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Pension Spotlight: Texas

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Pension Spotlight: Texas

Chart 1

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Credit Fundamentals By Sector

  • State of Texas: Texas' unfunded pension liability represents the state's collective proportionate share in several pension plans, of which the Teacher Retirement System (TRS) and Employees Retirement System (ERS) are the largest. The state is a contributing employer and nonemployer contributing entity to TRS. Following the passage of pension reform for TRS and ERS during the past two legislative sessions, we expect the state's pension liability pressures will moderate in the long term, although they will require continued active management in the near term to ensure the affordability of benefit costs.
  • Local governments: For most local governments that participate in one of two agent multiple-employer plans, contribution costs are not a near-term credit pressure due to the plans' funded status, funding discipline, and generally conservative assumptions. However, single-employer plans, while not common, have resulted in credit stress for certain issuers due to weak funding discipline and political challenges.
  • School districts: Contributions remain manageable for most school districts due to a special funding situation whereby the state pays most of the employer contribution costs. With the passage of Senate Bill 12 in the 2019 legislative session, increased contributions from all participating entities have improved the TRS plan's funded status alongside outsize market returns in 2021.
  • Enterprise: Some higher education institutions and charter schools participate in TRS. Similar to school districts, increased contributions following the passage of Senate Bill 12 have helped improve the funded ratio of TRS, which should help to keep costs manageable.

Plan Summaries

Most issuers in Texas participate in one of the following four defined-benefit pension plans.

  • TRS: A cost-sharing multiple-employer plan for school districts and certain charter schools and colleges and universities;
  • ERS: A single-employer plan for the state of Texas;
  • Texas Municipal Retirement System (TMRS): An agent multiple-employer plan for municipal governments; and
  • Texas County and District Retirement System (TCDRS): An agent multiple-employer plan for local county and district governments.

The Texas constitution authorized the creation of these plans, protects participant benefits, and limits the ability to amend benefits to alleviate rising liabilities. Pension plans in Texas are subject to the oversight of the Texas Pension Review Board, which ensures compliance with state statute as well as reports on the actuarial soundness and health of public retirement systems throughout the state. S&P Global Ratings believes that this unique oversight supports transparency and adds a layer of protection for beneficiaries and taxpayers throughout the state. Despite this added layer of protection and oversight, the state's largest plans have historically underfunded actuarial recommendations.

Latest Changes: Increased Contributions To Texas' Largest Plans Improve Funding Discipline

In 2019 and 2021, the state legislated higher statutorily required contributions to TRS and ERS, respectively, to address historical underfunding and improve funded status. While future additional increases and changes to actuarial assumptions will likely be required to fully address the liabilities, these increased contributions have already helped both plans make or nearly make the actuarial determined contribution (ADC) for fiscal 2022 (see chart 2). Furthermore, decreased market returns in 2022 and 2023 could lead to higher contributions from the state in the coming years, potentially offsetting increased funding efforts. (See "Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans," published June 8, 2022.)

For TRS, the state legislated mandatory increases in contributions from all parties over a six-year period. We expect funding progress will remain slow, with contributions, as of Aug. 31, 2022, still falling below not only our minimum funding progress metric, but also static funding levels, which indicates expected funding weakening. This liability will likely continue to strain the state's balance sheet, as Texas is the largest contributor and covers costs for participating schools.

For ERS, during the 2021 state legislative session, the state took significant steps to address rising pension cost pressures and provide long-term stability for the plan. Senate Bill 321 requires the state to make ADCs, in addition to its standing 9.5% statutory contribution, necessary to amortize the system's unfunded accrued liability by Aug. 31, 2054 (30 years). Also, state employees hired after Sept. 1, 2022, are now part of a new cash balance plan; this is a hybrid defined-benefit structure with some properties of a 401(k) plan. The interest adjustment paid to employees has a minimum of 4% and maximum of 7%, with a further 150% match of the employee's balance applied at retirement payable as an annuity. We believe this will reduce both costs and contribution volatility risk.

