Dallas, Texas; General Obligation

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1 Primary Credit Analyst: James Hobbs, Dallas (972) ; Secondary Contact: Jennifer K Garza (Mann), Dallas (1) ; jennifer.garza@spglobal.com Table Of Contents Rationale Outlook Pension Plans JANUARY 11,

2 Credit Profile Dallas GO Long Term Rating AA-/Negative Downgraded Dallas GO Unenhanced Rating AA-(SPUR)/Negative Downgraded Many issues are enhanced by bond insurance. Rationale S&P Global Ratings has lowered its long-term rating and underlying rating (SPUR) on Dallas, Texas' general obligation (GO) bonds to 'AA-' from 'AA'. In addition, S&P Global Ratings has lowered its rating on Dallas' moral obligation bonds to 'A-' from 'A'. The outlook is negative. The downgrade reflects our view that despite the city's broad and diverse economy, which continues to grow, stable financial performance, and very strong management practices, expected continued deterioration in the funded status of the city's police and fire pension system coupled with growing carrying costs for debt, pension, and other postemployment benefit (OPEB) obligations is significant and negatively affects Dallas' creditworthiness. The negative outlook reflects our view that the city faces near-term budgetary pressure due to increased costs for police and fire compensation, including pensions. Furthermore, the negative outlook reflects our understanding that the city's proposed plan to resolve the current pension situation is subject to modification and approval by the Texas Legislature prior to implementation. The GO bonds are secured by the city's ad valorem tax pledge, within the limits prescribed by law. The state maximum for city tax rates is $2.50 per $100 of assessed value (AV); the city is currently levying 78.2 cents per $100 of AV, which is well under the state cap. Given the remaining flexibility under the state cap coupled with the city's rating level, we are rating limited tax GO debt on par with our rating on the city's GO debt. The 'AA-' rating and negative outlook reflect our assessment of the city's: Strong economy, with access to a broad and diverse metropolitan statistical area (MSA); Very strong management, with "strong" financial policies and practices under our Financial Management Assessment methodology; Adequate budgetary performance, with operating surpluses in the general fund and at the total governmental fund level in fiscal 2015; Strong budgetary flexibility, with an available fund balance in fiscal 2015 of 15.0% of operating expenditures; Very strong liquidity, with total government available cash at 50.0% of total governmental fund expenditures and 3.1x governmental debt service, and access to external liquidity we consider exceptional; Very weak debt and contingent liability profile, with debt service carrying charges at 16.3% of expenditures and net direct debt that is 119.4% of total governmental fund revenue, as well as a large pension and OPEB obligation and the lack of an adopted plan to sufficiently address the pension obligation; and JANUARY 11,

3 Strong institutional framework score. Strong economy We consider Dallas' economy strong. The city, with an estimated population of 1.3 million, is located in Collin, Dallas, and Denton counties in the Dallas-Fort Worth-Arlington, TX MSA, which we consider to be broad and diverse. The city has a projected per capita effective buying income of 90.6% of the national level and per capita market value of $87,267. Overall, the city's market value grew by 15.6% over the past year to $110.5 billion in The weight-averaged unemployment rate of the counties was 4.3% in The city's tax base rebounded from its recessionary trough and experienced five consecutive years of annual growth between 2012 and Most notably for fiscal 2017, the city's taxable value of a sizable $110.5 billion represents a solid 10% increase from the previous year. At 10% growth in taxable value, the city's recent growth outpaced that of many of its neighboring cities for fiscal 2017 valuations. Dallas is the ninth-largest city in the nation and serves roughly 1.3 million residents, and continues to be a center for and provide employment opportunities in business and professional services; finance, insurance, and real estate; information; transportation; and health care. It continues to be a regional draw as many nonresidents commute into the city for employment. The population estimate for the entire Dallas-Fort Worth MSA is roughly 6.3 million. The city's top 10 taxpayers are very diverse, comprise only 5.6% of the city's total tax base, and include several utilities, shopping malls, developers, and retail outlets. The city and surrounding communities continue to attract significant employers and businesses to the area. Dallas added approximately 80,000 jobs from 2010 to It also benefits from two major airports that are both undergoing renovations and upgrades. Given ongoing developments, city officials anticipate the current growth trend to continue. They report roughly $2.5 billion in new construction values for fiscal 2017, driven by commercial development, and well-above fiscal 2012 values of $700 million. Single-family residential and commercial permitting is growing and multi-family residential permitting remains strong. For fiscal 2016, overall permit valuation for the city is estimated at $4.67 billion, which we consider high. We anticipate stability within the local economy and continued stable tax base growth in the near term. Very strong management We view the city's management as very strong, with "strong" financial policies and practices under our Financial Management Assessment methodology, indicating financial practices are strong, well embedded, and likely sustainable. Dallas uses multiyear trends of certified property tax values, historical sales tax revenue trends, and other revenue stream data to formulate the budget. Management provides monthly reports to the city council except in October, given it is the first month in the fiscal year. City council can amend the budget at any time. City staff prepares and presents a long-range forecast for both the general fund and debt service, which are presented to the council during the budget development process or during bond program development. Council does not formally adopt these forecasts, but uses them as a financial planning tool in its policy deliberations. Dallas maintains an inventory of capital needs that it updates annually. It is also currently performing a formal facility condition assessment, which is being used to better plan for long-term maintenance/replacement needs. The city has historically used a multiyear capital bond program to fund infrastructure improvements. Management also reports investment results to the council monthly, and it reviews the investment policy annually. The city's financial management performance criteria (FMPC) JANUARY 11,

