Fanciful expectations of investments backing the pension system for state and county employees have put Hawaii in the deepest financial hole in the nation. That reality must be recognized and dealt with vigorously as legislators find a way to balance the budget in the years ahead.

The trend has been for states to assume an annual return of 8 percent in pension plan investments, while corporate pension plans expect a lower rate. That is why a study by Moody’s Investors Service determined that unfunded pensions for state employees nationally are sizable while states struggle to balance their budgets.

Hawaii is in the worst shape, owing $5.2 billion in bonded debt apart from the retirement system and an another $5.2 billion in unfunded obligations in the Employment Retirement System. Combined, that amounts to 16.2 percent of the state’s gross domestic spending, the country’s largest combined debt and pension obligations relative to their economies and revenues. Other states have put more money into their state pension funds so have relatively smaller shortfalls.

Investors look to Moody’s, a credit ratings agency, when buying municipal bonds — and underfunded pension pressures can damage a state’s credit quality and ratings. That could mean higher costs as it issues bonds, with more investor risk attached, to fund expensive construction projects. With local construction jobs finally on the cusp of rebound, Hawaii needs to get its financial house in order with an eye on the long term, beyond the immediate fiscal year.

How did things come to this? In the late 1990s, Hawaii legislators reduced contributions to the retirement fund for more than 90,000 current and future retirees so they could provide public employees with pay raises and still comply with the constitutional requirement of a balanced budget. State Auditor Marion Higa chastised the lawmakers in 2000, warning that relying on returns of at least 10 percent was "detrimental to the system’s unfunded actuarial liability."

No state is in such serious trouble that it is about to default on its bonds, says Robert Kurtter, managing director for public finance at Moody’s, and many analysts also consider it highly unlikely.

"These are really reflections of the budget stress that states and local government are now feeling," Kurtter told The New York Times.

He noted that while a company that fails can close its doors, governments don’t have that option. Some Republicans are suggesting that their states be allowed to go bankrupt so they can renegotiate their pensions, but Congress is not likely to allow them to go belly up.

Terms of Hawaii’s pension system are in the public employee unions’ collective bargaining contracts. Union opponents in some states want to abolish traditional government pensions and make all state workers save for their own retirements, but that is little more than a scare tactic. At the very least, though, union negotiators must be brought to the table soon, to make concessions and undertake meaningful reform such as raising minimum retirement ages.

The reality is that Hawaii and other states have been too generous to state and county employees with taxpayers’ money, providing government-paid pension and health care benefits that private sector workers cannot imagine. Hawaii’s current financial struggle should prompt a scaling down of those benefits to a prudent level resembling those of a company wage earner.