Chart 2

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TRS

TRS benefits employees of public schools (including charter schools), as well as some employees of colleges and universities. As outlined in its constitution, Texas is required to contribute at least 6% but not more than 10% of participating payroll costs to fund benefits. For schools, this results in the state (as a nonemployer contributing entity) assuming a large share of the annual expenses as well as the liability. However, the employer contribution (consisting of the state's and school's shares) is determined statutorily rather than actuarially, and this has resulted in persistent underfunding of the plan over time. As with ERS (pre-2021 legislative changes), this underfunding has increased the plan's unfunded liability, creating shortfalls that will need to be made up in the future. In addition, TRS' assumed rate of return of 7.0% indicates acceptance of increased market risk, in our view, which could lead to market-driven contribution volatility. However, the previously mentioned legislative changes to contributions should improve funding progress with minimal effect on affordability for participating issuers, although entities will need to sustain improved funding discipline to address the unfunded liability in the future.

ERS

ERS is a single-employer defined-benefit plan for employees of the state. Statutory employer contributions to the plan are set at 10% of payroll (with 0.5% coming from state agencies), which has been insufficient to meet actuarial recommendations in most years before fiscal 2022 when the state paid 100% of the ADC. In addition, in our view, ERS' assumed rate of return of 7% is aggressive for a plan with fixed liabilities resting completely on the state. However, we believe the actions taken with Senate Bill 321 have strengthened funding discipline overall and are positive steps toward addressing ERS' liability.

TMRS

TMRS administers more than 900 hybrid defined-benefit pension plans for municipal employers. Because it is a hybrid plan, members contribute at a designated rate that employers match, and at retirement, the employee's account balance, which includes credited interest and matching employer contributions, is used to calculate the benefit. Municipalities voluntarily participate in TMRS, and plan provisions vary by city (see chart 3). However, cities are required to pay 100% of their ADC and participating employers can elect to make additional contributions to address their liability.

Chart 3

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Assumptions and methods are common across all TMRS plans. They include a discount rate of 6.75%, which is higher than our guideline of 6%. Although the amortization periods vary by plan, we consider a 30-year maximum an aggressive deferral of costs. We view closed or layered amortizations with reasonably level payments over 20 years or less as the most prudent practice. Also, unique to TMRS is its asset-smoothing methodology, which cancels offsetting gains and losses to minimize contribution jumps and keeps the smoothed value of assets generally within 15% of the market value. Given the risk-sharing features, asset-smoothing policy, and statutory maximum amortization methods, we expect that contribution volatility will largely be mitigated.

TCDRS

TCDRS serves more than 830 counties and districts throughout the state. The plans are well funded, and contribution costs are generally not a credit strain for local governments. Participating employers choose their plan provisions as allowed for by state law, and each plan is funded independently by the county or district, its employees, and investment earnings (chart 4). Contributions by employers are actuarially determined, and employers are required to make the full required payment. Employers may also pay additional amounts to prefund benefit increases or mitigate future negative plan experiences.

We believe TCDRS' 7.5% assumed rate of return assumption increases risk and can lead to contribution volatility. The plan's amortization policy limits maximum amortization periods to 20 years, in line with our guidelines and typically limiting any negative amortization stemming from the level percent of pay amortization. Given the ADCs, closed amortization periods of modest length, and level percent of pay, we do not expect participating employer contributions will materially increase or fluctuate.

Chart 4

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Single-Employer Plans

While plan fundamentals, administration, and benefits are unique to each participant, single-employer plans have been a factor in several issuers' downgrades, typically related to aggressive assumptions, including above-average discount rates and poor funding discipline that led to weak funded ratios and rising fixed costs. Single-employer plans are mainly associated with the large metropolitan areas, including Austin, Dallas, El Paso, Fort Worth, Galveston, Houston, and San Antonio. Some local government issuers have issued pension obligation bonds (POBs) to improve the funded status of poorly funded firefighter plans or to control future contribution volatility and cost escalation. For more on our view of the risks and opportunities of POB issuance, see "U.S. Pension Obligation Bond Issuance Recedes In 2022 As Interest Rates Rise," Oct. 10, 2022, and "Five U.S. Public Pension And OPEB Credit Points To Watch In 2023," Jan. 31, 2023.

