(FORTUNE Magazine) – IT'S EASY TO IMAGINE THAT THE retiree health-care crunch doesn't really apply to you. That your pocketbook is somehow impervious to the demographic reality of millions of prescription-pill-popping, arthritic baby-boomers deluging the medical system. Let's say you've never had your retirement health benefits dropped, and you don't own stock in a cash-strapped company struggling with its obligations to retired union workers. Let's go further and assume that you're among the precious, perfect few who are diligently salting away enough money now to cover your future medical costs, just in case your employer isn't there for you. But even if all those things are true, you're still in grave danger.

There is a time bomb quietly ticking away in the netherlands of state and local government, and it is set to blow up in the next few years. When it detonates, the damage will easily run into the hundreds of billions of dollars--forcing tax hikes and public service cuts that will affect the lives of millions of Americans unless dramatic action is taken soon. Why? Because, unlike the private sector, the majority of government employers--48 out of 50 states and more than half of all municipalities--still provide health-care benefits for their workers after retirement. The problem is, lawmakers haven't bothered to set aside nearly enough money to pay for these contractually guaranteed benefits. With health-care costs soaring and the rolls of public workers at retirement age growing fast, the tab for these obligations is expanding exponentially. And the bill is now coming due.

This phenomenon is already weighing on state and local governments. Consider the estimated $17 billion in unfunded retiree health benefits that California's largest school districts have now racked up--money that must eventually come out of school budgets. Or the $26 million a year that the city of Buffalo now shells out on health care for its retirees (more than it spends on health care for active workers and equivalent to about 20% of the city's annual haul from property taxes). Even tiny hamlets are starting to feel the pain: In Crosby, Minn., high school teachers have just returned to the classroom after an eight-week strike that centered on health benefits in retirement.

So why, you're wondering, haven't you heard much--perhaps not anything--about this impending crisis? The reason is simple: State and local governments don't have to disclose the extent of their health-care liability for retirees, so they don't. And what's worse, they habitually foist the cost onto the next generation of legislators.

That's about to change. The Governmental Accounting Standards Board, which sets the accounting rules for state and local governments, will soon force public-sector employers to show on their financial statements the total dollar value of the retiree health-care promises they have made to each worker and retiree. They'll also have to book an expense in their annual budgets for the dollars that will be required to fully fund those retiree health-care liabilities over a 30-year period. (The rules don't technically require governments to come up with that amount of cash each year--but if they don't, the squeeze that hits when the boomers retire en masse will be even more severe.) The rules kick in for budgets in fiscal years closing after December 2006. But as we have seen above, the effects are already being felt.

Under the current system, municipal and state governments make room in their budgets every year for the amount of money they need to cover retiree health care over the next 12 months only. The problem with that pay-as-you-go accounting system is that it ignores the value of the health-care benefits that retirees and active workers alike have already earned but not yet received. It isn't simply an accounting issue: We're talking about real health-care benefits that must eventually be paid with real cash.

There's a precedent in the private sector for this kind of shift in accounting standards--and it's not pretty. Back in 1990, the same rules that are about to take effect for state and local governments were forced on U.S. corporations. Companies suddenly began disclosing huge retiree health-care liabilities on their balance sheets and dramatically increased health-care expenses on their income statements. And Wall Street promptly threatened to punish the stocks of companies offering retiree health care to workers. Executives responded, of course, by taking an ax to the plans. From 1993 to 2003 the number of large companies offering medical coverage to retirees dropped by half, from 40% to 21%. And experts say the decline in the private sector will continue. "Companies just can't afford it," says Dale Yamamoto, a health-care actuary with benefits consulting firm Hewitt Associates. Nor, he asserts, can governments. "They're 20 years behind in the public-sector world," says Yamamoto.

Since governments aren't yet required to disclose their anticipated liabilities, no one knows what the scope of the damage will be. But Richard Johnson, an actuary who heads the public-sector health-care practice at benefits consulting firm Segal Co., says he has already begun crunching the numbers for some of his clients. The result? They are "shocked, simply shocked."

