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Vallejo, a working-class community of 120,000 northeast of San Francisco, has long been a strong union town. Like many cities, it gives its workers generous retirement benefits: Police and firefighters can retire as young as age 50 with a pension equal to 90 percent of their final salary, and they enjoy free health care for life. Salaries, which serve as the base for determining pension levels, have also been generous: Forty-four percent of the city’s 613 employees had gross wages in excess of $100,000 in 2008.

Financing such largesse isn’t easy in the best of times. But in the midst of the worst economic downturn since the Great Depression, such salaries and benefits are becoming unsustainable. So facing an $8 million budget deficit and nearly $200 million in unfunded pension and health care liabilities, Vallejo filed for bankruptcy in May 2008, making it the largest governmental body to go bust since Orange County did so in 1994. In March a federal bankruptcy judge ruled that the city could tear up existing contracts as part of its reorganization, a landmark verdict that paves the way for cuts in once-sacrosanct public sector salaries and retirement benefits.

Earlier this year the city reached a deal with police to cut salaries by 18 percent through June 2010 and cap medical benefits; the agreement also imposes a 6 percent pay cut on managerial employees and requires new hires to contribute 20 percent of the cost of their medical insurance. City negotiators are playing hardball with other unions that have yet to settle; they rejected a firefighters’ proposal to take a 6.5 percent pay cut, forego previously agreed-to pay raises of 13 percent and cap health care benefits.

As goes Vallejo, so may go the nation. The cost of public sector pensions is set to soar in coming years because the recent meltdown in the financial markets has worsened the health of systems that were already badly underfunded. Municipal and state governments across the country are struggling with massive budget shortfalls, leaving them in no position to fill the pension gap. As a result, public workers look likely to bear the burden through cutbacks in their salaries and benefits and increases in their pension contributions.

“No one can isolate themselves from the effects of the economy,” Gray Davis, the former governor of California and currently counsel at Los Angeles law firm Loeb & Loeb, told Institutional Investor in a recent interview.