The state and local government sector is likely to face persistent fiscal challenges within the next decade. In July 2007, we issued a report based on simulations for the state and local government sector that indicated that in the absence of policy changes, large and growing fiscal challenges will likely emerge within a decade. Our report found that, as is true for the federal sector, the growth in health-related costs is a primary driver of these fiscal challenges (see fig. 1). Two types of health-related costs are of particular concern at the state and local level: (1) Medicaid expenditures, and (2) the cost of health insurance for state and local government employees, retirees, and their beneficiaries. Retirement benefits consist primarily of two components: pensions and retiree health benefits. According to Census data, in fiscal year 2004-2005, state and local governments provided retirement benefits to nearly 7 million retirees and their families. In addition to supporting a secure retirement for state and local government employees and their families, such benefits constitute an important component of the total compensation package state and local governments offer to attract and retain the skilled workers needed to protect lives and health, and to promote the general welfare. These workers include highway patrol officers, local police, firefighters, school teachers, and judges, as well as general state and local government employees who staff the broad array of state and local agencies. Pension plans can generally be characterized as either defined benefit or defined contribution plans. In a defined benefit plan, the amount of the benefit payment is determined by a formula typically based on the retiree’s years of service and final average salary, and is most often provided as a lifetime annuity. In defined benefit plans for state and local government retirees, postretirement cost-of-living adjustments (COLA) are frequently provided. But benefit payments are generally reduced for early retirement, and in some cases, payments may be offset for receipt of Social Security. State and local government employees are generally required to contribute a percentage of their salaries to their defined benefit plans, unlike private sector employees, who generally make no contribution when they participate in defined benefit plans. According to a 50-state survey conducted by Workplace Economics, Inc., 43 of 48 states with defined benefit plans reported that general state employees were required to make contributions ranging from 1.25 to 10.5 percent of their salaries. Nevertheless, these contributions have no influence on the amount of benefits paid because benefits are based solely on the formula. In a defined contribution plan, the key determinants of the benefit amount are the employee’s and employer’s contribution rates, and the rate of return achieved on the amounts contributed to an individual’s account over time. The employee assumes the investment risk: The account balance at the time of retirement is the total amount of funds available, and unlike with defined benefit plans, there are generally no COLAs. Until depleted, however, a defined contribution account balance may continue to earn investment returns after retirement, and a retiree could use the balance to purchase an inflation-protected annuity. Also, defined contribution plans are more portable than defined benefit plans, as employees own their accounts individually and can generally take their balances with them when they leave government employment. There are no reductions based on early retirement or for participation in Social Security. Accounting standards governing public sector pensions were established by the Governmental Accounting Standards Board (GASB) in 1994. Comprehensive accounting and financial reporting standards governing other postemployment benefits (OPEB) in the public sector, such as health care, were issued in 2004 (superseding the interim standards issued previously). Implementation of the new OPEB standards is currently being phased in (see app. IV). The purpose of these standards is to prescribe accounting and financial reporting requirements that apply broadly to state and local government employers’ benefit plans. Reporting by employers and plan administrators helps keep the municipal bond market, taxpayers, elected public officials, plan members, and other interested parties informed about employers’ OPEB costs and obligations, and the operation and funded status of the plans. As with the Financial Accounting Standards Board (FASB) in the private sector, it is not the GASB’s function to enforce compliance with the standards it promulgates. Rather, the GASB functions as an independent standard setter, and its statements and interpretations constitute the highest source of generally accepted accounting principles (GAAP) for state and local governments, as specified in the Code of Professional Conduct of the American Institute of Certified Public Accountants. State and local governmental entities issue annual financial reports prepared in conformity with GAAP for a variety of reasons—such as to comply with general or specific state laws requiring GAAP financial reporting, or to protect the highest possible credit rating on the government’s bonds in order to reduce the government’s cost of borrowing. Compliance with GASB standards is necessary in order to obtain an independent auditor’s report that the financial statements are fairly presented in conformity with GAAP, and a failure to do so would result in a modification of the auditor’s report if the effects were