There's been a warning shot across the bow of state and local pension funds. After the U.S. Congress passed the Pension Protection Act this summer, which revises the funding of private pension funds so that they are on more stable ground, it asked the Government Accountability Office to check out public pension funds--their funding, benefits and overall fiscal condition.

Federal attention targeted on state and local retirement plans highlights the pressure on those governments to set their pension houses in order. Most of the focus is--and has traditionally been on-- the funding side: Is there enough money in the pot to fulfill the pension's obligations? But in recent months, the benefits side of the package has been emerging as a new focal point: Will employees agree to cutbacks in benefits to help keep the books in balance?

"These are very threatening times for public pension plans," says Joan McCallen, president and CEO of the ICMA Retirement Corp. "There may be trade-offs."

The trade-offs in question are negotiations between state and local governments and their employees over reducing existing benefits in order to maintain defined-benefit plans, which are more difficult for employers to keep funded than defined-contribution plans, which don't offer regular benefits based on salary and years of service and are fully funded from the get-go.

This past spring, Colorado set the template for trade-offs. The state agreed to maintain its defined-benefit pension plan. In return, employees said they would forgo scheduled cost-of-living raises worth 3 percent of their income and put that money into the pension fund instead. They also accepted a five-year increase in the minimum retirement age--from 50 to 55.

While Colorado negotiated its package, Arizona didn't even bother. In early September, it told thousands of its retired employees that they would not be getting cost-of-living raises for the next five years. The Arizona State Retirement System, which covers 76,000 state and local retirees, said that low returns on investments had drained the special fund used to pay for the annual increase. The legislature has never appropriated money for increases in retiree stipends, and the raises were never guaranteed--although retirees have received them almost every year since 1974. So far, the legislature has not been moved to intervene on retirees' behalf.

There may be little political will to do so--in Arizona and elsewhere. Increasingly, private-sector workers no longer have defined-benefit pensions or retiree medical coverage, so taxpayers may no longer be as sympathetic to guaranteeing such benefits to state or local employees--especially if those benefits mean a cut in services or an increase in their taxes. "Cities and counties are going to have to manage the benefits or manage the service expectations of their constituents," McCallen says. "There's no easy out."

As a result, state and local employees may also be reassessing their priorities. There may be more give on issues such as retirement age and more take on health care. "When we interview participants in our plan," McCallen says, "retiree medical coverage is first and foremost what they talk about."