A showdown is looming over whether commitments made to retirees by government pension funds can be scaled back in dire economic times.

Facing shortfalls, some public pension funds are responding by paring back payouts pledged to retired workers. Earlier this year, pension funds in Colorado and Minnesota curtailed annual cost-of-living increases.

"No matter how draconian you got on the new hires, you ran out of money" if you didn't cut benefits to current retirees, said Meredith Williams, chief executive of the Colorado Public Employees' Retirement Association, with $34.2 billion in assets.

In February, Colorado lawmakers passed a bill that reduced the pension system's cost-of-living adjustment from a fixed 3.5% a year to a maximum of 2%—but possibly less for current and future retirees. The new law also increased contributions from employees and employers. For example, retirees who were expecting a 3.5% increase in cost-of-living adjustments this year will receive no increase.

In response, Colorado and Minnesota have been hit by lawsuits filed by retirees, who claim the changes violate state law. Those retirees have "lived up to their end of the bargain, and the state is not living up to theirs," says Stephen Pincus, a Pittsburgh lawyer representing plaintiffs in both states.