(Bloomberg News) Michigan's "radical reform" 14 years ago to rescue its retirement system by placing newly hired workers in a 401(k) program may show struggling states the way back from the worst pension crisis ever.

Thirty-three states have assets less than 80 percent of what is needed to pay promised benefits, a common threshold for sustainability, according to an annual study of pensions by Bloomberg Rankings. Median funding fell to 73.7 percent from 76.2 percent in 2009, the data show, even as the U.S. economy rebounded from the deepest contraction since the Depression.

"This is a crisis that is requiring states and municipalities to evaluate and take real, pro-active steps," said William Jasien, executive vice president for institutional markets at ING U.S., a subsidiary of Amsterdam-based ING Groep NV that manages retirement programs for about half the states, including Michigan. They face "very volatile markets, funding pressures -- a lot of public eyes on these pension benefits."

Rating companies are now considering the liabilities in determining credit grades, and 40 states, including New Jersey, New York and Illinois, have taken such steps as increasing what employees pay into retirement funds and curbing cost-of-living increases for future retirees. California's $146.6 billion teachers retirement plan will ask lawmakers for money to diminish a $56 billion unfunded liability, which has more than doubled since 2008.

State and local pension assets dropped to $2.17 trillion by the end of 2009 from $3.2 trillion in September 2007, the largest dollar loss ever, said Keith Brainard, the Georgetown, Texas-based research director at National Association of State Retirement Administrators. Since then, assets have rebounded to close to $3 trillion, he said, the largest gain.

Michigan saw the crisis coming. In 1997, with its unemployment rate the lowest in at least two decades, the state placed all new employees -- including legislators, judges and other elected officials -- in a 401(k) as a way to head off future funding crunches. The idea faced little opposition.

Other states should copy the "radical reform," said Scott Beaulier, director of the Johnson Center for Political Economy at Troy University in Alabama. Michigan's pension-funding ratio was 78.8 percent in 2010 -- 18th best among the 48 states Bloomberg ranked.

"They were able to get around some of the challenges that other states face now," Beaulier said.

Michigan converted when its pension was well funded and the stock market was growing. Beaulier said it would be harder for states with large unfunded liabilities to make the switch now.

Taking the Risk

So-called defined-contribution plans such as a 401(k) set the amount employers and employees pay into investments, and, unlike traditional pensions, don't guarantee a set return for retirees. Some plans let workers choose investment strategies, and they assume the risk -- rather than the government.

In 2004, 80 percent of public employees relied on a defined-benefit pension plan. In private enterprises, 64 percent were in defined-contribution plans, according to the Center for Retirement Research at Boston College.

Michigan's switch shaved as much as $4.3 billion from its obligations, according to a study by the Mackinac Center for Public Policy in June.

The Bloomberg ranking didn't include Hawaii and showed only Wisconsin's pension-funding ratio for 2009 because of insufficient data. The analysis combined each state's pension plans to calculate an overall funding deficit.

Pension costs consumed an average 3.8 percent of state and local government operating budgets in 2008. That share may grow to as much as 12.5 percent by 2014 in places with large unfunded liabilities, according to an October 2010 report by the Center for Retirement Research.

Since 2009, 40 states have cut benefits, made employees pay more for retirement or both, said Ronald Snell, senior fellow at the National Conference of State Legislatures.

Still, seven states this year rejected plans to switch to 401(k)s, Snell said. Among them was Oklahoma, where lawmakers decided conversion was too expensive, said Tom Spencer, executive director of the Public Employees Retirement System.

Oklahoma's pension funding was in a three-way tie for fourth lowest, at 55.9 percent, along with Louisiana and West Virginia, according to Bloomberg data.

Spencer said the funds were eroded by the stock market plunge and the Legislature's failure to fund benefit increases it approved in the 1990s. Lawmakers this year eliminated cost- of-living increases and raised the retirement age. Those changes will reduce the liability by one-third, Spencer said.

In Michigan, about 19,000 employees covered by the old pension plan pay nothing into it. For the 25,000 in the 401(k) plan, the state places a minimum 4 percent of their salaries into their fund. If they contribute an additional 3 percent, the state matches it.