Other Postemployment Benefits

OPEB costs are generally not a credit stress for local governments because they are a relatively small portion of issuer budgets and benefits can be legally altered, although there may be some political obstacles. Most local issuers fund OPEB costs on a pay-as-you-go basis, which can lead to rapidly rising and volatile payments.

Appendix

Plan Details As Of Most Recent Plan Comprehensive Annual Financial Report
Teacher Retirement System Employees Retirement System Texas Municipal Retirement System Texas County and District Retirement System S&P Global Ratings' view
As of date Aug. 31, 2022 Aug. 31,2022 Dec. 31, 2021 Dec. 31, 2021
(Mil. $)
Funded ratio (%) 75.62 69.74 90.50 88.50 TMRS and TCDRS funded ratios are an average of actuarial funded ratios and not GASB reported.
Discount rate (%) 7.00 7.00 6.75 7.50 A discount rate higher than our 6.0% guideline indicates higher market-driven contribution volatility than what we view as within typical tolerance levels around the country.
Total plan ADC 4,672 1,260 1,077 958 Total contributions to the plan recommended by the actuary.
Total actual contribution 4,658 1,260 1,077 1,073 Total contributions to the plan that were made last year.
Actual contribution as % ADC 99.70 100.00 100.00 112.00 Given statutory funding of TRS and ERS, payments have historically not met ADC.
Actual contribution as % MFP 81.40 87.90 N/A N/A Under 100% indicates funding slower than what we view as minimal progress. Planwide data for TMRS and TCDRS is not available.
Actual contribution as % SF 88.30 104.20 N/A N/A Under 100% indicates negative funding progress. Due to amortization notes below, this will likely continue to be under 100%, though statutory increases in TRS contributions will likely move this closer to SF. Planwide data for TMRS and TCDRS is not available.
Amortization method
Period Open Open Closed Closed A closed funding period ensures the obligor plans to fully fund the obligation during the amortization period.
Length 23 31 Varies Varies Length greater than 20 generally correllates to slow funding progress and increased risk of escalation due to adversity. Amortization periods for TMRS and TCDRS are capped at 30 years and 20 years, respectively.
Basis Level % of payroll Level % of payroll Level % of payroll Level % of payroll Level % explicitly defers costs, resulting in slow or even negative near-term funding progress. Escalating future contributions may stress affordability, particularly if payroll growth is less than the assumption.
Payroll growth assumption 3.00 2.70 2.75 3.00 The higher this is, the more contribution deferrals are incorporated in the level percent funding methodology. There is risk not only of market or other adversity causing unforeseen escalations to contributions, but of hiring practices not keeping up with assumed payroll growth leading to contribution shortfalls.
Longevity Generational Generational Generational Generational A generational assumption reduces risks of contribution “jumps” due to periodic updates from experience studies.
ADC--Actuarially determined contribution. ERS--Employees Retirement System. GASB--Governmental Accounting Standards Board. MFP--Minimum funding progress. N/A--Not applicable. SF--Static funding. TCDRS--Texas County and District Retirement System. TMRS--Texas Municipal Retirement System.

This report does not constitute a rating action.

Primary Credit Analysts:Stephen Doyle, New York + 1 (214) 765 5886;
stephen.doyle@spglobal.com
Todd D Kanaster, ASA, FCA, MAAA, Englewood + 1 (303) 721 4490;
Todd.Kanaster@spglobal.com
Secondary Contacts:Geoffrey E Buswick, Boston + 1 (617) 530 8311;
geoffrey.buswick@spglobal.com
Oscar Padilla, Dallas + 1 (214) 871 1405;
oscar.padilla@spglobal.com
Christian Richards, Washington D.C. + 1 (617) 530 8325;
christian.richards@spglobal.com
Joshua Travis, Dallas + 1 (972) 367 3340;
joshua.travis@spglobal.com

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