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. For state and local government retirees, postretirement cost-of-living adjustments (COLAs) are frequently provided in defined benefit plans. But benefit payments are generally reduced for early retirement, and in some cases payments may be offset for receipt of Social Security. 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. Both government employers and employees generally make contributions to fund state and local pension benefits. For plans in which employees are covered by Social Security, the median contribution rate in fiscal year 2006 was 8.5 percent of payroll for employers and 5 percent of pay for employees, in addition to 6.2 percent of payroll from both employers and employees to Social Security. For plans in which employees are not covered by Social Security, the median contribution rate was 11.5 percent of payroll for employers and 8 percent of pay for employees. Actuaries estimate the amount that will be needed to pay future benefits. The benefits that are attributable to past service are called “actuarial accrued liabilities.” (In this report, the actuarial accrued liabilities are referred to as “liabilities.” Actuaries calculate liabilities based on an actuarial cost method and a number of assumptions including discount rates and worker and retiree mortality. Actuaries also estimate the “actuarial value of assets” that fund a plan. (In this report, the actuarial value of assets is referred to simply as “assets”). The excess of actuarial accrued liabilities over the actuarial value of assets is referred to as the “unfunded actuarial accrued liability” or “unfunded liability.” Under accounting standards, such information is disclosed in financial statements. In contrast, the liability that is recognized on the balance sheet is the cumulative excess of annual benefit costs over contributions to the plan. Certain amounts included in the actuarial accrued liability are not yet recognized as annual benefit costs under accounting standards, as they are amortized over several years. State and local government pension plans are not covered by most of the substantive requirements, or the insurance program operated by the Pension Benefit Guaranty Corporation (PBGC), under the Employee Retirement Income Security Act of 1974 (ERISA), which apply to most private employer benefit plans. Federal law generally does not require state and local governments to prefund or report on the funded status of pension plans. However, in order to receive preferential tax treatment, state and local pensions must comply with requirements of the Internal Revenue Code. In addition, the retirement income security of Americans is an ongoing concern of the federal government. Although ERISA imposes participation, vesting, and other requirements directly upon employee pension plans offered by private sector employers, 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. Since the 1980s, the Governmental Accounting Standards Board (GASB) has maintained standards for accounting and financial reporting for state and local governments. GASB operates independently and has no authority to enforce the use of its standards. Still, many state laws require local governments to follow GASB standards, and bond raters do consider whether GASB standards are followed. Also, to receive a “clean” audit opinion under generally accepted accounting principles, state and local governments are required to follow GASB standards. These standards require disclosing financial information on pensions, such as the amount of contributions and the ratio of assets to liabilities. Three measures are key to understanding pension plans’ funded status: contributions, funded ratios, and unfunded liabilities. According to experts we interviewed, any single measure at a point in time may give a dimension of a plan’s funded status, but it does not give a complete picture. Instead, the measures should be reviewed collectively over time to understand how the funded status is improving or worsening. For example, a strong funded status means that, over time, the amount of assets, along with future schedule contributions, comes close to matching a plan’s liabilities. Under GASB reporting standards, the funded status of different pension plans cannot be compared easily because governments use different actuarial approaches such as different actuarial cost methods, assumptions, amortization periods, and “smoothing” mechanisms. Most public pension plans use one of three “actuarial cost methods,” out of the six GASB approves. Actuarial costs methods differ in several ways. First, each uses a different approach to calculate the “normal cost,” the portion of future benefits that the cost method allocates to a specific year, resulting in different funding patterns for each. In addition to the cost methods, differences in assumptions used to calculate the funded status can result in significant differences among plans that make comparison difficult. Also differences in amortization periods make it difficult to compare the funded status of different plans. Finally, actuaries for many plans calculate the value of current assets based on an average value of past years. As a result, if the value of assets fluctuates significantly from year to year, the “smoothed” value of assets changes less dramatically. Comparing the funded status of plans that use different smoothing periods can be confusing because the value of the different plans’ assets reflects a different number of years. We reported recently that state and local governments will likely face daunting fiscal challenges, driven in large part by the growth in health- related costs, such as Medicaid and health insurance for state and local employees. Our report was 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. We found that, as is true for the federal sector, the growth in health-related costs is a primary driver of these fiscal challenges. State and local governments typically provide their employees with retirement benefits that include a defined benefit plan and a supplemental defined contribution plan for voluntary savings. 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. Statutes and local ordinances protect and manage pension plans and are often anchored by provisions in state constitutions and local charters. State and local law also typically requires that pensions be managed as trust funds and overseen by boards. Most state and local government workers are provided traditional pension plans with defined benefits. About 90 percent of full-time state and local employees participated in defined benefit plans as of 1998. In fiscal year 2006, state and local government pension systems covered 18.4 million members and made periodic payments to 7.3 million beneficiaries, paying out $151.7 billion in benefits. 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 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 combined both defined benefit and defined contribution components in 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. 1.) Although still providing defined benefit plans as their primary plans for general state employees, some states also offer defined contribution plans (or hybrid defined benefit/defined contribution plans) as optional alternatives to their primary plans. These states include Colorado, Florida, Montana, Ohio, South Carolina, and Washington. In 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.