Nationwide, pension monies currently promised to state and local workers and retirees total an estimated $2 trillion. But the shortfall in funds to pay this amount is estimated at $460-700 billion. How did the situation get so bad?

Like corporations, states and cities invest their pension trust funds. In fact, Calpers, the California Public Employees Retirement System, is one of the largest pots of investment money in the world. During the stock market boom of the 1990s, public pension funds' investments reaped the same high returns as private funds. Many state and local governments, like many corporations, used the windfall as an excuse to reduce their contributions to their pension funds. When the boom ended, governments found themselves scrambling to make up the difference.

To make matters worse, cities and states are not subject to ERISA, the federal law for private sector pension plans. Without ERISA-style rules, it's easier for state and local governments to make unfundable pension promises. San Diego, dubbed "the Enron-by-the-Sea" in one New York Times headline, is the poster child for this problem. Now teetering near bankruptcy, San Diego has racked up $1.5 billion in pension debt, another $1 billion in retiree health care debt, and faces six conflict-of-interest indictments against members of its pension board, who cut deals to raise benefits while letting the city underfund its plans.

In addition, state and local governments don't have a pension insurance system like the federal Pension Benefit Guarantee Corporation (PBGC) that guarantees private sector pensions. They must either raise taxes to cover their debts or float bonds, passing the interest on to another generation of taxpayers. And while distressed cities like San Diego can elect Chapter 9 bankruptcy to walk away from their pension promises, states have no such recourse.

Faced with these shortfalls, some states are following the private sector's lead and shifting their employees into 401(k)-style retirement plans:

-- After estimating that its pension plan was short $5.7 billion, Alaska dropped lifetime pensions for new hires, offering instead a 401(k)-style plan. Alaska also reworked its health care benefits for state employees, shifting more of the cost onto workers and retirees.

-- Michigan has done away with lifetime pensions for new employees.

-- Oregon has taken the middle ground, capping some pension benefits for current employees and offering new hires cash-balance or "hybrid" plans instead.

-- And California is talking about dropping pensions. Governor Arnold Schwarzenegger has seized on San Diego's plight to call for a statewide shift to 401(k)-style plans. If California, a bellwether state on social and economic issues, were to dump pensions, many other states could follow.