Illustration by Bloomberg View
Illustration by Bloomberg View

The pension liabilities that helped bankrupt Detroit have cast a harsh light on similar problems in Chicago and other large American cities, adding urgency to the question of who should close the shortfall. This is a challenge that public-sector workers and retirees shouldn’t bear on their own.

The public pension problem is by now well known. Detroit’s emergency manager estimates its unfunded liabilities at $3.5 billion, about a fifth of the city’s debt. As of last year, Chicago had funded just 36 percent of its pension obligations, while, as of 2011, Philadelphia had put aside just 50 percent of its promised benefits.

States aren’t doing much better. Thirty-four states failed to make their required pension contributions last year, and nine have set aside less than 60 percent of what’s needed. All told, U.S. state and municipal pensions are underfunded by at least $1 trillion, and perhaps much more.

The twin questions facing policy makers are how to fix the problem and how to apportion the cost among workers, retirees and taxpayers as a whole.

Self-Delusion

First, governments need to stop lying to themselves. Money that’s slated to cover annual pension and health-care fund contributions but is instead siphoned away to cover other costs won’t magically reappear in later budgets. In the future, states and cities should agree only to benefit packages that are based on reasonable rates of return and annual contributions they can actually make -- and then make them.

Many jurisdictions will also have to scale back their past grandiose promises. Given the magnitude of the shortfall, this will have to entail asking public sector employees to accept a new deal, including some combination of working longer, contributing more to their pension and health-care costs, and getting reduced benefits. It may also, as a last resort, require sacrifices by workers who have already retired.

A particularly thorny issue is the future of defined-benefit pensions, which most public sector workers still enjoy but private employers have largely replaced with cheaper defined-contribution plans. Those benefits help governments compete with private employers, which may be able to offer higher wages. They also reflect the power of public-sector unions, which have mostly outlasted their private-sector counterparts.

If governments continue to provide defined-benefit plans, it should be under more stringent conditions, including conservative assumptions about rates of return, larger initial payments and protections against gaming the system. Or, they can scale back gradually to defined-contribution pensions by first adopting hybrid plans, in which lower benefits are topped off with 401(k)-style accounts.

Shared Pain

No matter how gracefully such changes can be accomplished, it won’t be fair to expect workers and retirees to be the only ones to sacrifice. After all, they are not the people who set the unaffordable policies in the first place.

Some jurisdictions will have to help meet their pension obligations by cutting spending elsewhere, finding new revenue or both. Those steps won’t be popular, but this is a shortfall too large to close easily or cheaply.

The lesson of Detroit is that states and cities can’t afford to ignore their obligations forever, and waiting makes things worse.

To contact the Bloomberg View editorial board: view@bloomberg.net.