Sanitation workers, firefighters, teachers and other state and local government employees have performed their duties in the public sector for decades with the understanding that their often lackluster salaries were propped up by excellent benefits, including an ironclad pension. But Moody’s Investors Service recently estimated that public pensions are underfunded by $4.4 trillion. That amount, which is equivalent to the economy of Germany, accounts for one-fifth of national debt. It’s a significant concern for public employees who were banking on a fully funded retirement to get them through their golden years.

But the issue has wider implications for all taxpayers, who likely will be tapped to make up the shortfall. The Knowledge@Wharton radio show, which airs on Wharton Business Radio on SiriusXM, asked two experts to explain how governments dug themselves into such a deep hole — and whether they can ever get out. Olivia Mitchell is a professor of business economics and public policy at Wharton. She’s also director of both the Pension Research Council and the Boettner Center on Pensions and Retirement Research at the school. Leora Friedberg is a professor of economics and public policy at the University of Virginia’s Frank Batten School of Leadership and Public Policy. The following are key points from their conversation.

Not Enough time, Not Enough Money

There are plenty of reasons why state and municipal pensions are sorely underfunded, and those reasons sound unnervingly familiar. Mitchell and Friedberg ticked off a list of ingredients reminiscent of other financial stews, including the collapse of the housing market. Like that event, the pension problem has been simmering for decades. Government administrators believed their investment returns would be bigger, and they believed retired employees would die sooner. They used overly optimistic actuarial assumptions, and they thought the long-term nature of the investments could handle higher risk.

They were wrong.

“It seems like there’s enough blame to point to everyone,” Mitchell said. “All of those different approaches proved wrong, especially after the financial crisis where state and local pensions lost 35% to 40% of their money. It’s true that things have been doing a little bit better in terms of their investments, but still the fundamental flaw is that over the years employees were offered a future benefit that was not properly collateralized.”

Mitchell said the problem is worsening because state and local governments have neglected to take corrective action.

“Every year that goes by leads to more red ink and more concern because the state and local plans across the country have clearly not done what they should have done to contribute the right amounts, to invest their assets in their pension plans carefully and thoughtfully,” she said. “Older folks are living longer and needing more medical care, needing longer retirement benefits. It’s a series of challenges that, frankly, nobody is paying much attention to.”

“Every year that goes by leads to more red ink and more concern because the state and local plans across the country have clearly not done what they should have done to contribute the right amounts….”–Olivia Mitchell

Friedberg said the problems with pensions are often inherent in the system, and they only compound.

“There aren’t strong incentives for the governments to actually take care of this … before it becomes a problem…,” she said. “After years of underfunding, some combination of taxpayers and state and local government workers bear the cost of that. We’ve already seen that going on for the last 10 years.”

In addition to the pension overhang, Friedberg noted, many states also face health insurance obligations that they aren’t adequately funding. Elected leaders are forced to increase taxes or cut spending to balance budgets thrown out of whack by pension debt, and the public workers are often vilified in the process.

“Politically, that ends up easier than dealing with the funding,” Friedberg said.

Money Problems Run Deep

Mitchell and Friedberg warned that the pension hole will swallow public- and private-sector employees alike, because all income earners will pay for it. Mitchell ran a simple calculation to illustrate her point: If the shortfall were $5 trillion, divide that amount by the 158 million workers in the American labor force for an obligation of about $32,000 per worker.

“That gives you a concrete sense of the shortfall that we’re facing,” she said. “A lot of people don’t have $32,000 for their own retirement, much less to pay for state and local workers.”

Mitchell also said that governments are probably underestimating pension debt because they are allowed to use whatever actuarial assumptions “that they feel like without any oversight from the federal government.” While states and municipalities are reporting that they are 72% funded, the real rate is closer to 45%, she said.

Broaden that to the federal level, where the impending shortfall in Social Security is well-documented, and the scope of the problem grows. Instead of $32,000 per worker, it’s about $171,000, according to Mitchell.

