Market participants worry that as the federal government faces growing pressure to deal with the huge unfunded liabilities of its Medicare and Social Security programs, it will cut benefits that employees will expect state and local governments to pick up.

"What's going to happen is the federal government is going to start reducing benefits, no question about that," said Thomas R. Saving, a former member of the Social Security Administration and Medicare Trust Funds, who now is a National Center for Policy Analysis senior fellow and Texas A&M University professor of economics. "States are going to be under a lot of pressure from their employees to give back some of the benefits that the feds cut."

Saving said that while there is no federal mandate that would force state and local governments to absorb the benefit cuts, it is likely that the "pressure to pick up that difference is going to get bigger."

Saving's comments come as Standard & Poor's issued a report last week detailing the unfunded liabilities in the two federal programs. Analyst Nikola Swann, one of the report's authors, warned in a release accompanying the report that "significant" changes, such as cuts in benefits, will be needed to address the growing imbalance.

"Ultimately, raising the eligibility age and tightening other criteria, cutting benefits, hiking mandatory contributions, transferring more revenue from the central budget, or some combination of these measures will likely be necessary," he said.

The report projects a shortfall between future Social Security benefits and program revenue over the next 75 years will be $6.8 trillion greater than the $5.1 trillion of federal debt held by the public. The shortfall equivalent for Medicare will be $34.1 trillion, or almost seven times the federal debt held by the public.

"Without other action, they will grow at approximately the rate of interest each year," the report said.

The looming crisis is quickly approaching as baby boomers begin to retire and claim benefits. The 2007 Social Security Trustees Report estimates the current generation is owed $28.5 trillion. That is in addition to $16.5 billion in Social Security benefits.

The Standard & Poor's report said that if the liabilities are left unchecked, they will make the federal government's paying currently promised benefits at existing payroll tax rates "progressively less realistic."

"Absent significant changes" to these programs, expenditures for Social Security and Medicare will increase more rapidly than the U.S. economy in the coming decades, according to the report.

The Standard & Poor's report also warns that the federal government's growing unfunded pension and other post-employment benefits liabilities are almost as large as federal debt held by the public and are continuing to soar. State and local governments are also having to grapple with how to address their unfunded liabilities of these benefits, the report said. Forty states estimate their OPEB liabilities to be $400 billion, more than their total public debt, according to Standard & Poor's.

"Allowed to grow, the pension and OPEB shortfall will make its own contribution toward reducing the fiscal flexibility of these governments," the report said.

The Governmental Accounting Standards Board's deadlines for reporting OPEB liabilities on an accrual basis are being phased in. By the end of 2009, all states and localities are expected to be required to adhere to the new reporting standards and currently. The GASB standards are not binding, but state and local governments must meet them in order to get a clean audit approval from accountants.

Most governments have reported and covered OPEB costs on an annual pay-as-you-go basis for current retirees. Under the GASB standards, they will have to begin using the accrual method, and will have to take into account the cost of paying for benefits for future retirees as well as the annual required contribution, or ARC, that is needed to amortize the liability over 30 years. Governments will have to report the difference between their current funding level and the ARC.


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