Texas-Size Pension Problems Threaten Cities' Infrastructure Plans

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DALLAS – Three of Texas' largest cities have already paid a price for unfunded pension obligations in the form of rating downgrades. Now there are worries that those pension obligations could squeeze their ability to issue debt for infrastructure.

In Dallas, Mayor Mike Rawlings last week proposed delaying an $800 million bond election until a solution for the troubled Dallas Police and Fire Pension Fund could be worked out.

"I just want to reiterate for the sake of history that we knew about this pension fund some time ago and at the beginning of the year I suggested that we put off this (bond election) until we figured out what we were doing with the pension fund," Rawlings told the city council at a Sept. 21 meeting.

Rather than delaying the May bond proposal until fall, council member Scott Griggs proposed reducing it to $500 million.

"I would like to do a hedge this time," Griggs said. "We don't want to be in a position with a big bond program that we get it out there, the pension system requires money from the city of Dallas, and we don't really have the money to put in. Because then I know what Moody's and Standard & Poor's are going to do to us. They're going to junk our bonds down."

Griggs' statement is hyperbolic, but the pension problem did spur Moody's Investors Service's October downgrade of Dallas to Aa2 from Aa1.

With falling investment returns, the Dallas Police and Fire Pension Fund is just 45% funded, down from 64% at the end of 2014. From a funding ratio of 90% a decade ago, the fund is in danger of running out of cash in 15 years, according to a July report from Segal Consulting.

The city and pension fund members allocate 36% of officers' pay to the pension fund, but that percentage needs to more than double to fully fund the pension over the next 40 years, according to Segal.

Dallas, Houston and Fort Worth, three of Texas' five most populous cities, have already suffered downgrades because of unfunded pension obligations.

In addition to the Moody's downgrade, Dallas saw S&P Global Ratings lower its rating to AA from AA-plus in November. Both agencies assigned stable outlooks after their downgrades.

Houston Controller Chris Brown in March estimated that downgrades by Moody's and S&P cost the city up to $1.5 million net present value savings on $493 million of refunding bonds.

In advance of that deal, Moody's lowered the city's general obligation rating one notch to Aa3. S&P dropped its rating to AA from AA-plus, and both agencies retained a negative outlook.

"The negative outlook reflects our view that there is at least a one-in-three probability that we could lower the rating again within the next two years if Houston is unable to develop and implement a credible plan that lowers its unfunded pension liability or if continued softness in oil prices leads to ongoing contractions in tax revenue," Standard & Poor's analyst Omar Tabani wrote.

With that warning in the air, Houston Mayor Sylvester Turner on Sept. 14 announced "points of agreement" with city union leaders on a plan to eliminate the city's $7.7 billion pension obligation over 30 years. Part of the plan includes $1 billion of pension obligation bonds.

In an initial comment on the proposal, S&P analyst Bianca Gaytan-Burrell said S&P is concerned about how pension bonds might affect the city's ability to meet future capital needs.

"Even measures that reflect increased conservatism are not without risk," she wrote. "For example, we view full funding of actuarially determined contributions as positive, but that practice could place significant stress on the city's budget and be difficult to execute should investment returns fall short of assumptions or savings not materialize as expected."

Regardless of whether a city issues pension obligation bonds, it must carry unfunded pension obligations on its books as debt under Government Accounting Standards Board Rules 67 and 68.

That rule change, which took full effect in 2014, dramatically raised the debt profile of Texas' largest cities.

"It took our net position from $3.2 billion to $146 million with one accounting change," Brown said. "From the 2014 Certified Annual Financial Report to the 2015 CAFR, the unfunded pension obligation went from $1.14 billion to $5.16 billion."

Marc Lieberman, chairman of the Public Pension Alternative Investments Group at the law firm Kutak Rock in Arizona, said the GASB rule change could not have come at a worse time for government pensions.

"The rule changes will result in the reporting of greater volatility in government liabilities from year to year, as market swings in the value of plan assets will be more apparent from year to year and because smoothing fair value determinations of plan assets over a three- to five-year period will no longer be the norm," Lieberman wrote in a 2014 report with partner Mark Lasee.

In an interview with The Bond Buyer, Lieberman stuck with his 2014 view that fears about the impact of GASB 67-68 on credit ratings were overblown.

"For the most part, I haven't seen much movement in ratings," he said. "I see Chicago as a total aberration. It's horribly managed and the state's got major problems.

"All the rating agencies knew what the unfunded liabilities were before this rule went into effect," he said.

Fort Worth's growing pension obligations brought a Moody's downgrade to Aa2 from Aa1 in May. It returned its negative outlook to stable after the downgrade.

Joelle Mevi, executive director and chief investment officer of the Fort Worth Employees Retirement Fund, told the city council in June that the city might need to increase payroll contributions by 5% to close a gap in the amount of time the city would need to make its pension fund whole. That would reduce the city's liability from its current 72.5 years to a more moderate 30-year amortization period, she said.

Lieberman said the Federal Reserve's low interest-rate policies have forced pension fund managers to abandon once-solid assets such as muni bonds and Treasuries for equities, real estate and other riskier investments.

Over his 34 years in the business, Lieberman said he has seen the percentage of pension funds invested in fixed income fall from a typical 30% to as low as 3% now.

"The Fed has largely destroyed many pension systems," Lieberman said, "because fixed income is returning what, 0.2%?"

In addition to working with public employees' unions to reach agreement on resolving the pension crisis, city leaders in Texas must also withstand often fierce political opposition to debt.

Houston's Brown said that the public likely doesn't recognize that the dramatic shift in indebtedness was the result of an accounting rule change.

"The public thinks: 'Oh, my God, it's the beginning of the end,'" he said.

Against a Republican fiscal conservative who made debt the top issue, Turner, a Democratic state Senator, won election to the mayor's office in December. Brown, who worked for former Controller Ronald Green, won a runoff to succeed his boss, who did not run again because of term limits.

Neither Turner nor Brown shy away from discussions of the pension crisis.

"There is a public perception that the pension problem is exacerbating the city's financial problems," Brown said. "But this is probably one of the best times to issue debt in history. We have to continue to fund these capital projects."

Judging from results of recent city bond elections, the voters remain supportive, Brown said.

In Dallas, city council member Griggs warned fellow council members that their constituents would find it hard to stomach reductions in services caused by pension obligations.

"When you talk about cutting city services, I'll tell you what goes on the chopping block first," Griggs said. "That means we're going to do a whole bunch of layoffs. It's those quality of life issues that go first."

Economist Ray Perryman, founder of the Perryman Group in Waco, Texas, said it's good for the economy to put pension balances "on the books, so to speak," to give voters a clearer picture of the overall fiscal situation when they are asked to approve future bonds.

"To the extent that the public didn't realize these obligations were in place, it does give the appearance of a rapid increase in debt levels," he said. "Mayor Turner in Houston appears to be seeking viable solutions, but the process will be difficult and will require voter understanding."

As for reducing the unfunded obligation, given today's low interest rates, "issuing pension bonds may be a financially sound decision," Perryman said, "but there is some possibility that it will be more difficult to get bonds for other purposes sold."

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