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Debt woes: Can Illinois (or your state) avoid becoming the next Greece?

Illinois ranks at the bottom of a new listing of states ranked by fiscal difficulties, as its governor and lawmakers grapple over how to balance the state鈥檚 budget and manage pension reform.  

America may not be the financial equivalent of Greece, but states聽including Illinois and New Jersey are on a path that may justifiably聽evoke that incendiary comparison.

And their troubles may be merely the leading edge of larger聽challenges: Six years after the recession鈥檚 end, many US states are聽still in fiscal trouble, according to 聽by聽the Mercatus Center at George Mason University in Arlington, Va. In many cases, pension聽liabilities are a聽significant burden that could force a reckoning 鈥� not聽this year but in the not-so-distant future.

The report鈥檚 50-state ranking, coupled with parallel headlines of聽distress out of Springfield, Ill., and Athens, raises a question: What聽must US states do to avoid becoming the next Greece?

The comforting side of the answer is that not all US states are in聽deep fiscal trouble. Experts differ on how deep the problems are, but not even Illinois is facing the kind of聽bond-market turmoil that surrounds Greece, amid uncertainty over聽whether that nation will slide into a chaotic debt default and exit聽from the euro currency union.

Still, Illinois stands as a poster child for risks that could arise聽over time in numerous US states and localities that have promised more聽than they have funded in public pensions. In Springfield, Gov. Bruce聽Rauner (R) is in a standoff with the Democratic legislature over how聽to balance the state鈥檚 budget while reforming public pensions. Talk of聽a possible state-government 鈥渟hutdown鈥� has risen as the state entered聽a new fiscal year on July 1 without a budget.

Illinois ranks at the bottom of the new ranking of states in the聽Mercatus Center report. And its path toward long-term fiscal solutions聽looks rougher than that of most states, because Illinois has unusually聽strong constitutional protections for state workers against pension聽cuts. (Governor Rauner has proposed a constitutional amendment to pave聽the way for reforms.)

Whether in Illinois or in other states, the basic options to deal聽with pension shortfalls are similar: find ways to reduce pension聽obligations (for future or in some cases current retirees), ask public聽workers to fund more of their benefits out of their own pockets, or聽bolster funding from the outside through new tax revenues or聽general-budget cuts.

鈥淭he solution to this issue is going to have to be some kind of shared聽pain,鈥� predicts Joshua Rauh, a Stanford University finance expert. The聽answers, he says, will vary by state based on 鈥渨hat is legal and what聽is palatable.鈥�

Fiscal experts don鈥檛 all agree on the scale of the problem.聽Where Mr. Rauh says the magnitude of the pension problem alone is聽enormous 鈥� a nationwide challenge much larger than states acknowledge聽in their official reports 鈥� some others argue that pensions and聽long-term finances more generally are manageable for the vast majority聽of states. (Even Illinois can borrow money at high but not聽astronomical rates of interest.)

Still, both camps in this debate see a need for action and for shared聽sacrifice to put states on a sound footing.

鈥淵ou need a balanced solution鈥� on pensions, which could mean part from聽current employees, part in benefit adjustments, and part from a聽state鈥檚 general fund, says Liz McNichol, a senior fellow at the聽liberal Center on Budget and Policy Priorities in Washington.

The Mercatus Center report seeks to make state fiscal challenges聽visible in one ranking. In general, states with low debts and a聽natural-resource base, such as public revenue from the oil industry,聽rank high in fiscal health (the top five are Alaska, North Dakota,聽South Dakota, Nebraska, and Florida).

At the bottom of the list is Illinois, followed by New Jersey,聽Massachusetts, Connecticut, and New York. California joins聽Kentucky in narrowly escaping bottom-five status.

The ranking merges several gauges of state health, from pension聽liabilities, public debt, and other long-term obligations to the extent to which聽states聽are already tapping much of their potential tax base.

Is the overall outlook alarming?

The answer may hinge on whether states are making realistic accounting聽assumptions. On the more pessimistic side, analysts like Rauh say a fundamental flaw in state budgeting is to assume roughly 7.5 percent聽returns on money聽invested in pension funds.

鈥淲e've had a remarkable period鈥� during which such returns have聽materialized, he says. But looking forward, Rauh doubts such returns are聽reasonable to bank on.

If his view is correct, the unfunded pension liabilities for states聽now total about $4 trillion, compared with an officially acknowledged聽total of roughly $1 trillion.

鈥淭here are more states than you would expect that need to do聽something鈥� to fix their finances, says Eileen Norcross, the Mercatus聽senior research fellow who wrote the new report.

Others are more optimistic about the current state of pension funds 鈥撀燼nd hence of state budgets overall.

鈥淥n average, the pension contributions are a fairly small piece of聽state budgets,鈥� about 4 percent of total state and local government聽spending, says Ms. McNichol. Even if funding payments need to go up,聽pensions are 鈥済enerally not the thing that makes or breaks state聽budgets.鈥�

By the commonly used accounting methods, state and local public聽pensions had an assets-to-liabilities ratio of 74 percent in 2014, up from 72 percent in 2013, according to data tracked by Boston College鈥檚聽Center for Retirement Research.

Still, the pension shortfall comes at a time of overall uncertainty for state budgets.

Tax revenues have recovered since the recession, but some 27 states have less purchasing power (adjusted for inflation) than they had six聽years ago, says Barb Rosewicz, a state fiscal expert at the Pew聽Charitable Trusts in Washington.

This leaves states struggling as they look toward future needs, with聽the number of retirement-age Americans on the rise.

Demand for spending on pensions and health care is rising even as 鈥測ou聽need to be investing in education and transportation and other things聽that states care about in order to grow their economies,鈥� McNichol聽says.

Some analysts say more states may feel impelled to consider changing聽from a 鈥渄efined benefit鈥�-style pension toward the 鈥渄efined聽contribution鈥� or 401(k)-style plans that have become common in the聽private sector. Another option is some hybrid of the two systems.

US states, for the most part, aren鈥檛 in Greece-style chaos. But they聽aren鈥檛 on easy street, either.