Cities and states on the edge of default over underfunded employee pension plans could find the climb out of their hole a bit steeper, thanks to changes at ratings agency Fitch. Rather than presume return on assets of 8 percent, Fitch now will consider 7 percent to be more realistic, reports the Financial Times. That might push some states into downgrades, a result which would in turn ratchet up borrowing costs at the worst possible moment.

Using data from 2009, Fitch noted in a report that labor costs were eating into budgets, creating new pressure on the states as they battle to resolve massive shortfalls.

“The key questions are whether states and local governments are funding their pensions, how much it is taking up of their general fund and concern about the crowding out of spending for other needs,” Laura Porter at Fitch told the newspaper.

The problems are common in dozens of states, but the pension poster child of the moment is Illinois, where the government just announced a $53 billion fiscal budget that relies on an $8.75 billion bond sale to work.

If the bond effort fails, Illinois faces a $10 billion deficit in 2012.

Illinois Gov. Pat Quinn

“Even with our new revenues, if we do not restructure our debt it will take decades for us to return to the prompt payment cycle of a fiscally responsible government,” Illinois Gov. Pat Quinn told lawmakers during his budget address.

A version of the bond sale bill had already been voted down in January. Quinn admonished politicians, calling on them to either right the budget or vote for the bond.

“If you don’t agree with our debt ­restructuring plan, tell us which programs you would eliminate to pay $8.7 billion in overdue bills today,” Quinn said. "Billions of dollars of existing bills will not go away by magic," Quinn said.

Illinois is currently facing roughly $10 billion in bills for state services, corporate tax refunds, and group health insurance payments, while it also has to pay back money it borrowed from other state funds, state officials said.

Illinois' finances were cited this month as the weakest among U.S. states in a Reuters poll of Wall Street professionals and investors who were asked about the $2.8 trillion municipal bond market.

The usually tame market has been shaken by predictions that some local governments may default on debt and by suggestions that states be allowed to file for bankruptcy, an option that is currently not available

Illinois, the fifth-most populous state, was the second largest issuer of debt in 2010 behind much-larger California, which shares with Illinois an A1 bond rating that is the lowest for states from Moody's Investors Service.