Even as they grapple with budget pressures from a sagging national economy, states are being forced to make tough decisions on how they will cope with an even more severe long-term fiscal concern: a projected price tag pushing $3 trillion to pay the pensions and health insurance of retired teachers and other government employees.

Those commitments are a remnant of a time when governments and teachers’ unions saw generous retirement packages as a fair trade for modest salaries. Now, as a generation of teachers enters retirement, the bills are coming due.

To meet those commitments, school districts are looking at diverting money that would otherwise have gone into operating funds. Teachers are being asked to contribute more of their salaries to keep pension funds and health-care systems afloat. And states are cutting retirement benefits while facing potentially more drastic measures down the road—from raising taxes to slashing other government services.

Complicating matters, 15 states are reporting budget deficits or shortfalls in fiscal 2008, according to the National Governors Association and the National Association of State Budget Officers .

All the while, policymakers are trying to balance the interests of teachers, unions, school districts, and the taxpayers who will ultimately foot the bill.

“These are legacy costs on kids and schools,” said Michael Podgursky, an economics professor at the University of Missouri-Columbia, who has studied teacher-retirement issues. “These benefits are sucking dollars from the classroom.”

Such concerns mirror the debate at the national level as federal leaders and policy experts eye strategies for keeping Social Security and Medicare solvent—with a key difference. While such a move would be politically unpopular, Congress could legally change Social Security and Medicare benefits. But state employees’ and teachers’ pensions and health-care benefits are considered by courts to be property, and thus they’re not easily taken away.

Retirement Wave

The problem is a product both of demographics and of fiscal planning—or the lack of it.

Overall Funding Liabilities

States vary widely in the financial health of their public-employee pension funds, as measured by the percentage they have set aside to meet future pension obligations.

SOURCE: Pew Center on the States

As the baby boomers age, more teachers are retiring, some of them because of lucrative early-retirement incentives, and they’re living longer and collecting more benefits. Meanwhile, states haven’t been setting nearly enough money aside to pay the retirement bills, research shows.

Now, years after policymakers and researchers first sounded the alarm over rising pension liabilities, some states are beginning to get the message. The pension bill for teachers and other government employees, nationwide, is a mind-boggling $2.35 trillion over the next 30 years. But about 85 percent of that has already been funded, according to a report by the Pew Center on the States called “Promises With a Price,” which for the first time attempted to tally what the states owe their teachers and other employees in pensions and retiree health care.

Much of that liability has been whittled down because of double-digit stock-market returns on pension-fund investments, however, and not necessarily because states are putting aside more money. In fact, during the economic downturn that strangled state budgets earlier this decade, many states skipped or skimped on annual pension payments into the funds—and their unfunded liabilities grew.

In 2000, for example, Hawaii paid just 13 percent of its $155.8 million pension tab into its fund, according to the Pew report. In 2002 in New Jersey, the state funded just 3 percent of the $560 million that its actuaries had recommended (in 2006, the state paid 27 percent). Even during the recent good times, such as in 2006, states weren’t making required payments—Illinois paid 33 percent of its bill that year, and Pennsylvania paid 35 percent.

With recession worries now looming, things could get worse as about 1 million teachers near retirement, according to National Education Association predictions.

“When states get into deep fiscal problems, there’s a tendency to skip payments,” said Jim Mosman, the executive director of the Sacramento, Calif.-based National Council on Teacher Retirement. “Once you skip one or two payments, it’s very difficult to catch up.”

Other states are selling pension bonds to help close their shortfalls. States sell bonds and reinvest the revenue in the hope of earning a higher rate of return. Illinois did so in 2003, raising $2 billion. And Connecticut officials decided Jan. 25 to sell $2 billion worth of bonds to help narrow the state’s $7 billion liability.

There’s another, politically more difficult tactic: scaling back or recrafting traditional defined-benefit plans, in which retirees are guaranteed a set pension amount. Such plans are expensive and are disappearing in the private sector. Now some states, including Alaska, Michigan, and Oregon, have switched their plans for teachers and other employees so that some, or all, of the retirement benefits are through defined-contribution plans. Such plans are akin to 401(k) plans in the private sector: Teachers or their school districts—or both—put a percentage of the teachers’ salaries into an investment account.

But changes of this kind, which almost always require legislation, typically encounter strong opposition from teachers’ unions.

Tallying Health Costs

And pensions may be the smaller problem in the long term. The pension price tag is relatively clear; what’s muddier is just how much school districts and states have promised future retirees in health-care coverage. With the costs of medical care skyrocketing, the matter is becoming urgent.

Annual Payments Into Pension Funds

Some states are making greater progress than others in paying down their pension liabilities, as measured against their recommended contribution each year.

SOURCE: Pew Center on the States; based on states’ 2006 comprehensive annual financial report data

The Pew Center wasn’t able to figure those costs, although it plans to do so in a forthcoming report. No other comprehensive study exists on teacher retirees’ health-care costs. But if the amount owed to cover state employees is any clue, the price tag will be hefty. States have promised $381 billion in health coverage to employees, 97 percent of which is unfunded, according to the report.

The National Center for Education Statistics, an arm of the U.S. Department of Education, is conducting a small-scale study using the annual financial reports of the 50 largest school districts to get a better snapshot of pension and retiree-health-care liabilities.

“Right now, we don’t have any information on these local school district conditions,” said NCES Commissioner Mark S. Schneider. However, he added, the phase-in of new financial-accounting rules called GASB 45 (which stands for Statement 45 of the Governmental Accounting Standards Board) means schools and other government agencies will have to tally their unfunded liabilities for retiree health care by 2009 at the latest. (“Accounting Rule Targets Benefits in Public Sector,” Mar. 22, 2006.)

