* Local, state governments try to rein in pension costs
* States are short $660 billion for future pension payments
* Public sector unions challenging pension changes in court
By Jim Christie and Lisa Lambert
SAN FRANCISCO/WASHINGTON, May 8 (Reuters) - Public employees in San Jose, California's third-largest city, are gearing up for a marathon court battle if local voters approve a measure in June to overhaul the city's pension system.
"It's just a straight-up war with us," said Jim Unland, board president of the San Jose Police Officers' Association, the union representing the city's police force. " Once the thing passes, we'll be in court for years."
San Jose is part of a broader legal and political struggle shaping up across the United States as cash-strapped state and local governments, Republican- and Democratic-led, try to rein in rising pension costs that are gobbling up big chunks of their budgets.
The stakes are high. Local and state officials have to make tough choices between using their shrinking or flat revenues for local services such as police, firefighters and schools, or making up for falling financial returns on pension investments.
The ballot measure being decided by San Jose's voters would require city employees to pay more toward their pensions or accept a reduced retirement plan.
Related graphic on funding: r.reuters.com/wyp29r
"There is a strong case for reform in many places," said Keith Brainard, research director of the National Association of State Retirement Administrators (NASRA), many of whose members are struggling to get public pension funds in balance.
"Since 2009, more than 40 states have made reforms to their pension plans and ... in the few remaining others they are working on them," Brainard added.
State and local governments administer pension benefits for retired public employees. The cost of providing for those guaranteed benefits has been escalating at a time of shrinking government budgets amid a weak economy. Many people receiving or due to get pension benefits are members of public sector unions.
Most states have announced some sort of public pension reforms since 2008 - from Wisconsin, scene of mass protests in 2011 against changes in public workers' compensation packages, to Rhode Island, where the city of Central Falls last year filed for bankruptcy because of an $80 million unfunded pension and retiree health benefit liability.
States are short by $660 billion for future pension payments, a Pew Center on the States report last year showed. Some expect the Pew Center's next report, due this month, to show a bigger gap because the improvement in the stock market in recent months will take years to show up in actuarial values.
In the 2001 fiscal year, large public pension plans had enough assets to cover more than 100 percent of their liabilities. By 2010, the ratio had fallen to 75.5 percent or lower in some cases, according to the Government Accountability Office (GAO), the investigative arm of the U.S. Congress.
A study published on Tuesday by Boston College predicts that the asset-to-liability ratio probably will have fallen a bit further to 75 percent in 2011 and 2012.
The study says the ratio may pick up to around 82 percent in 2015, but depending on how the stock market performs, for 126 state or locally run plans it could range as low as 74 percent.
Some voters are not happy about losing services to preserve public pension benefits for retired government employees that are, in some cases, much more generous than their own recession-battered retirement funds. Public employees argue that they have worked for lower salaries than in the private sector in exchange for a secure retirement.
Any quick fixes would be hard to carry out. Each state has its own constitution, courts, case law and retirement systems that affect how they can try to rein in pension costs.
Moira Kearney-Marks, a research analyst at the Federal Reserve Bank of Cleveland, said authorities trying to rewrite the rules have a big challenge on their hands.
"The law is bound by considerations that are completely different from those reformers might have in mind," she wrote in a blog post in April. "If you want to help public pension plans close their funding gaps by reducing benefits, the law will probably work against you."
There are at least eight lawsuits nationwide contesting attempted pension fixes, such as one in Florida that is aimed at saving $1 billion a year by reforming public pensions. These lawsuits generally are brought by public sector unions.
"I think they will only grow," said Amy Monahan, a University of Minnesota Law School associate professor looking at the wide range of legal challenges that states face.
Even as legal battles unfold, local and state officials are pushing ahead with pension savings, creating another potential blow to their finances in the future if the unions win and past benefits have to be made good, said Steve Baker, a spokesman for the New Jersey Education Association, a teachers' union.
While legal fees pile up, the financial health of pension funds is worsening. In April, the Northern Mariana Islands, way out in the Pacific Ocean, became the first U.S. public pension fund to file for bankruptcy protection.
States have tended to avoid trying to change pensions for existing retirees and have tried instead to raise retirement ages and lower benefits for new hires. While that strategy may help them avoid lawsuits, it also makes only a small dent in the financial problem.
A case in point is Illinois, where pensions are among the most poorly funded in the country. Nearly two years ago, the state government tried to cut retirement packages for new hires but its unfunded pension liability remains at $83 billion.
In fiscal 2013, starting July 1, state payments into the pension system will hit $5.2 billion, or 15 percent of general revenue spending. It was 6 percent in 2008.
In April, Democratic Governor Pat Quinn went further, making existing employees contribute more or take fewer benefits. That choice was unfair and a violation of the state constitutional, said Michael Carrigan, speaking for public worker coalitions.
A more common approach has been to cut cost-of-living adjustments, or COLAs, for benefits, with 18 states either reducing or eliminating the annual increases, the GAO said.
Two recent court rulings in Colorado and Minnesota upheld the states' rights to change COLAs after challenges by unions.
Florida is appealing a court ruling that its elimination of COLA increases and its requirement of higher worker contributions violate the state constitution.
"It is not clear what level of legal protection is provided in a lot of states. It is an area of laws that is unfolding in front of us," NASRA's Brainard said.
While state courts are reluctant to back big changes to pension contracts, states can alter a contract if "it's reasonable and necessary to provide a public service" and changes are done "in the least drastic way," said the University of Minnesota's Monahan.
The problem: defining what is drastic. "There’s not a nice little rule book," she said.
(Writing by Tiziana Barghini, Editing by William Schomberg and Will Dunham)
((Tiziana.Barghini@thomsonreuters.com)(+16462236312)) Keywords: USA ECONOMY/PENSIONS
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