No matter how you slice it, $3 trillion is a lot of money.

That’s the amount of money states will need to come up with to pay for the health care and retirement benefits of all of their employees if stock markets fail to rise in coming years. It’s the result of a bargain struck by governments across the nation that sought to build workforces with salaries below comparable private sector jobs. Lower salaries and higher retirement benefits were a deal many were willing to make. The system worked very well as long as the stock market steadily rose and pension funds generated enough profits to match looming obligations.

But two things went wrong.

First, the stock market stopped rising. The S&P 500 is now -15% lower than a decade ago, while the Nasdaq is -40% below its March 2000 peak. Second, baby boomers are now retiring in droves — and they’re living longer than ever. We all saw it coming, but we never took action. And now the chickens are coming home to roost.

And it’s not just the states that are starting to sweat. A study performed by Northwestern University found that U.S. cities face a collective $574 billion shortfall that will need to be addressed in coming years. At current rates, Philadelphia will run out of money by 2015, and Boston and Chicago’s pension plans will be insolvent a few years after that. And those forecasts assume that pension funds will generate +8% annual investment returns until then.

States and cities can do one of three things. They can hope and pray that their invested portfolios suddenly surge in value in order to cover future obligations. they can reduce obligations to current and future retires, or they can raise taxes to bolster pension funds. The hope-and-pray approach is their preferred choice, as they are wary of taking on retirees or taxpayers. Trouble is, it would take a small miracle for this problem to be resolved by a bull market.

The $3 trillion state shortfall noted earlier assumes that investments fail to appreciate. Even if you assume that the stock market is on the cusp of a major multi-year rally that boosts the major averages at close to a +10% annual clip, these states will still have a shortfall of around $500 billion. So hope-and pray isn’t really an option.

State and city tax hikes? Well, that’s becoming an increasingly tough sell, especially when you consider that Washington will likely need to raise taxes to cover the massive federal shortfall. Ironically, overall taxation levels as a percentage of the economy remain below historical levels, and many recent media discussions have focused on Harry Truman and his 91% federal tax rate on the highest earners. Increased tax rates would not be the economic death knell that many predict, but in the current political environment, it isn’t seen as a viable option.

So if increased tax receipts aren’t the answer, then a sharp cut in benefits become the only answer. Yet even if you raise the retirement age to 68, curtail benefits by -20%, and stop offering pensions to any new municipal employees, then states and cities will still face a major shortfall in meeting retiree obligations if the markets fail to rise smartly. So it will take a great deal of political courage and a great deal of luck to escape this crisis. And that’s not a good bet to make.

The other step that states and cities can take is to reform the pension system. Currently, an employee becomes entitled to a retirement benefit based on a stated percentage of final salary multiplied by the number of years of service. That’s why many state and city employees seek to work as much as they can, and attain the highest income they can just before retirement, even if that means logging lots of overtime. As a first step, states and cities can go back and determine the average income of the last 10 years, and use that figure as a basis for determining benefits.

Assured Guaranty as a proxy
Shares of Assured Guaranty (NYSE: AGO) have surged +30% in the past three weeks as investors bet that this underwriter of insurance against municipal bonds will benefit from expected action by the Federal Reserve, known as Quantitative Easing (QE). Yet as I noted recently, the market may not be fully aware of the level of financial distress being felt at the state and local level. [See: “12 States in Financial Distress”]

The most distressed
Many states have only 70% or 75% of the funds in place to meet the retirement and health care obligations of current and future retirees, according to analysis by the Associated Press. Only a small handful of states such South Dakota, Nebraska and Idaho are above 90%. The five states noted below are under the greatest stress to make up the shortfall either through a cutback in benefits, higher taxes — or a whole lot of luck.



Action to Take –> Deep stress at the state and local level could lead to a worsening in local economies as taxes are raised or confidence-sapping defaults come into play. You should be very wary of investing in any company that does a great deal of businesses with state and local governments, as they’ll likely see heavy pricing pressures to maintain any level of business they have.