05/19/2010 02:22 pm ET | Updated May 25, 2011

Act Now to Prevent the Pension Crisis From Bankrupting Our Cities and States

As budget deadlines approach, state and local governments face tremendously difficult choices. They must choose between cutting education, public safety and welfare - at a time of record unemployment - or default on retirement obligations guaranteed to, and counted on by their employees.

In California, Governor Arnold Schwarzenegger's decision to pay his state's hefty $6.2 billion pension fund contribution to CalPERS, the state's public employees' pension fund, comes at a severe cost. To finance the pensions, California will freeze funding for public schools, eliminate its welfare to work program, decrease money for local mental health clinics by 60 percent, and slash state employee pay by 5 percent.

It is the same dilemma faced by a growing number of states and scores of municipalities led by the mega cities of New York, Los Angeles and Chicago.

The pension tsunami slamming state and local governments across the country is a long-overdue bill borne from multiple causes, including: failure to fully fund past employer pension contributions; lower than projected investment returns; rapidly escalating benefits that now offer retirees 70 percent or higher income replacement; and poorly considered early retirement policies and lump sum retirement payments that are accelerating demands for distribution payments.

Pension fund solvency has morphed into the next massive financial bubble. Municipal defaults, brought on by pension debt, threaten to put an end to defined-benefit retirement programs taken for granted by millions of public employees, destroy investor confidence in public securities, and derail the national economic recovery.

This year is only the beginning of the liquidity storm, as public pension funds brace for the acute concentrations of baby boomers set to retire in the immediate future. Public employees are nearing retirement far more rapidly than their private sector counterparts. According to Census Bureau data, approximately two out of every three state and local government employees (65 percent) are over 40 years old, compared to less than half of private sector employees (47 percent). Bold action must be taken now, before Gov. Schwarzenegger's difficult choice confronts every governor and mayor in the country. Here are three steps that can be taken immediately to address the serious liquidity pressures faced by state and local governments.

Open Public Pension Funds to" Civilian" Employees

Taxpayers are angry at government workers. Many have seen their retirement plans shrink, while public employees are getting benefit increases (at taxpayers' expense) even amidst the worst recession since the Great Depression. Private sector employees should have access to the same opportunities and investment expertise available to public employees. Everyone should be able to invest their own money in public pension plans. While such "civilian" accounts would not have the guaranteed benefits of public employee funds, they would offer non-public employees multiple advantages including: access to a professionally managed, highly diversified investment pool; much reduced investment fees - as low as .50 basis points, compared to the 1.5-2.0 percent standard market fees, that can increase a nest egg by 20 percent over 20 years; and financial literacy programs available through public funds without commercial overtones.

Opening membership may also dispel taxpayer resentment at providing tax support for generous public pension benefits while facilitating retirement fund access for the 50 percent of working Americans who do not have employer-based plans.

Establish Municipal Resources Facility

Just as General Motors, AIG and Citibank were deemed too important to the nation's economy to fail, it is critical that the federal government act to prevent municipal defaults or bankruptcies. Surely, continued operations of schools, police and fire protection, Medicare, and local roads and sewers are as vital as automobile production, insurance and banking. The feds should acknowledge that "Too Big to Fail'' applies to Main Street by setting up a federal mechanism to avert municipal defaults. Such support could be structured as a "crisis municipal resources facility," lending credit support to weakened municipalities, or be structured as supplemental stimulus funds to free up dollars to meet pension obligations. Any discussion of a municipal resources facility or other federal support would have to address the "moral hazard" issue by requiring applicants for federal support to reform their pension systems.

Supplement Defined-Benefit Programs With Shared-Risk Pensions

It is time to redefine shared-risks between employer and employee in creating retirement structures. The federal retirement system and several State and local pension funds offer a menu of retirement programs, including: a guaranteed defined benefit option, capped at lower income replacement levels; supplemental defined contribution/401 K plans; annuity options; matched savings; and robust financial literacy programs. All pension systems need to adopt these hybrid approaches that share retirement risks with employees.

The traditional notion of a three-legged stool to fund retirement (Social Security, retirement or pension plan, and personal savings) needs to be revived. In an era where investment returns are likely to be permanently reduced, all workers will value the certainty of Social Security payments that will pay essential living costs. Their personal savings and pension benefits will, hopefully, earn additional dollars to upgrade their lifestyles.

Beyond these steps, any discussion of pension reform must also include a broad revision of pension oversight and governance. Reforms are needed to prevent the self-dealing conflicts that pervade many funds' investment decisions and to upgrade the financial expertise of those who serve in these important roles .The new Governmental Accounting Standards Board guidance on transparency of pension actuarial models, discount rates and investment risks should be welcomed.

The "new normal" for public pension funds dictates a course of action that incorporates bold new approaches to structuring retirement security for government employees. Those municipal governments who demonstrate such leadership will be better positioned to ride the wave of massive demographic boomer retirements, continued public sector downsizing, and volatile investment markets, and spare themselves the unacceptable choice between progress and pensions. Those who don't reform their pension systems face a crisis that will make the housing and Wall Street bubbles look miniscule by comparison.

Dr. Kathleen Connell was California State Controller from 1995-2002, serving as a Trustee of both CalPERS and CalSTRS, two of the nation's largest public pension funds. She is the founder and executive director of the University of California Retirement Security Institute.