A lot is said about the sorry condition of certain local and state public pension systems, with Illinois a poster child for being among the sorriest.

The gulf between what Illinois owes pension beneficiaries and its assets available to pay the liabilities continues to widen.

There are 656 public-sector pension systems in Illinois, and the five largest state-funded pensions have a total unfunded liability of $112 billion by some estimates. This has left workers questioning their retirement security — and potential hires looking for jobs elsewhere.

For many, Illinois is an example of how not to run a pension system. The state's pension crisis is in some ways an outlier. Its pension debt — unique in its size and the length of time it has been growing — results from an intentional policy of underfunding, several public pension experts say. For years, the state's elected officials borrowed against the pension system to fund public services, and in 1995 then-Gov. Jim Edgar, a Republican, signed into law the “pension ramp,” which continued the practice of diverting funds for public services for 15 more years.

In short, Illinois “intentionally kicked the can down the road for generations through legislative action,” said Ralph Martire, executive director of the Center for Tax and Budget Accountability, a nonprofit economic research organization in Chicago.

Illinois is not alone. New Jersey and Pennsylvania have also chronically underfunded their plans, according to a March 2015 report by the National Association of State Retirement Administrators, based in Lexington, Kentucky.

Still, chronic underfunding has occurred in only a few states. The majority have made a “good-faith” effort to continuously fund their pension plans, NASRA said in the report.

A mixed bag

The varying conditions of the many pension funds in Illinois act as a “microcosm of what we see around the nation,” said Keith Brainard, an Austin, Texas-based expert on public sector retirement systems and NASRA research director.

While many of the major pension systems in Illinois are “in serious distress,” others, such as the Illinois Municipal Retirement Fund, based in Oak Brook, which caters to employees of local governments and school districts except Chicago and Cook County, “is in very good condition,” Mr. Brainard said.

That's because it funds its pension plans.

Similarly, throughout the nation, “you've got some (systems) in fine shape and others that are not so much,” Mr. Brainard said.

The United States comprises about 4,000 public-sector retirement systems, 227 of which are state-administered and 3,771 locally administered, according to the U.S. Census Bureau. In total, these pension systems have about $3.80 trillion in assets. The total debt of state and local pension funds exceeds $1 trillion, according to a July report by the Pew Charitable Trusts, Philadelphia.

The condition of these public-sector pension funds varies widely, sources say. According to Mr. Brainard, Florida, North Carolina, South Dakota, Tennessee and Texas are among the state plans in good condition, while those in Illinois, Kentucky, New Jersey and Pennsylvania are not.

Troubled pensions

Pension funds become troubled for two major reasons. The first is failing to adequately fund the plan. City and state pension systems are funded through employer and employee contributions and investment returns. Much of the success of a pension plan depends on whether sponsors make the required annual contributions determined by actuaries, sources said. Failing to do so is often a straight road to distress.

In some cases, pension systems became complacent when markets were good and funding levels were high, and so they took a break from making necessary contributions. But liabilities continued to grow each year with nothing to keep them in check. Sound pension systems, on the other hand, looked to the future and saved extra money to weather weak markets.

“If you don't maintain adequate funding on an ongoing basis, you certainly set yourself up for the development of a big unfunded liability,” said David Driscoll, Boston-based consulting actuary with Xerox HR Services.

But market conditions also play a significant role in pension funding, sources said.

“Volatility in returns on assets leads to big shifts in contribution requirements, and it's often the case that state and local governments cannot easily accommodate the kind of swings,” Mr. Driscoll said.

According to the Public Fund Survey, sponsored by NASRA and the Elk Grove, California-based National Council on Teacher Retirement, a strong investment market in the 1990s created an aggregate funding ratio in excess of 100% in 2000 to 2001. But sharp economic declines in 2000-2002 and 2008-2009 helped shrink the aggregate funding ratio for the nation as a whole to 71.8% in 2013, the latest year for available data.

Filling the gaps

According to NASRA, almost every state has changed its pension funds' structures since 2009. “In most cases, these (changes) have had the effect of making these benefits less generous,” Mr. Driscoll said.