“I think the problem is one of political non-transparency and also of population aging,” she said. “You keep running unfunded or underfunded plans as long as you have a growing workforce. Our workforce is not growing as quickly as it should be or could be. Our productivity is not what it could be, and what it means is we are going to be supporting more and more retirees on fewer and fewer workers. That gets very expensive quickly.”

Save Your Pennies

The professors have some advice for public-sector workers who are counting on a pension — don’t.

“I think they need to be aware that the benefits they’ve been expecting may not be there.”–Leora Friedberg

They said workers should take control of their own retirements by saving often and early.

“I think they need to be aware that the benefits they’ve been expecting may not be there,” Friedberg said. “It depends on those states and how tight those legal obligations are. In some states, it’s written into the constitution. In other states, it’s not. And it’s not legally protected by the federal government in any way as private-sector pensions are.”

Governments sometimes manage pension debt by cutting benefits, postponing cost-of-living adjustments or extending the vesting period. Many states are also starting to require employee contributions, similar to a 401k.

“There’s some advantage to that because it makes workers aware of their own savings and it familiarizes them with investment in the stock market,” she said. “But we know from the history of the private sector and moving away from defined benefit plans toward 401ks that voluntary contributions often fall well below what workers need to replace their recumbent retirement.”

Governments have turned to other coping mechanisms, including shedding employees before they are vested or not filling vacant positions.

“I think it is undercutting the competitiveness of the public sector as a place of employment,” Friedberg said. “It was already the case that pay was often lower for comparable jobs, especially for high-skilled workers. The promise of the pension benefit was supposed to make up for that. If that promise is no longer being fulfilled, talented people will certainly go elsewhere.”

Indeed, some cities and states have turned to outsourcing items once thought of as strictly in the public domain. Mitchell pointed to the privatization of prisons and emergency services as examples. Governments that outsource don’t have to deal with a pension payout at the end of a worker’s career.

But those measures still aren’t enough, Mitchell said.

“The bigger issue is the so-called hidden borrowing problem that, when folks that hired teachers and firefighters and so forth 30 years ago, they didn’t pay them the full amount that would make their salaries as well as their pensions robust,” she said. “Instead, they underfunded the plans, leaving today’s taxpayers to pay for services that were rendered 30 years ago.”

Start with Transparency

Mitchell and Friedberg strongly believe that governments need to be more open with employees, citizens and investors about how they handle their pension plans. In turn, those stakeholders need to engage.

“I think the place to start is to begin with transparency,” Mitchell said, citing federal regulations that require corporate plans to report their financial promises and set aside money to meet those obligations. But decentralization means the federal government has no power to compel states to report liabilities and assets or to follow similar protocols.

Mitchell reiterated the point that, ultimately, everyone will pay. She referred to a recent study that contended property owners will be held responsible for unfunded liability through what could be considered a “stealth tax.”

“Twenty percent of your property value is already going to be liable to be covering these state and local pension shortfalls,” Mitchell said. “So, you can sell and move out of Chicago or Detroit, but there’s already that capitalization of the underfunding in the value of your house.”

Friedberg said insolvency comes down to constitutional issues. Citizens need to start asking the right questions, because it’s easy for politicians to “pass the buck.”

Sharing a personal example, Friedberg noted that her home city of Charlottesville, Virginia, operates its own pension fund for police and municipal workers.

“There’s not much information about it, so it’s hard to know [how it’s performing],” she said. “I’d be happier if the city of Charlottesville didn’t have to do this very complicated financial operation of running a pension fund.”

The professors agree that many of the proposed solutions being floated are unlikely to fill the pension hole because the only way to get bigger investment returns is to take on greater risk. The stock market is just too volatile for that.

“There’s no magic investments that states can make here to recoup the money. Just like we saw with the financial crisis, high risk means that at some point there are going to be big declines and they won’t be able to pay their bills,” Friedberg said. “The other problem with bonds is it pushes the problem off to the future, then it makes it harder to understand what the future obligations are.”