AFTER $1 BILLION in investment losses, Philadelphia's municipal pension fund has sunk into its biggest hole yet - about $5 billion short of the assets it should be holding to pay future retirement benefits to thousands of city employees.

An actuarial report prepared for the city pension board says that the system's assets, valued at $4 billion in mid-2009, amounted to just 45 percent of its liabilities - significantly weaker than the pension funds in most of the nation's big cities.

The deficit will force city taxpayers to come up with $1.7 billion for the pension system over the next three years - more than $1,000 for every man, woman and child in Philadelphia, according to projections that the city has put into its five-year financial plan.

City Finance Director Rob Dubow describes the escalating pension costs as "perhaps the biggest financial challenge we face."

They also could lead to a fight between the Nutter administration and municipal unions over reducing pension benefits for future employees.

A new five-year contract with the city's police officers, awarded by arbitrators in December, allows the city to set up a new pension program for new police hires. It will require them to contribute more toward their own retirements and allow them to enroll in a hybrid program with a 401(k) component.

Another arbitration panel is considering a new contract for firefighters. But no progress has been made on pensions or other issues between the Nutter administration and the two unions representing nonuniformed workers, whose contracts expired last summer.

Because of the 2008 stock-market crash, the market value of the pension fund's assets declined more than $1 billion from mid-2008 to mid-2009.

But the overall problem goes back to the 1950s, when the city increased pension benefits with little attention to their ultimate costs, and unfunded liabilities merited only a footnote in the pension system's annual reports.

Since then, it has grown into one of the city's biggest financial sinkholes, as one mayor after another has left a bigger pension hole for his successor, kicking the problem down the road to future taxpayers.

Politicians who run for office every two or four years are usually inclined to ignore issues like climate change and pension reform, where it may take decades to see the consequences.

It wasn't until 1994 that the Government Accounting Standards Board, a national rules-making panel for accountants, asked state and local governments to disclose their unfunded pension liabilities and develop plans to reduce them.

Then-Mayor Ed Rendell proposed to pay off the city's liabilities with escalating payments over the next 30 years. Rendell stuck with the plan for six years. But then he rolled the dice in 1999, borrowing nearly $1.3 billion in a 30-year bond deal, figuring that the pension system would invest the money and earn a bigger return than the 6.87 interest rate on the city bonds.

The plan crapped out, as the city's investments soured.

Cheiron Inc., the pension fund's actuarial consultants, reported last week that the pension fund's average gain over the last 10 years has been only 3.0 percent, not even enough to pay the interest on Rendell's bond deal. And the city still owes $1 billion in principal on Rendell's bonds, on top of the $5 billion deficiency in the pension fund itself.

In 2003, the Street administration reduced its pension payments below the levels in Rendell's 30-year plan, and the unfunded liability climbed sharply.

The Nutter administration proposed to confront the problem last year with a major bond deal, to refinance $4.5 billion in pension-related obligations. But the proposal was torpedoed by the worldwide credit crisis. Last summer Nutter mounted a lobbying effort in Harrisburg to temporarily relax pension-funding requirements.

The city is paying the pension fund $350 million in the current budget year, down from $461 million last year. Next year's payment is projected at a record $476 million - and after that the pension payments will balloon even higher, to $558 million in fiscal 2012 and $681 million in fiscal 2013, according to projections in the city's five-year financial plan.

A Pew Charitable Trusts report last year found that only Atlanta, with 52 percent funding, and Pittsburgh, with 29 percent funding, had shakier pension systems than Philadelphia, then reporting a 55 percent funding level.

A more-comprehensive analysis of 84 public pension plans was conducted by the Center for Retirement Research at Boston College, based on funding levels in 2006. It ranked Philadelphia's system fifth from the bottom.

Staff writer Catherine Lucey contributed to this report.