It might come as a surprise to some, given the drumbeat of reports about underfunded public pensions, that a number of states and localities boast retirement systems that consistently perform well: In North Carolina and Milwaukee, for example, policymakers paid their pension bills when they came due and raised benefits only after determining how to pay for them.

Unfortunately, however, there are all too many examples of governments that continue to struggle to cover the long-term costs of their employees' pensions. Some of the challenges facing these retirement systems can be traced to the collapse of pension investments during the recent financial crisis, but states and local governments that are in the worst shape had pension problems that preceded the Great Recession. Their retirement systems are deep in the red because of poor policy choices--not just a weak economy.

Want more management news and commentary? Click here.

One aspect of this important issue is often overlooked: the connection between state pension policy and local government. Many cities and counties are tethered to the rules, administration and financing of their states' pension systems. When states get in trouble, local governments can end up having to cover the costs of decisions beyond their control. The reverse is also true: A state can help its local governments by enacting sound pension policies. Examples from Illinois and Kentucky illustrate both aspects of this situation.

In Illinois, the pensions of most cities are managed by the state-administered Illinois Municipal Retirement Fund. The state fund sets rules and imposes fiscal discipline on participating employers. In 2009, it had 83 percent of the money needed to cover its long-term pension obligations. While Illinois was failing at managing its own state pensions, the rules it set for IMRF kept that system in relatively good shape.

Chicago, however, is not part of this fund, and is weighed down with a retirement system that imposes runaway costs on the city's budget. Mayor Rahm Emanuel, noting that cost-of-living adjustments allowed by the plan exceed the city's ability to pay, proposed a 10-year freeze on these COLAs. But because Chicago cannot act without state approval--and Illinois lawmakers have so far avoided voting on Chicago's reforms--the city's unfunded pension liabilities are going from bad to worse.

A different, and far more positive, scenario took place in Louisville, Ky., where city employees participate in a state-run retirement plan. Louisville's unfunded liability has continued to grow, even though the city made 100 percent or more of its recommended pension contributions each year. These shortfalls were primarily the result of investment losses and unfunded cost-of-living adjustments awarded by the state.

With pension costs eating up 15 percent of the city's general fund, Louisville Mayor Greg Fischer had to rely on state legislators to tackle Kentucky's pension challenges. And during the last legislative session, policymakers did just that, passing a bipartisan set of reforms that is projected to save more than $10 billion for Kentucky and its local governments over the next 20 years while keeping the promises made to public employees and retirees.

Kentucky is moving forward with three key reforms. First, the law commits Kentucky to paying the full amount owed into the pension system and includes a funding plan that makes nearly $100 million available each year to help meet this promise. Second, Kentucky will limit future cost-of-living adjustments unless the benefit can be fully paid for; this reform essentially ends an unfunded mandate on Louisville and other municipalities across the state. And third, employees hired after Jan. 1 of next year will be placed into a hybrid cash-balance retirement plan that will make costs more predictable and easier to budget for.

There are no simple answers for the challenges facing public pensions. State and local leaders must work together to craft fair, data-driven solutions. This will require tough choices but, as some states have shown, with collaboration and a willingness to face up to the challenge there are solutions to the problem of underfunded public pensions.