Unlike pension plans, which are regulated by the state in many cases, decisions on what health benefits to extend to school district retirees are often left to districts and their employees to decide during contract negotiations. And since a free public education is guaranteed under all state constitutions, school systems can’t easily wriggle out of such obligations by simply going out of business, as some private employers have done.

“The state’s going to have to bail them out,” Mr. Podgursky, the economics professor, said of districts that may come up short. “But we’re not even sure how the big the problem is yet.”

No matter how big the problem is, John Abraham, the deputy director of research for the American Federation of Teachers, said it can be fixed through a long-term commitment by states, districts, and teachers. He said there is a tendency by those who want to scale back teacher benefits to lump pension and health care together, come up with an alarming dollar figure, and proclaim “the sky is falling.”

In Kentucky, a report prepared for a consultant for the Prichard Committee for Academic Excellence, a citizens’ advocacy group, estimated last year that 83 percent of the state school funding increases from 1992 to 2004 paid for health insurance for current employees and retirees, and retirement costs. In December, Kentucky’s Blue Ribbon Commission on Public Employees Retirement Systems recommended scaling back benefits, including eliminating automatic cost-of-living increases and considering longer working careers.

California is perhaps the only state to have undertaken the mission of accounting for its retiree-health-care promises. And the results are startling.

School districts statewide have a retiree-health-care liability of at least $15.9 billion—an amount that accounts for only about half the 1,036 districts contacted as part of the survey by the state’s Public Employee Post-Employment Benefits Commission. The rest—mostly smaller districts—weren’t able to provide information to the commission.

While California districts aren’t socking money away, that’s not the only reason for the giant tab. Some also offer quite generous benefits, such as the Los Angeles Unified School District’s promise of fully paid lifetime health insurance for retirees and their eligible dependents.

As a result, the commission recommended that local governments and school districts immediately start “prefunding” those benefits and stop relying on a pay-as-you-go method.

“The results of this survey should serve as a wake-up call about the importance of planning ahead,” Commission Chairman Gerald Parsky said when the report was released last month.

Struggling to Change

States are finding it hard to fundamentally change the promised benefits, or how they’re paid for.

Just ask the folks in West Virginia.

Political forces and a substantial unfunded liability prompted the state in 1991 to switch from a defined-benefit pension plan for teachers to a 401(k)-style defined-contribution plan. But the transition didn’t go well. Teachers complained for years about a lack of education on how to invest their money, a lack of choices in of types of investments, and customer-service personnel who knew little or nothing about investing.

“This program just failed in every way,” said David Haney, the executive director of the West Virginia Education Association, a 17,000-member affiliate of the National Education Association. He said that participants in the defined-contribution plan who are now 60 or older and ready to retire have an average balance of $23,100—far short of what most people need for retirement.

“I’m not going to say defined-contribution plans are bad things,” Mr. Haney said. “But I certainly know this: The defined-contribution plan will not work if it does not have adequate education, and diversification.”

In 2005, the legislature closed the defined-contribution plan to new members, and instead put new hires into the traditional pension plan. Employees already in the 401(k)-style plan were, eventually, to be merged into the traditional pension plan as well. But some of them balked—and fought the state in court. Late last year, the state supreme court blocked the merger.

Now, 19,800 employees are stuck in limbo in the defined-contribution plan while the legislature debates whether, and how, to allow members to switch to the traditional pension plan. Though the pension fund’s soundness is improving, West Virginia still has the worst funding level in the country, according to the Pew report, at 55 percent.

In Ohio, legislators are struggling to put money away for state’s retiree-health-care obligations, pitting teachers’ union against school districts.

The Ohio Education Association estimates that the $4 billion health-care fund that supports retired teachers will go broke by 2021, so the union is supporting a bill that would increase district contributions to the fund by 2.5 percent of payroll. School districts in Ohio negotiate retiree health care as part of union contracts.

But school districts, which already contribute 14 percent of payroll toward retirement and health costs, are balking.

“Enough is enough,” said Fred Pausch, the director of legislative services for the Ohio School Boards Association. “The [retirement system] should deal with this problem on their own... instead of passing it on to the backs of students. Our districts can’t afford this.” The retirement system should look at other options, he said, such as cutting back on health coverage. Legislation is pending.

In South Carolina, Gov. Mark Sanford declared in his State of the State speech last month that it is time to end the state’s early-retirement incentive program for teachers and the traditional defined-benefit plan because they’re too costly.

“Our proposal is essentially to keep promises made to current participants, but to end both benefits for new employees,” said the governor’s spokesman, Joel Sawyer. The state had a $9 billion unfunded liability as of 2005, but so far, efforts to scale back benefits haven’t gained traction in the legislature.

Yet some states have managed smaller changes without major opposition. Hawaii and Missouri, for example, have changed state law to prevent benefit enhancements so long as the plans remain underfunded, according to the Pew report.

Oregon may be one of the biggest success stories.

The state went from an $18 billion unfunded liability in 2003 to what is now a surplus. Before significant changes were made by the legislature in 2003, the pension benefits were so rich that some government employees, including teachers, were making more money in retirement than they earned during their last year on the job.

Paul Cleary, the executive director of the Oregon Public Employees Retirement System, attributed the erasure of the liability to three factors: sound investment earnings, the sale of $6 billion in pension bonds, and a switch to a less-lucrative hybrid retirement plan.

New teachers now have a defined-contribution plan, into which they put 6 percent of their own salaries, and a smaller defined-benefit plan. Combined, the two are likely to pay retirees 65 percent of their final average salaries in retirement—which typically was about $53,500 for 2006 retirees. Mr. Cleary said about one-third of the liability disappeared because of that change.

“The lessons we learned is if you’ve got some flaws in your system, you need to address them,” he said. “Members need a retirement system that they can rely on when they retire.”