The debate about US public employees’ pension benefits is hotting up, and the results will have a great impact on the pension fund industry. For the first time there is a discussion about the real costs of promises made by politicians to public sector employees and the bill to tax payers. In fact, the whole matter is extremely political, as one can see from the very different approaches of two neighbouring states, Wisconsin and Illinois.

Illinois is one of the most financially troubled states: its pension system has unfunded liabilities of at least $80bn (€58bn). In order to pay its annual contribution to the state pension fund, Illinois sold $3.7bn of bonds last February. But Governor Pat Quinn, a Democrat, is not thinking of any radical change of the public retirement system, besides the partial reform that was already approved last year (applying only for new hires). However, the Wisconsin Retirement System is one of the better funded plans in the country, according to a Pew Center on the States report, with a funded ratio of nearly 100%, based on its own assumptions.

But the new governor, the Republican Scott Walker, wants to look deeper at the state’s financial situation, even after he succeeded in raising the state employees’ contributions to the fund from zero to 5.8% of their pay. So he may take further action after the release of new pension cost estimates, which were requested last October by the executive director of the State of Wisconsin Investment Board, Keith Bozarth (the details were not known at time of going to press). Bozarth thought it was time to revisit the pension state fund’s assumption of an annual return of 7.8%: if it is lowered, contributions must increase or benefits must decrease.

Walker is one of the new generation of Republican governors who are not shy of confronting the unions on behalf of the taxpayers: his bill to curb dramatically the collective bargaining in the public sector has drawn protests from Democrat activists for weeks, but he went through all of that until he won. His next step could be to introduce a 401(k)-style plan for public sector employees, as he said he would during the electoral campaign. The same shift from defined benefit (DB) to defined contribution (DC) is being evaluated in many US states.

One vocal backer of this shift is Joshua D Rauh, associate professor of finance at the Kellogg School of Management at Northwestern University. “State and local governments have failed to recognise the cost of promises provided by taxpayers,” he wrote in an op-ed on the New York Times. “The public pension debt is actually $3trn beyond the assets set aside.” That figure comes from assuming investment returns lower than the average 8% used by the states and more in line with insurance companies’ models. If the necessary increase in contributions is too high, the only alternative to start up DC plans, Rauh concludes, who suggests copying the model of the Thrift Savings Plan (TSP), which is working well for the employees of the federal government.

Opposing this solution is economist, Teresa Ghilarducci at the New School for Social Research. She claims that 401(k) plans would cost taxpayers more, because they have higher fees, they cannot retain good workers and they destabilise the economy and financial markets.

Other are concerned that 401(k) plans cannot provide sufficient retirement income. However, the experience of the private sector, with the shift from DB to DC plans, is reassuring according to Jack VanDerhei, the research director of the non partisan Employee Benefit Research Institute. His studies show that employees - after a full career of eligibility in a 401(k) plan - can have retirement payouts of between 43-57% of pre-retirement income. Which is acceptable when added to Social Security benefits, which can vary from 36-69% of pre-retirement income according to estimates by Aon Consulting and Georgia State University (GSU).

But research by the independent consultant Sylvester J Schieber, to be published in the Journal of Pension Economics and Finance, shows that the real issue is not the DB versus DC, it is about the retirement age in the public sector: state employees can often start claiming their pensions in their 50s, meaning they will get benefits over a longer period.