This month, Kentucky joined scores of states and municipalities in passing legislation that aims to tackle the state’s woeful funding of its pension plans for retired workers. But lurking in the background of that $33 billion unfunded liability is another multibillion dollar problem waiting to happen: how to pay for the rising cost of retiree health care.

Kentucky is taking a rather unusual approach and opting to issue bonds in order to cover its annual costs for "other post-employment benefits" (OPEB), which includes benefits like health care and life insurance for retired workers. In fiscal 2012, the state’s five main retirement health insurance plans combined for a total unfunded liability of more than $6 billion, while the state’s OPEB cost that year was nearly $850 million, according to an analysis of its Comprehensive Annual Financial Report. The tactic of borrowing money to pay for those costs has not won the state favor with ratings analysts.

“It’s something we view negatively any time a state does that,” says Eric Kim, Fitch Ratings’ director of U.S. Public Finance. “It’s not a sustainable path -- you can’t continue borrowing to pay for current expenses. When that’s happening, that would be a credit risk.”

Of course Kentucky isn’t the only state that’s patching over its retirement health payment holes with Silly Putty (although it is the only one Kim knows of that is paying off those bills today by issuing more debt for tomorrow). Most states and municipalities today are grappling with the growing cost of retiree health care, a problem highlighted now on balance sheets thanks to relatively new accounting rules that require governments to report their OPEB unfunded liabilities.

As of the end of fiscal 2012, many states’ OPEB unfunded liabilities are in the billions: California’s is more than $80 billion between its state, trial court and university system retirees; New Jersey reports a roughly $49 billion total unfunded liability for its retiree health benefits and Illinois’ State Employees Group Insurance plan reports more than $33 billion in unfunded liabilities.

These billion-dollar figures have failed to grab headlines in the same way that pension liabilities have. One reason is that the liabilities tend to be smaller by comparison – California’s unfunded pension liabilities for its two largest funds (state employees and teachers) combine for more than $150 billion. Another reason is that, unlike pensions, retiree health and other benefits are largely viewed by most governments as malleable.

“For the most part it’s easier to change the benefits or eliminate benefits,” says Joshua Franzel, vice president of research for the Center for State and Local Government Excellence. (Franzel notes that California is one of the few exceptions where it is harder to change retiree benefits.) “Governments can tweak around the edges or cut out a lot of the subsidies they provide. [So] when these costs continue up, states are shifting more costs over to the retiree.”

Unlike pensions, governments are not actually required to set aside money for a trust fund from which to pay OPEB costs each year. Most states and localities operate on a pay-as-you-go basis, paying out whatever is needed each year.

Still, the rising cost of health care will force more states and localities to address their costs and unfunded liabilities in the coming years. Jim Link, managing director and chief marketing officer of the PFM Group, notes that the cost increases are largely coming from price inflation in health care that is rising faster than the consumer price index rate of inflation and retirees living longer and, thus, reaping more benefits. However, the accounting standards enacted for most governments in 2007 that required reporting unfunded OPEB liabilities is making that debt harder to dismiss.

“Medical insurance wasn’t really viewed in quite the same way as a pension,” Link says. “Pensions for a long time were something where you needed to set aside money for a long term benefit. OPEB, … it wasn’t required for a record to kept from an accounting and reporting standpoint and, as a result, I think some of the benefits are very large. It was out of the line of sight, if you will.”

Localities on the whole have addressed OPEB gaps more readily than states. In addition to passing on more of the heath-care costs to retirees, localities are lengthening their vesting period and requiring employees to work longer before they qualify for retirement health-care benefits. Link said he worked last year with Roanoke, Va., to help develop a health savings plans for the city's retirees, to be implemented this year.

But states are starting to follow suit. In January, a Massachusetts special commission appointed to study post-employment benefits estimated the unfunded OPEB liability for Massachusetts' state and local governments at approximately $46 billion -- a liability larger than the commonwealth’s unfunded pension liabilities. The report recommended phased-in changes including extending the vesting period for benefits by 10 years, cutting benefits for spouses and transferring more heath care costs to employees.

But implementing changes will likely be a point-by-point battle as states will have to walk the line between cutting benefits for retirees on a limited income and stashing away much-needed income now for a payment far in the future. And it’s a battle that many believe is still years in the making.

“If I’ve got to decide if I want an extra police officer or do I want to make sure in 10, 15 or 20 years that retirees are going to have sufficient medical care,” says Link, “what am I going to pick?”

This article has been amended to remove a misstated unfunded liability and to include New Jersey's figures.