To get a feeling for how quickly the costs add up, let's look at a specific example. In North Carolina any state employee who puts in just five years of service becomes eligible to receive free retiree health insurance for life. (That's at the low end of the spectrum; many public-sector employers require ten years of service to be eligible for benefits.) So a 35-year-old state worker with five years on the job, for instance, can then head off to the private sector for the rest of his career. When he retires from that private-sector job, he'll receive free health insurance from the state of North Carolina for the rest of his life--a benefit that could easily be worth over $100,000. But under current accounting rules, North Carolina doesn't have to tell the public how much the package they just handed that 35-year-old will ultimately cost them.

And that kind of generosity will soon come back to haunt both taxpayers and state workers. According to recent estimates, the new accounting rule would create an instant liability of about $13 billion on North Carolina's balance sheet--that's about 40 times the amount the state currently spends on retiree health care each year. "This is really going to shake things up," says Sherry Melton of the State Employees Association of North Carolina, which represents about 55,000 workers. "Our health plan is in a death spiral, and the lawmakers are underfunding it."

It's not just North Carolina that will be shaken up. In many public systems, half of the active workers are now eligible for retirement. Compounding the problem is the fact that public-sector workers are typically eligible to retire with full pension and health benefits at a much younger age (often in their mid-50s) than their private-sector counterparts. That puts the government employer on the hook for even more years of retiree health care. And all this is happening against a backdrop of health costs escalating at a far greater pace than the tax base. "How many politicians will have gone on to higher office telling taxpayers what a wonderful job they have done keeping taxes down, all the while deceiving them--either intentionally or ignorantly?" asks Frederick Faerber, a CPA who until recently served as the vice chairman of the Trusts and Investments Commission for the city of Newport, R.I.

A few politicians have taken an early stand. In Duluth, Minn., Mayor Herb Bergson says he's already decided to cut services in order to get a leg up on funding the city's estimated $150 million retiree health liability. "The city will be bankrupt in ten years if we continue to go down the path we're going," warns Bergson. He's put a freeze on hiring additional workers, which has resulted in about 80 positions not being filled during the past couple of years. "We're at a point now where our level of personnel in police and fire is getting dangerously low," says Bergson. But the only real solution, he says, is to get rid of the retiree health benefit altogether for newly hired employees. "The cost is just too high now, and we can't afford to give it out in the future," he says.

That's proving to be a tough sell with union officials. "We have traded wage increases and other benefits for this," says Ken Loeffler-Kemp, a Duluth-based representative with the American Federation of State, County, and Municipal Employees. Indeed, don't expect the public sector to follow the lead of many corporations, which have simply eliminated retiree health care for active workers and retirees alike. For starters, government employees are far more likely to be unionized--a mere 9% of all private-sector workers are now represented by a union, compared with about 43% of all state and local workers. And elected officials are often loath to take on those powerful unions, whose members can both vote and strike. "When you look at the union strikes over the last few years, most were over health benefits," notes Paul Fronstin, a researcher at the Employee Benefit Research Institute, based in Washington, D.C. And even if they wanted to eliminate the retiree benefits of existing employees, lawmakers would probably run into a brick wall, since courts have almost uniformly enforced public employee retirement benefits once they've been granted.

So what's the solution? There's certainly the possibility of offloading more state and local health-care spending to the federal government. In fact, that has already begun. Last year's prescription-drug bill provides that government employers offering drug benefits to retirees that are at least equal to those provided by Medicare will get a subsidy from the federal government. Some lawmakers at the state and local levels will no doubt attempt to fill the retiree health-care gap by, say, issuing bonds. But of course that doesn't get rid of the obligation--it simply postpones it.

While eliminating retiree health care may not be possible, cutting back on the generosity of the benefit is. Melton, of the North Carolina workers association, says that state workers have seen their retiree health-care benefits cut continually during the past five years, mostly in the form of increased premiums and co-payments for prescription drugs. She also says that in an effort to drive down the plan's costs, her organization has proposed an increase in the eligibility requirement for full retiree health care from the current five years of service to 20 years. But the idea hasn't taken hold with legislators. "Lawmakers are in the same health plan," notes Melton. "And it's a lot easier to win three two-year terms of office in order to get that five years than it is to meet a 20-year vesting requirement."