DALLAS -- State pension systems in Texas are unusually vulnerable to an economic downturn.

That's the finding of a recent Moody's Investors Service report that ranked Texas as the third-most susceptible state to pension investment losses based on the rating agency's “budget shock” indicator.

“For fiscal 2016, we assigned a 7.8% probability that Texas experiences an investment loss amounting to 25% of its own-source revenues in a given year,” analysts noted in a Nov. 21 report on state and local pension performance in Texas.

That 7.8% compares to a 50-state median of 1.2% that includes 12 states with no probability of a budget shock. Alaska ranked first with a 17.5% probability, followed by Connecticut with an 8.4% rating. Maryland followed Texas with a 7.1% probability, while Massachusetts ranked fifth at 6.9%.

Analysts see Alaska as an outlier because of its high dependence on oil and gas revenue.

“While 7.8% represents only moderate level of ‘budget shock,’ Texas ranked third-highest among the 50 states under this particular measure, reflecting a comparatively large scale of pension assets to revenues and our estimate of expected return volatility,” Moody’s analysts Thomas Aaron and Timothy Blake observed.

Ten years after the global financial crisis, pension funds are enjoying a bull market in equities, even after reducing their investment return assumptions. The Texas economy continues to grow with the state's population, and oil prices are rising again. But economic downturns are difficult to predict.

The Texas Employees Retirement System recently reviewed its investment strategy after lowering the assumed rate of investment return to 7.5% from the previous 8%.

The revised rate still remains higher than the maximum 7.25% recommended by plan actuaries and the 7% return assumed by the California Public Employees Retirement System. CalPERS, the largest U.S. public pension fund, has a Moody’s budget-shock rating of 1.7%.

Tom Tull, chief investment officer for the ERS, said the recently completed study of asset allocation led toward a slightly riskier and, therefore, more rewarding strategy.

“Of course, we expect to get paid for that,” Tull said.

After the study, ERS lowered its 3% inflation assumption to about 2.5%. Alternative investments such as private equity and hedge funds will grow to 37% from the current 26% over the next four years.

The trust fund remains highly diversified, Tull said, with a sharp eye on volatility. Before tweaking the assets, the plan was run through varied stress test scenarios, including the 2008 crash, the 2000 dot-com bust and the 1987 crash.

“We take that stuff very religiously,” he said. “We’ve got a very proactive board.”

In the 2008 crash, when stocks were down 38%, the Texas ERS suffered only a 4.58% blow, said Tull, who was operating a private company at the time.

“What it taught me is that you never react to a drop like that,” Tull said. “You look at what the causes are, but you never make decisions on investment positions quickly. You find out what was the cause and where would I like to step back in? Then you slowly get back into the market. That worked in ‘87, that worked in the early 2000s, and it worked in the 2008 crash.”

Texas has two pension funds; the other is Teachers Retirement System.

“ERS investments are highly diversified and designed to withstand market fluctuations,” the system asserted in its report on the plan to review asset allocation through the end of the fiscal year in Aug. 31, 2018.

“The asset allocation impacts both the short term return expectations that guide investment decisions and the long term assumption ERS’ retirement actuaries can recommend during the pension experience study,” its officials said.

Moody’s analysts said the TRS also has a higher than recommended rate of return assumption at 8%.

In terms of adjusted net pension liability, Texas ranked third behind Illinois and California with $108.6 billion, according to Moody’s. Illinois’ fiscal 2016 ANPL was $200.6 billion, while California’s was $192.5 billion. New Jersey and Pennsylvania ranked fourth and fifth.

“Despite a recent increase, the state's contributions to Texas ERS remain relatively weak compared to the plan's funding needs,” Moody’s wrote.

Texas raised employee contributions to 9.5% of payroll in fiscal 2016 and also increased government contributions to 10% of payroll from 8%. The increases brought total contributions closer to the “actuarially sound contribution” benchmark for the first time since 2008, Moody’s said.

“Since Texas' actuarially sound contribution is a very backloaded cost formula, it falls below our ‘tread water’ indicator, which is the level of funding needed to prevent unfunded liabilities from growing if a plan hits its investment return target,” Moody’s said. “As a result, plan unfunded liabilities remain on a growing trajectory.”

In general the risk to state pension funds in an economic downturn is much lower than those of cities and school districts, Moody’s said.

“Houston's probability of a shock-level investment loss was much higher at 17.5%,” the analysts said. “Dallas' plan to rebuild assets in its public safety pension system is particularly sensitive to the future investment rate of return and volatility or returns.”

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