Fitch Downgrades City of Dallas, TX GOs to 'AA' on Pensions; Outlook Negative
--Issuer Default Rating (IDR) to;
--$1.7 billion of outstanding limited tax general obligation (GO) debt.
The Rating Outlook is Negative.
SECURITY
The GOs are payable from the city's ad valorem tax levy, limited to $2.50 per $100 of taxable assessed valuation (TAV). Certificates of obligation (COs) are additionally payable from surplus revenues of the city's utility system.
KEY RATING DRIVERS
Downgrade Reflects DPFP Pension Challenges: The downgrade reflects heightened concern about the city's unfunded pension liabilities given the reporting of updated plan valuations since the time of Fitch's last review that increased the total unfunded pension liability to the city's general fund by about 40%, and particular concerns about the city's DPFP (combined) plan pertaining to persistent investment losses and risks highlighted by recent developments related to its deferred retirement option plan (DROP).
Financial Resilience: The city's 'AA' rating continues to reflect strong operating performance enabled by robust economic and revenue growth prospects, strong control over revenues, conservative budgeting, solid reserve funding, and long-term liabilities that Fitch expects to remain a moderate burden on resources if current extensive pension reform efforts are successful.
Economic Resource Base
Dallas is a center for technology, trade, finance and major medical centers; it also ranks as the top visitor and leisure destination in the state.
Revenue Framework: 'aaa' factor assessment
Positive growth prospects are based on expectations for generally positive trends in taxable value and sales tax revenues and ongoing economic development. The assessment also reflects the city's ample independent revenue raising capacity.
Expenditure Framework: 'a' factor assessment
The city's pace of spending is expected to be generally in line with revenue growth given its mature residential base. The assessment considers the city's expenditure flexibility derived from workforce cost controls and conservative budgeting practices. However, Fitch expects that pension contributions will likely increase as the city works to bolster plan sustainability, resulting in somewhat elevated carrying costs. The city's debt amortization rate is rapid.
Long-Term Liability Burden: 'aa' factor assessment
Long-term liabilities comprise about 60% of unfunded pension obligations and estimated debt 40%. The long-term liability burden currently represents a moderate 20% of personal income. The rating assumes that pension reform efforts, in conjunction with continued economic growth, will maintain the burden at about this level or lower.
Operating Performance: 'aaa' factor assessment
The city of Dallas' gap-closing capabilities and healthy reserves position it to maintain financial resilience through an economic downturn.
RATING SENSITIVITIES
Pension Reform Efforts: Maintenance of the current rating will require successful pension reform efforts that stabilize the level of the city's obligations and reduce the risks presented by the deferred retirement option plan. Fitch expects information on pension reforms to inform the rating during the next rating cycle.
CREDIT PROFILE
Dallas is located in north-central Texas and ranks among the top 10 cities nationwide by population. The city serves as corporate headquarters for AT&T, Southwest Airlines, Texas Instruments, 7-Eleven, Inc., HollyFrontier Corp., Pizza Hut, Inc. and other large corporate concerns. Top employers in the education, government and health services sector lend stability to the city's employment base.
The city's role as a wholesale and retail trade center is enabled by a strong transportation network of airports, rail and interstate highways. The Dallas Area Rapid Transit (DART) provides the city with easy access to a highly skilled work force to support its growing technology, finance, business and medical service sectors. Driven by professional service, construction, mining and trade sector growth, the city's employment base is in its sixth consecutive year of expansion. Top taxpayers represent utility, air transportation, developers, real estate, manufacturing and retail industries. The tax base is without concentration.
Revenue Framework
City of Dallas general fund operations are supported by a diverse mix of ad valorem tax revenues (43%), sales tax revenues (24%), service charges (17%), and franchise fees (12%). Revenue growth has exceeded inflation but has been somewhat below GDP growth over the last decade.
Medium-term growth prospects appear likely to outstrip national GDP based on the strength and trajectory of growth in the trade/transportation, professional business/services and leisure/hospitality sectors. New development continues as indicated by three years of consecutive growth in the city's residential and commercial construction valuation/building permit activity through 2015. The Federal Reserve reports that despite the rapid home-price appreciation in the metroplex resulting from strong demand and tight inventories, Dallas home prices remain much more affordable than those in other large metros such as New York and Los Angeles, contributing to affordable living costs. However, an analysis of home price and economic trends over time leads Fitch to believe home prices may be above long-term sustainable levels (for more information, see Fitch'sU. S. RMBS Sustainable Home Price Report (First-Quarter 2016 Update) - Amended, May 26, 2016).
The city's fiscal 2016 tax rate of $0.797 per $100 of TAV provides ample legal revenue-raising capacity below the statutory cap of $2.50. If a proposed tax rate results in an 8% year-over-year levy increase (based on the prior year's values), the rate increase may be subject to election if petitioned by voters.
Expenditure Framework
Public safety, 60% of spending, has grown at a pace supported by revenue growth over the past five years.
