The pay raises that Tomball, Texas, employees had received for 22 consecutive years came to a halt in 2009 thanks to the Great Recession. Yet, other than the wage freeze, the Houston suburb has been largely able to resist the kinds of benefits cutbacks that have been common in other cities and towns.

But how long the city can hold the line against cuts seen elsewhere remains a big unknown, says Lisa Coe, the city's director of human resources. While popular benefits like life insurance and disability coverage appear safe for now, health insurance is a major concern, with possible increases in employee cost-sharing on the table. "The costs keep skyrocketing so fast, it's hard to tell," she says. "We keep looking for ways to save. You never know what will work."

Coe is certainly not alone in her focus on benefit expenses in the face of the worst climate for government finances in many years, with increasing demands for services, reduced revenue from traditional sources and an angry constituency that is not in any mood for tax increases. The competing forces have set the scene for a vigorous debate between those who maintain that public sector employees are overcompensated in pay and benefits, and observers who warn that the continuing cuts may place state and local governments at a disadvantage in trying to fill critical skill positions once the employment picture brightens.

"The public sector is walking on a knife's edge," says Keith Bender, an economist at the University of Wisconsin-Milwaukee (UWM), who recently completed a study comparing compensation levels in the public and private sectors. "They need to supply a service and maintain the kind of labor force with the right skills that they are having a hard time paying for. It's a real challenge."

Most public sector officials believe that the effects of the reduced compensation levels will not be felt for some time, because the high unemployment rate nationally keeps employees from seeking better paying jobs in the private sector. In the meantime, the pressure to trim expenses continues to weigh down on the kinds of benefits being offered and the contribution levels employees expect.

Pension obligations loom large

A March 2010 study of public sector compensation levels by the Brookfield, Wis.-based International Foundation of Employee Benefit Plans (IFEBP) identified a continuing "trend toward increased cost-sharing with workers" and "slow movement toward consumer-driven health care in the public sector." While the generally difficult economic climate is a big factor, additional pressure comes from the severe decline in value in public employee defined benefit retirement plans, which will likely require substantial increases in contributions from employers. Under defined benefit plans, the employer is responsible for the pension payment, even if the value of the stocks and bonds set aside to cover the costs suffers market losses, as was the case in the 2008 bear market. The Washington-based Pew Center on the States estimates that pensions are underfunded by more than $1 trillion, bringing their funding levels down to 77 percent in 2008. Estimates from some conservative think tanks (using different assumptions) place the total liability as high as $3 trillion.

The money to fund healthcare benefits for retirees also is lacking. As of November 2009, the federal government estimated that state and local governments had promised more than $530 billion more in post-employment health benefits than they had set aside. The net effect, regardless of the assumptions, is that governments will be forced to contribute more to pay for retiree health plans and the retiree pension plans to keep their promises.

As a result, the IFEBP study found that more employers are turning to wellness initiatives and disease management to reduce health costs, cost-sharing of deductibles and co-pays to add to employee responsibility, and voluntary benefits that have no effect on the employer's bottom line but can lift employee morale. "Plans are embracing initiatives in wellness, value-based health care and disease management even more than a year ago," says Sally Natchek, IFEBP's senior director of research. "It's caused by challenges on the pension side and the cost stress of health care. They are definitely stepping up health care cost control, more than the last few years."

In addition to the health care initiatives, the IFEBP study found:

• Governments are trying to keep health care increases to single digits;
• Employee contributions are growing, despite evident economic hardship;
• Retiree health care costs loom ominously over governments, especially those that have promised a high level of benefits to retirees; and
• Pension plans will require increased contributions from employers to make up for losses on plan assets.

"In the past, the public sector has not followed the changes in the private sector," Natchek notes. "They are following now, maybe a few steps behind, but increasingly they are passing the costs on to employees. The corporations were doing this before. The public sector is following suit."