By Tim Reid

DESERT HOT SPRINGS, California (Reuters) - A resort town in California warned on Tuesday that it will run out of money by March due to burdensome salary and pension costs and could join other U.S. cities that have recently filed for bankruptcy protection.

A bankruptcy filing by Desert Hot Springs, a city of 26,000 about 110 miles east of Los Angeles, would make it the third California city along with San Bernardino and Stockton to seek court protection from creditors.

San Bernardino and Detroit - the biggest U.S. city to seek Chapter 9 protection - are likely to set precedent on whether retirees or Wall Street bondholders suffer the most when a city goes broke.

The problems in Desert Hot Springs came to light last week when a new finance director reviewed the city's records and discovered a $3 million shortfall in its budget of $13.5 million. Amy Aguer, the interim director of finance, did not have details on how the shortfall occurred but said it was the result of higher-than-expected pension and salary costs, especially in the police department, and overly optimistic estimates of revenue.

"It's obvious we can't continue with salaries and pensions that are in the stratosphere, no matter how much love there is for our police department," said Russell Betts, a council member.

Desert Hot Springs, which is near Palm Springs, filed for bankruptcy in 2001 after losing a multimillion dollar lawsuit and still servicing $9.7 million of bond debt issued to fund its exit from Chapter 9 bankruptcy.

In a report issued last week, Aguer said bankruptcy was a real option under consideration, although on Tuesday she expressed hope that the city could avoid that fate this fiscal year.

Aguer said nearly 70 percent of the city's budget was consumed by police costs, most of which were spent on salaries and pension payments to the California Public Employees' Retirement System, or Calpers.

The fate of other cities struggling with pension costs - including Desert Hot Springs - will add to the pressure for pension reform, said Karol Denniston, a bankruptcy attorney in San Francisco.

"What is happening in Desert Hot Springs, and San Bernardino, are not going to be highly unusual events," Denniston said. "Calpers keeps increasing costs and many of these cities have cut costs down to where there is nothing else left to cut."

An outside consultant's report earlier this year warned Desert Hot Springs that its pension costs were dangerously high.

Detroit, in Michigan, and Stockton and San Bernardino in California, have all struggled to meet their rising pension obligations. Managers in Detroit are seeking a judge's permission to slash pension benefits.

Illinois has a $100 billion unfunded pension liability that has resulted in credit downgrades that have left the state with the lowest ratings among U.S. states.

Although Stockton is on the verge of exiting bankruptcy without cutting payments to Calpers, a newly elected cadre of officials in San Bernardino say they are keen to confront Calpers over rising costs. Calpers is San Bernardino's biggest creditor.

Calpers is America's biggest public pension fund, with assets of $277 billion. It has argued strenuously in court that pension payments cannot be touched, even in a bankruptcy.

(Reporting by Tim Reid; Editing by Lisa Shumaker)