Fitch expects spending to continue in line with revenue growth based on a relatively mature residential tax base. The 'a' assessment is informed by the city's elevated carrying costs, 25% of fiscal 2015 governmental spending, which Fitch expects to continue to limit flexibility given demands presented by the city's poorly funded combined plan. Carrying costs reflect a rapid 71% amortization schedule and declining debt service trajectory; Fitch does not expect the cost of future debt issuance to fully replace the amount being retired annually. The city's legal ability to control headcount and salary costs is strong, and additional flexibility is reflected in a modest pay-go capital program.
Long-Term Liability Burden
The city of Dallas' long-term liability burden is 20% of personal income, with an increasing portion (currently 60%) attributable to unfunded pension liabilities. The city anticipates the potential for additional GO authorization within the next several years to fund ongoing moderate capital needs.
Dallas participates in three single-employer defined benefit plans. The Dallas Employees Retirement Fund (ERF) covers non-uniform employees. The DPFP (combined plan) and Supplemental Police and Fire Pension Plan of the city of Dallas (Supplemental Plan) cover police and firefighters.
Under GASB Statement 68, the DPFP plan reports a net pension liability (NPL) for the combined and supplemental plans of $6.9 billion and $24 million, respectively, as of Dec. 31, 2015. A 40% increase in the net pension liability over the prior year resulted primarily from realized losses in private equity and real estate investment values. The DPFP's DROP provisions have also contributed to increased liabilities, liquidity challenges and investment losses associated with required triggering of investment portfolio rebalancing given the level of withdrawals. Fiduciary assets of the combined plan cover a low 28% of liabilities based on a blended discount rate of 3.95% (the 7.25% actuarial rate of return during the period that the plan was projected to have a fiduciary net position, and a 3.57% municipal bond rate thereafter). Fiduciary assets cover 45% of the liabilities of the supplemental plan using a blended rate of 7.19%.
The combined DPFP plan has begun pursuing reforms intended to support longer-term sustainability, although changes are likely to result in higher employer contributions over time. The current rating assumes that the DPFP and the city will be successful in providing structural changes sufficient to achieve affordable long-term sustainability of the plan. A DPFP membership vote on plan amendments is expected as early as this month, which if approved by 65% of the membership, would go into effect in January 2017. The city and DPFP expect to present other plan amendments, subject to state legislative approval, to the Texas Legislature in 2017, which if approved, could go into effect as early as fall 2017. Proposed changes are expected to address plan contributions, benefits and DROP provisions.
Under GASB Statement 68, the ERF plan reports a NPL of $2.2 billion, with fiduciary assets covering 60% of total pension liabilities at the plan's 5.76% investment return assumption (the 8% actuarial rate of return during the period that the plan was projected to have a fiduciary net position, and a 3.57% rate thereafter). The 2015 ERF plan NPL has more than doubled from a year earlier, reflecting a decline in investments from the prior year. This was preceded by six years of positive plan returns.
The Dallas ERF Board approved changes to the ERF benefit plan on May 10, 2016, which were subsequently approved by unanimous Dallas city council vote on Aug. 17, 2016. These are expected to improve long-term plan viability if approved by a majority of voters on a Nov. 8, 2016 ballot initiative. Proposed changes include benefit changes for new employees (increasing year of service requirements and reducing the benefit multiplier), operational/governance changes, and more conservative actuarial assumptions. The city estimates these changes would reduce normal costs by 36% and contribute to long-term viability of the plan.
The DROP provisions of the city's DPFP have been a particular concern. A DROP program typically provides participants with the option of a lump sum benefit on demand in addition to a monthly retirement benefit upon employment termination, which for most DROP programs is limited to 3-5 years. The DPFP DROP by contrast has had uncharacteristically long participation provisions, and as a result, the DROP balance made up a high 56% of total DPFP plan assets as of Jan. 1, 2016. The ability of retirees to withdraw these funds on demand exposes the plan to the risk of a materially reduced asset position, which in turn would pose near-term liquidity challenges and further increase the net pension liability. In recent weeks, the plan has been confronted with an unexpectedly high level of withdrawals that, while they appear to have abated, are expected to require investment portfolio rebalancing.
DPFP has announced some DROP reforms including lower guaranteed return rates, and anticipates further reforms to the plan. However, the most recent 2014 DROP plan amendments reducing guaranteed returns are being litigated on the grounds of constitutionality. The courts thus far have found in favor of DPFP, upholding the constitutionality of DROP plan amendments.
Operating Performance
Fitch expects Dallas to demonstrate strong financial resilience during economic downturns as demonstrated by a history of strong gap-closing capacity enabled by solid expenditure management and sizable reserves.
The city completed fiscal 2015 with a net surplus of $19.4 million (1.7% of spending) and unrestricted reserves of $181.7 million (15.9% of spending). The fiscal 2016 budget is operationally balanced. Fitch anticipates the city will outperform the budget and maintain a sound financial cushion, consistent with its 30-day target for unassigned reserves.
Strong budget management practices include programmed expenditure reductions that have enabled the city to maintain a strong financial cushion. The city's contractually required pension contributions have fallen short of actuarially-determined contributions to the ERF plan due to weaker than assumed investment performance. This mismatch equates to about 1% of governmental spending in recent years. The city council-approved ERF reforms to be presented to voters in November is designed to close this gap.
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