4 establishes guidelines and targets for operating programs and cash and debt management, including minimum reserves, debt ratios, and restrictions on debt use and issuance. The FMPC is provided as part of the budget development process, at year-end, and as part of GO bond program development. The city has officially hired a new city manager who is expected to begin on Feb. 1, We will continue to monitor the assumptions that the city uses for its financial performance in light of what we view as potential increases to pension-related costs. Adequate budgetary performance Dallas' budgetary performance is adequate in our opinion. The city had operating surpluses of 1.7% of expenditures in the general fund and of 1.7% across all governmental funds in fiscal General fund operating results of the city have been stable over the last three years, with a result of 1.8% in 2014 and a result of 0.3% in Weakening our view of Dallas' budgetary performance is the city's deferral of significant expenditures, including pension funding, which we think inflates the budgetary result ratios. The city's primary operating revenues consist of property taxes (43% of general fund revenues), sales taxes (24%), and service fees (17%). Strong property and sales tax collection growth in 2015 benefitted operating performance. Fiscal 2015 budgetary performance remained adequate after adjusting for capital outlay financed out of various capital projects funds including the street and drainage, building, and transportation funds. Also taken into consideration was the full cost of the city's actuarially determined contribution (ADC). Historically, Dallas has not contributed 100% of the ADC to the Employees' Retirement Fund of the City of Dallas (ERF) pension plan due to the city's code, which limits the increase or decrease in pension contribution payments to 10% per year. Thus, the city's unfunded pension liability grew. As a result, to better reflect ongoing budgetary performance, we added back the deferred amount of the ADC to the total governmental fund expenditures. Recent changes made by the city to the plan should curb future liability growth trends. Not taken into consideration in operating performance is continued growth in the DPFP plan's liability. The city continues to pay its full statutorily defined contribution rate, yet given recent underperforming investment returns, updated plan assumptions, and recent trust asset reductions due to DROP plan withdrawals, we anticipate the plan's liability to continue to grow. Fiscal 2016 year-end estimates remain stable given strong property tax and sales tax growth. Officials anticipate a modest operating surplus in the general fund and note roughly 4% growth in sales tax collections for the year. Nevertheless, near-term budgetary pressures do exist, which are reflected in the negative outlook. The city recently adopted a meet and confer agreement for increases to police and fire pay, including starting pay. The plan calls for a four-year phase-in of funding. Once fully implemented in year four, the cost of the increases will equate to an $89 million a year increase to a fiscal 2016 police and fire compensation budget of $599 million (or a 14.8% increase). The cost assumptions do not include funding for any additional officers. In addition to pay increases, increases in the city's contribution rate for the police and fire pension system could grow by $20 million by Dallas' current pension plan proposal for changes includes increasing city contributions to 34.5% of payroll from 27.5%. Increases in compensation and pension expenditures will have to be absorbed by the city. For fiscal 2016, AV growth of 10% led to an increase in the city's adjusted levy slightly above $100 million when calculating for a modest decline in the total tax rate. However, this does not take into consideration generally rising expenditures and demand for services. Weakening our view of Dallas' budgetary performance is the city's deferral of significant expenditures, including pension costs, which we think inflates the budgetary result ratios. The city made 90% of its annual required pension JANUARY 11,