There are several types of reforms a pension plan sponsor can implement: increasing employee contributions, increasing employer contributions and requiring people to work longer. Additionally, states can modify their laws to increase the amount of time an employee must work before becoming fully vested.

The retirement age for city and state workers varies according to the pension plan, but many plans have raised retirement ages to as high as 67 years old from as low as 55.

Making plan participants work longer shortens the retirement period, so the pension system will pay out less money. Meanwhile, a longer vesting period requires an employee to work more years before becoming entitled to the full pension benefit, and saves the system money if the employee quits prematurely.

Many pension systems have also reduced or eliminated cost-of-living adjustments meant to combat the effects of inflation on the benefit.

Amanda Kass, Chicago-based research director at the CTBA, said these adjustments generally have been in line with the historical inflation rates, but the recent period of low to zero inflation makes many COLAs seem excessive. In Illinois, for instance, the COLA increase is 3% annually, more than double the consumer price index of 1.4% for the last 12 months starting in February, according to the U.S. Bureau of Labor Statistics.

Some plans have also switched to a defined contribution design from a defined benefit plan to address funding issues, but there's disagreement among pension experts over whether that's an effective strategy.

Alaska and Michigan are among those that have fully switched to a defined contribution plan. West Virginia moved to a defined contribution model for new hires, but reverted back to defined benefit because beneficiaries weren't accumulating enough retirement income, Mr. Driscoll said. Nebraska also took the defined contribution route but went back to a defined benefit under a cash-balance plan for similar reasons, he said.

“The reality of that switch is that it immediately increases your unfunded liability significantly,” because it halts future contributions that were anticipated to go into the defined benefit plan from new hires, said the CTBA's Mr. Martire, adding that it also increases costs for taxpayers because of the unfunded liability and “diminishes retirement security.”

When it comes to pension reform, officials must strike a balance between cost savings and providing an attractive benefit, sources said.

Pension funds “are human resources tools,” Mr. Brainard said. “You have to have a benefit that's going to keep people on the job.”

Diminishing the benefit too much may mean potential employees will look for work elsewhere. For instance, Illinois created a second benefit tier for state-funded pension systems in 2010. Employees contributing to the fund for the first time on

or after Jan. 1, 2011, are considered Tier II and receive a far lower benefit than those who were in the pension fund before 2011. Though this structure is expected to shrink the state's unfunded liability, there is concern about ill effects it may have on employees.

In 2015, state legislators convened a special task force to determine how the structure will affect recruitment and retention of teachers in Illinois, according to a letter by Dick Ingram, executive director of the Teachers' Retirement System. According to Ms. Kass, anecdotal evidence says higher education may be having difficulty filling positions because of the watered-down pension plan.

More risk for employees

The future of public pension funds will likely place more risk on the employees, much like the trend in the private sector but to a lesser degree, pension experts say.

“Employees are taking on more of the overall investment risk or inflation risk or longevity risk, which are the three main types of risks in a pension plan,” Mr. Brainard said.

That may mean incorporating defined contribution elements into the defined benefit plan, the way a cash-balance plan does.

The goal of city and state pension plans is to reach full funding, Mr. Brainard said. There's “no need to get there right away, but you do want to be moving in that direction. And in some of these cases it'll probably take 20-30 years to get there,” he said.

As for Illinois, the future is murky.

The state's most recent attempt to overhaul the pension system in 2013 was unanimously struck down by the Illinois Supreme Court in May 2015. The court deemed the reform, which was estimated to save $160 billion over 30 years, unconstitutional because it violated a clause in the state constitution that said benefits promised as part of the public pension system “shall not be diminished or impaired.” Very few states have that level of legal protection for a public pension system, the CTBA's Mr. Martire said.

So Illinois has to find a way to fill the gaps without rolling back benefits of current workers.

“What they have to do is come up with a rational way to fund the systems that allows the system's funded ratio to grow while meeting all cash-flow obligations,” Mr. Martire said.

It's “eminently doable,” he said. “It's just a matter of political will. They'd have to put a little bit more into the systems now than what the current law requires, but the amount would grow, and that's a huge advantage.”

“There's no real magic. You just have to put money into the system,” Ms. Kass said.