State, local finances: Better but not great

Union members protest New Jersey Gov. Chris Christie's plan to use pension payments to balance the budget in June of last year.
Mel Evans | AP
Union members protest New Jersey Gov. Chris Christie's plan to use pension payments to balance the budget in June of last year.

Five years after the Great Recession blew a giant hole in state and city budgets, many governments across the country are showing progress in digging out of the historic financial hole.

But with ballooning liability for pensions and retiree health-care costs, they're not out of the woods yet.

That's the message from a national survey of more than 1,500 state and local governments and school administrators conducted by Cobalt Community Research, a nonprofit research group.

The Great Recession hit local governments hard—thanks to a collapse in property values and a slide in income and sales taxes. Since then, the recovery in the job and housing markets have helped rebuild state and local revenues. About a third of the governments surveyed expect revenues to continue rising next year—up from just 13 percent in 2011. Only 17 percent expect revenues to fall, down from 43 percent in 2011.

Read MorePublic pensions face $2 trillion hole: Moody's

Since the recession, tighter budgets unleashed a wave of state and local government layoffs. But while revenues have begun rising again, just 7 percent of governments expect to boost employment. Still, the worst of the layoffs are apparently over; just 7 percent expect to cut jobs.

"They're not in fantastic shape, but they're starting to get a little bit of breathing space," said William SaintAmour, executive director of Cobalt Community Research. "There still very cautious for the most part. When you look at employment levels, they're just filling in the holes to delivery core services."

Even as the economic recovery has helped stop the bleeding, states and cities face ongoing budget pressure from rising pension and health-care costs. In states and cities that have enacted statutory limits on tax increase, those benefit costs are rising faster than those limits—putting added pressure to cut services.

States vary widely in their pension funding shortfall. Illinois, Kentucky and Connecticut, for example, have set aside less than half of what they need to meet pension obligations for current retirees and active workers. Wisconsin and South Dakota, on the other hand, are among a handful of states that are fully funded.

The funding of health-care benefits is even more problematic, SaintAmour said. "Health-care costs are much less predictable and they're generally not well-funded at all. That's really the 800-pound gorilla that local governments are looking at."

About half of governments surveyed said health-care costs were up more than 4 percent in 2014, and 56 percent expect those costs to rise by more than 4 percent next year.

Read MoreInvestment returns improve for US public pensions in Q2

But government officials acknowledge they could do a better job at controlling those health-care costs. Overall, they gave themselves a 5.1 on a 10-point scale in health-care cost controls. One reason: many said they don't fully understand how to take best advantage of the Affordable Care Act to manage healthcare cost. Respondents rate their knowledge of just 4.5 on a 10-point scale.

You have municipalities that might have 200 employees and one HR employee that's taking care of all of the HR functions. So some of the more strategic changes to health care are not necessarily being done.

Read MorePensions stick with hedge funds despite CalPERS exodus

One solution: Just don't set aside the money. Unlike pension benefits, which are protected in most cases by state constitutions, health care benefits are covered in most cases by contracts that can be renegotiated at some future date. That allows governments more discretion in how much revenue to set aside for health-care costs, SaintAmour said.