under-funded when they report on assets in the coming months.

Pension-accounting rules add to the problem. The riskier the assets in the pension plan (stocks are considered riskier than bonds), the higher the anticipated return they can use to make the plans look solvent. That encouraged many plans to become overweight in equities in the past few years.

Paying the piper:

When it comes to making good on retirement promises, states have a far different picture than the federal government or public companies. The federal government can "print" money to pay its retirement obligations, including Social Security benefits. But municipalities can only borrow the money by raising taxes or selling bonds and other IOUs, or selling assets. It's not a good market for any of those solutions.

When companies go bankrupt, the Pension Benefit Guaranty Corp. (PBGC) steps in to cover most defined-benefit pension promises. The PBGC took over 110 plans in 2007, the latest year for which figures are available, paying a maximum benefit of $51,750 a year to eligible retirees. But the PBGC does


cover municipal or state retirement plans.

The little-known Chapter 9 of the bankruptcy code allows cities to reorganize and renegotiate all contracts and promises. Chicago attorney James Spiotto of Chapman and Cutler says the law can be murky: "There are varying levels of protection, ranging from strict constitutional rights to general statutory provisions, that might allow for some renegotiation of benefit levels in light of adverse conditions affecting the pension fund."

In other words, if a government body attempts to renege on pension promises, there will be a huge court battle.

The stage is set. If the generous state and local pension promises negotiated by unions are to be kept, it will be up to taxpayers to come up with the money, either through higher tax levies or lower service levels. That debate is coming soon to a taxing body near you! And that's the Savage Truth!

Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated. She was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. Savage currently serves as a director of the Chicago Mercantile Exchange Corp.