Pension funding shortfalls surpassed funding gaps for retiree health care and other benefits for the first time since states began reporting these liabilities in 2006. In all, state pension systems were just under 78 percent funded—declining 6 percentage points from 2008 levels of 84 percent. New York had the highest funding level at 101 percent—the only state with a surplus—while Illinois and West Virginia trailed all states with slightly more than half of their liabilities accounted for.

Experts such as those with the Government Accountability Office advise states to have at least an 80 percent funding level. Thirty-one states were below this threshold in fiscal year 2009, a dramatic one-year increase from fiscal year 2008, when 22 states were less than 80 percent funded.

"In many states, the bill for public sector retirement benefits already threatens strained budgets, and is competing for resources with other critical needs, including education, infrastructure and health care," said Susan Urahn, managing director for Pew Center on the States in a press release. "The $1.26 trillion shortfall for pensions and retiree health care will drive up annual costs and make already tough budget decisions even tougher."

The situation in retiree health care and other non-pension benefits has worsened since 2008, when states had $587 billion in liabilities and $32 billion in assets. In 2009, states made only 36 percent of the $47 billion in contributions required by their own actuaries for this long-term bill. Alaska, Arizona, North Dakota, Utah and Washington made full contributions.

Pew's study applies the states' own actuarial assumptions. Most states use an 8 percent discount rate, which is the investment target that they expect to earn on average in future years. But there is significant debate among policy makers and experts about what rate is most appropriate to use when valuing pension liabilities. The stakes of this debate are high because when a state lowers its investment return assumptions, the projected value of its liabilities and the annual contributions required to meet them increase dramatically.

A November 2010 Pew report, Roads to Reform, found that many states took steps to address the rising cost of public sector retirement benefits between 2001 and 2010. At least 19 took action to manage their pension liabilities, either reducing benefits or increasing employee contributions in 2010.

"A significant number of states are trying to deal with the bill coming due for their employees' retirement benefits head on," Urahn said. "Given the size of the problem and the challenges of reform, there are no quick fixes. But there is considerable momentum for change."