The leak in states' budgets

NEW YORK (Fortune) -- As cities and states wonder whether their starved pension funds will dry up and force them to use budget money to pay the annual cost, retiree health care benefits are already draining state coffers.

States pay the costs of retiree health care, which range from full coverage for life to more modest benefits, out of their annual budgets. And the tab has been spiraling out of control. In 2008, employer health insurance premiums increased by 5%, or twice the rate of inflation.

"Governments have piled up huge unfunded health care liabilities, the dimensions of which are just now being realized," writes Lance Weiss in a report released in 2006 by Deloitte titled "Paying for Tomorrow." "Estimates of unfunded liabilities associated with retiree health benefit plans represent a fiscal crisis for many states and municipalities."

Deloitte estimates that public pension systems owe employees about $1 trillion in current and future health care costs; and that as medical expenses zip higher they will eat away at larger portions of state budgets.

For example, New Jersey owes about $68 billion in future health benefits, the largest unfunded obligation of its kind in the country, according to a 2008 study by the Center for State and Local Government Excellence.

The study also found that Jersey has the highest future health care obligations per capita at $7,946.92 per resident, and that total future obligations were equal to about 140% of the state's overall budget.

New Jersey's proposed 2010 budget allocation for public school funding is set at $11.4 billion, according to the state's budget proposal. Of that amount, $775.5 million is set aside to pay for retiree health care costs. That's about 7 percent of the overall budget and up about 3 percent from the previous year.

Actuaries say that New Jersey is quite typical of what is going on all across the country.

At the very least, this fluctuating health care cost makes it difficult for states to budget and at worst it forces them to siphon funds from other programs to meet the needs of their retirees. And for now these are legally binding promises that must be paid.

Until the federal government can reveal a plan to dramatically rein in health care costs, services and taxpayers will feel significant strain for years to come as state and local governments cut spending and raise taxes to meet this rising cost.

In their fight to address the problem, politicians find themselves in the constant tug-of-war between being fiscally responsible and keeping their constituents happy. Now they're in a position where it is impossible to do either and the result could be more than a financial disaster.

"They'll have to try and throw the agreements with public employees out," says Roland Machold, a former treasurer of New Jersey. "There will be salary freezes and benefits will be slashed and people will forget that our future as a society depends on quality of these institutions."