material. Although the Employee Retirement Income Security Act of 1974 (ERISA) imposes participation, vesting, and other requirements directly upon employee pension plans, governmental plans such as those provided by state and local governments to their employees are excepted from these requirements. In addition, ERISA established an insurance program for defined benefit plans under which promised benefits are paid (up to a statutorily set amount), if an employer cannot pay them—but this too does not apply to governmental plans. However, for participants in governmental pension plans to receive preferential tax treatment (that is, for plan contributions and investment earnings to be tax-deferred), plans must be deemed qualified by the Internal Revenue Service. State and local governments typically provide their employees with retirement benefits that include a defined benefit plan, a supplemental defined contribution plan for voluntary savings, and group health coverage. However, the way each of these components is structured and the level of benefits provided varies widely—both across states, and within states based on such things as date of hire, employee occupation, and local jurisdiction. Most state and local government workers still are provided traditional pension plans with defined benefits. In 1998, all states had defined benefit plans as their primary pension plans for their general state workers except for Michigan and Nebraska (and the District of Columbia), which had defined contribution plans as their primary plans, and Indiana, which had a combined plan with both defined benefit and defined contribution components as its primary plan. Almost a decade later, we found that as of 2007, only one additional state (Alaska) had adopted a defined contribution plan as its primary plan; one additional state (Oregon) had adopted a combined plan, and Nebraska had replaced its defined contribution plan with a cash balance defined benefit plan. (See fig. 2.) Although still providing defined benefit plans as their primary plans for general state employees, some states also offer defined contribution plans (or combined plans) as optional alternatives to their primary plans. These states include Colorado, Florida, Montana, Ohio, South Carolina, and Washington. In the states that have adopted defined contribution plans as their primary plans, most employees continue to participate in defined benefit plans because employees are allowed to continue their participation in their previous plans (which is rare in the private sector). Thus, in contrast to the private sector, which has moved increasingly away from defined benefit plans over the past several decades, the overwhelming majority of states continue to provide defined benefit plans for their general state employees. Most states have multiple pension plans providing benefits to different groups of state and local government workers based on occupation (such as police officer or teacher) and/or local jurisdiction. According to the most recent Census data available, in fiscal year 2004-2005, there were a total of 2,656 state and local government pension plans. We found that defined benefit plans were still prevalent for most of these other state and local employees as well. For example, a nationwide study conducted by the National Education Association in 2006 found that of 99 large pension plans serving teachers and other school employees, 79 were defined benefit plans, 3 were defined contribution plans, and the remainder offered a range of alternative, optional, or combined plan designs with both defined benefit and defined contribution features. In addition to primary pension plans (whether defined benefit or defined contribution), data we gathered from various national organizations show that each of the 50 states has also established a defined contribution plan as a supplementary, voluntary option for tax-deferred retirement savings for their general state employees, and such plans appear to be common among other employee groups as well. These supplementary defined contribution plans are typically voluntary deferred compensation plans under section 457(b) of the federal tax code. (See table 1.) While these defined contribution plans are fairly universally available, state and local worker participation in the plans has been modest. In a 2006 nationwide survey conducted by the National Association of Government Defined Contribution Administrators, the average participation rate for all defined contribution plans was 21.6 percent. One reason cited for low participation rates in these supplementary plans is that, unlike in the private sector, it has been relatively rare for employers to match workers’ contributions to these plans, but the number of states offering a match has been increasing. According to a state employee benefit survey of all 50 states conducted by Workplace Economics, Inc., in 2006, 12 states match the employee’s contribution up to a specified percent or dollar amount. Among our site visit states, none made contributions to the supplementary savings plans for their general state employees, and employee participation rates generally ranged between 20 to 50 percent. In San Francisco, however, despite the lack of an employer match, 75 percent of employees had established 457(b) accounts. The executive director of the city’s retirement system attributed this success to several factors, including (1) that the plan had been in place for over 25 years, (2) that the plan offers good investment options for employees to choose from, and (3) that plan administrators have a strong outreach program.