Last fiscal year, Michigan paid $370 million into the pre-1997 pension fund and $96 million into 401(k) plans as of Sept. 30, 2010, according to the Office of Retirement Services.

The average monthly benefit to retirees in the old plan was $1,497 as of Sept. 30, 2009. Thirty percent -- those with 30 years' service -- received an average $2,234.

Teachers have a separate pension, and since 2010 new ones have been placed in a hybrid plan that combines features of traditional program and a 401(k).

Michigan's cost-cutting retirement programs don't get good reviews from all its members.

Tapping the Fund

Amanda Sweet, 35, said her 401(k) isn't helping her save much. She's worked 11 years as a disability examiner for the Department of Human Services in Traverse City.

With five children, she's had to often tap her account for expenses, even with a combined $80,000 annual income with her husband, a charter-flight pilot.

"The 401(k) plan is really for people who can save their money, put as much into a savings as they can and never withdraw it, who don't have kids," Sweet said.

Some states give employees the option of either a traditional pension or a defined-contribution plan. And Michigan, Utah, Georgia, Indiana and Oregon have plans that combine pensions with defined contribution deals.

New York Comptroller Thomas DiNapoli is among those who say 401(k)s are no substitute for the security of traditional government pensions. They are, he said, "a bad idea."

"Maintaining strong defined-benefit pensions is not only the right thing to do for our citizens, it's the best thing for our nation's economy," he told the Council of Institutional Investors in Boston on Sept. 27.

New York's pension system, with more than 1 million members and assets of $147 billion, was the best-funded in 2010, at 101.5 percent, the Bloomberg data show.

Unfunded liabilities can harm credit ratings, said Ted Hampton, vice president and analyst at Moody's Investors Service. Since April 2009, Moody's has downgraded Illinois three times -- with one upgrade -- dropping it to A1 with a negative outlook from Aa3, and tying it with California as the company's lowest-rated states.

"In each case, the weakness of Illinois' public retirement plan was a primary consideration," Hampton said. The Bloomberg data show Illinois with a funding ratio of 45.4 percent, the lowest among the states.

Dave Urbanek, spokesman for the Illinois Teachers Retirement System, said that in 2010 the General Assembly acted to reduce the fund's deficit. New employees must work until 67 to retire with full benefits, and cost-of-living increases were limited.

In May, legislation requiring employees to contribute as much as three times more toward retirement stalled in the face of union opposition. Unfunded liabilities for the pension system were at $80 billion.

"We've never missed a pension check," Urbanek said in a telephone interview. "We're treading water. We're not where actuaries would like us to be, but we're far from going broke."

The 18-month economic contraction that ended in June 2009 reduced the value of the 100 largest public retirement funds by $835 billion, according to a U.S. Census 2010 report. Meanwhile, the $99.9 billion paid from those state and local pensions in the first half of 2011 was 47.7 percent more than benefits paid five years ago, in the first half of 2006, according to the census.

The largest state retirement funds earned half what they needed during the past decade to meet future payouts, Bloomberg News reported in July. In that survey of pensions with more than $20 billion in assets, all gained below 4 percent for the decade through June 30, 2010 -- less than the 8 percent that many assume.

New Jersey's pension systems saw unfunded obligations reach $53.8 billion as of that date, said Andy Pratt, spokesman for the Treasury in Trenton. The state hasn't paid enough in, he said, and in 2001, it boosted benefits by 9 percent.

The deficit will shrink because of such changes as eliminating cost-of-living increases, requiring employees to pay more and gradually increasing state payments, Pratt said.

"If we follow this, we will be 88 percent funded by 2041," Pratt said.

The changes weren't enough to forestall a downgrade by Fitch Ratings in August, to fourth-highest AA-. Fitch cited pressure from pension and employee-benefit deficits.

Economist Beaulier said that like Michigan, other states should convert to defined-contribution plans, even if they have to borrow to pay upfront costs. He said while traditional pensions may provide more security and benefits, young employees will have to pay too much to sustain them.

"It's a question of how comfortable do people need to be made in the retirement years?" Beaulier said.