Poor management of the state’s long-term debt obligations could cause a downgrade of the state’s credit rating, resulting in increased borrowing costs and decreased investor confidence.
While Texas has received the highest possible credit rating from Moody’s and Standard and Poor’s (Aaa-stable since 2012 and AAA since 2013, respectively), unfunded pension liabilities have earned Texas declining debt scores in recent years.
Credit rating agencies are private, independent companies. Their ratings represent an estimation of the state’s ability and willingness to meet its financial obligations. The ratings have both qualitative and quantitative elements and are developed by teams of specialists who evaluate a state’s creditworthiness using budget documents, audited financial reports, economic data and relevant official statements.
Texas has been highly rated due to its above-average population growth, well-developed infrastructure and trade networks, large and diverse economic base, financial reserves and strong financial management and budgetary practices. Weaknesses noted by rating agencies include the continuing importance of the volatile energy industry to the state’s economic base and large shortfalls in employee pension contributions.
(one notch adjustment, subject to any applicable rating cap)
Source: Standard & Poor’s Financial Services LLC
Exhibit 6 displays Standard & Poor’s criteria for evaluating state debt as one part of its state credit rating. The company’s “overriding factors” contain some elements applicable to the long-term debt obligations, including pension systems. If analysts determine that a state has these overriding factors, they can be used to justify a downgrade of a state’s credit rating.
The “debt and liability profile” portion of the criteria examines how debt service and other long-term liabilities spending are prioritized. The criteria evaluate how these obligations may affect operating costs and budgets as well as future tax streams and other revenue sources. The pension component also considers changes in assets and liabilities, funded ratios, funding discipline and unfunded pension liabilities.
Texas has received a gradually declining score in Standard & Poor’s debt and liability profile since 2014. Possible scores range from one to four, with one being the strongest; Texas moved from a 2.1 in 2013 to a 2.7 in 2016. S&P assigned this score in response to contributions below the actuarially determined annual contribution, a “trend that could put the rating under pressure.”47 Furthermore, the agency notes that Texas’ pension funding policy is set in law as a percentage of payroll, making future payments below the actuarially determined contribution rate very likely.
Moody’s debt criteria assess relative debt burdens and debt affordability, the state’s debt structure and its capacity to meet long-term debt obligations, including unfunded pension liabilities (Exhibit 7). The pension component of the debt profile measures the total unfunded liability of state pension plans as a percentage of state revenues. Analysts assign scores in this category based on this ratio (Aaa = less than 25 percent, Aa1 = 25-40 percent, Aa2 = 40-80 percent, etc.).
Moody’s analysts also consider pension governance and management, contribution decisions and pension liability calculation mechanisms in their formulation of scores in this component of the profile. Moody’s also may move a rating up or down based on an “additional debt factor,” significantly strong or weak pension characteristics not reflected in the profile.
|Broad Rating Factors||Factor Weighting||Rating Sub-Factors||Sub-Factor Weighting|
|Governance||30%||Financial Best Practices||15%|
|Financial Flexibility/Constitutional Constraints||15%|
|Balances and Reserves||10%|
|Adjusted Net Pension Liabilities||10%|
Source: Moody’s Investors Service, Inc.
A June 2016 Moody’s analysis stated that Texas’ record of below-actuarial-level contributions are driving rising pension costs.48 While Moody’s credits Texas with successful pension reforms in 2013 and 2015, and a higher-than-national-average ratio of active employees to retirees, an October 2016 report by the company notes that Texas has one of the nation’s largest pension shortfalls due to continued underfunding.
In 2016, Moody’s introduced a “treading-water” metric that measures whether pension liabilities rose, fell or remained static in a fiscal year. Moody’s found Texas was considerably below the treading-water benchmark in 2015.49
In the last few years, most states have enacted some type of pension reform. Still, several have seen their credit ratings downgraded due to pension underfunding, including Kentucky, New Jersey, Kansas and Illinois. Pension shortfalls in Dallas and Houston captured attention recently, prompting credit rating downgrades and concern that the downgrades will put negative pressure on the state’s economy as a whole. Moody’s has cautioned that Texas local governments, with their own troubled pension systems, are contributing to growing concern about state government’s pension liabilities.50
Credit rating criteria don’t address deferred maintenance issues directly but such costs are eventually reflected in the state’s financials and could negatively affect the state’s ratings for financial management and governance. Standard & Poor’s overriding factors could be triggered by deferred maintenance, particularly the criteria evaluating financial best practices, flexibility and governance, among other elements. A poor rating on the overriding criteria can trigger a downgrade.
The Texas Tomorrow Fund is perhaps the least visible of the long-term debt obligations discussed in this report. While the ratings agencies criteria do not speak specifically to guaranteed tuition plans, it’s a general revenue pledge and a long-term obligation of the state. Shoring up the program’s finances would send a strong message to rating agencies that Texas intends to meet all its obligations.