5 contribution in 2015 for its combined three plans. While the city contributes fully its statutorily defined contributions for the police and fire pension plan, the amount fell below actuarial determined contributions and thus, the plan's liability continues to grow. Further deferred expenditures, including any future capital spending, will continue to challenge budgetary performance of the city and negatively affect the city's finances. In addition to increased pay and pension costs, litigation related to back pay could put additional strain and budgetary pressure on Dallas if resolution is not favorable for the city. The litigation involves maintaining pay differentials for all members whenever there is a raise. Potential exposure to the city could be as high as $4 billion for back pay and $330 million a year ongoing. Timing of the resolution of the litigation, which has continued since 1994, is not known at this time. Officials report an unfavorable ruling could require debt issuance for back pay and a 21-cent tax rate required to service $4 billion in debt. Our future credit analyses will continue to consider near-term budgetary pressures including any deferred spending due to rising expenditures related to police and fire compensation and deferral of capital needs. Strong budgetary flexibility Dallas' budgetary flexibility is strong, in our view, with an available fund balance in fiscal 2015 of 15.0% of operating expenditures, or $171.2 million. During fiscal 2015, management revised the operating reserve goal from 5% of expenditures to 30 days' expenditures for the unassigned general fund balance. The city's fiscal 2015 year-end general fund results were in compliance with the new goal and are expected to remain for Dallas' total tax rate was reduced slightly when compared with previous years. The current rate of 78.2 cents per $100 of AV was a modest decline from five years of a flat total tax rate of 79.7 cents since The city's maintenance and operations tax rate is 56.0 cents while its debt service tax rate is 22.2 cents, which is well below the state maximum for cities with a population of more than 5,000, at $2.50 per $100 AV. Given relatively stable budgetary performance, we do not anticipate any significant changes in budgetary flexibility in the near term. Very strong liquidity In our opinion, Dallas' liquidity is very strong, with total government available cash at 50.0% of total governmental fund expenditures and 3.1x governmental debt service in In our view, the city has exceptional access to external liquidity if necessary. We believe the city has exceptional access to external liquidity given that it has issued bonds secured by various revenue streams frequently for at least 15 years. The city's liquid and non-restricted investments are available in less than a year and are in highly rated investment pools such as Logic and TeXPool, and TexSTAR. While Dallas has pledged moral obligation support for the convention center hotel bonds (series 2009A, 2009B, and 2009C bonds), Downtown Dallas Development Authority tax increment financing (TIF) bonds (series 2006 and 2007), and civic center operational insufficiencies, we do not view it as likely it will need to substantially support these in the near-to-medium term. Tax increment fully supports the TIF bonds; for the convention center hotel bonds, coverage is just under 1x (which does not take into consideration Build America Bonds direct subsidy payments) with hotel revenues but we view the city's need for contribution as minimal if it were needed. The fiscal 2017 debt service costs of the aforementioned obligations amount to just 3.7% of the city's operating revenues budgeted for fiscal JANUARY 11,

6 Very weak debt and contingent liability profile In our view, Dallas' debt and contingent liability profile is very weak. Total governmental fund debt service is 16.3% of total governmental fund expenditures, and net direct debt is 119.4% of total governmental fund revenue. We anticipate that the city will continue to issue bonds in the future for general infrastructure improvements should AV growth support such issuances. Dallas continues to discuss taking an $800 million bond authorization package to voters in Recent discussions from the city indicate the previous tentative plan to go to voters in May could potentially be pushed back to November The city has a contingent liability to make up any shortfalls in debt service coverage for both the Dallas Convention Center Hotel revenue bonds and the Downtown Dallas Development Authority TIF revenue bonds. However, based on revenue trends and coverage for both bonds, GO support is not anticipated for the next year. The combined 2017 principal and interest payment amounts to a modest 2.7% of total governmental fund revenues. Management does not foresee a need to support the operations for the convention center in the near term and if support were needed, it is our belief the assistance would be marginal when compared with the city's sizable operations. In our opinion, a credit weakness is Dallas' large pension and OPEB obligation, without a formally adopted plan in place that we think will sufficiently address the pension obligation. Dallas' combined required pension and actual OPEB contributions totaled 12.7% of total governmental fund expenditures in Of that amount, 11.8% represented required contributions to pension obligations, and 0.9% represented OPEB payments. The city made 90% of its annual required pension contribution in 2015 for its combined three plans. The funded ratio of the police and fire pension plan was 75.5% for 2014, yet the current estimate of the funded ratio of the plan is 45%. While it should be noted that a large part of this decrease is due to updated assumptions, other reasons include low asset returns and insufficient contributions. The city provides pension benefits to its employees via three separate retirement plans: the ERF, the DPFP System, and the Supplemental Police and Fire Pension Plan of the City of Dallas. The ERF is for all eligible employees, excluding firefighters and police officers. The maximum increase or decrease in the city's contribution from one year to the next is 10%, per city code. The ERF was 85% funded as of the most recent valuation, and during fiscal 2015 the city contributed $49.1 million, or 72%, of its ADC. Over time, poorly performing investments, statutory defined maximum contribution rates, and changes in plan assumptions such as a reduction in discount rate from 8.50% to 7.25%, all influenced a drop in the funded status of the DPFP system from 2014 (75.6% funded) to 2015 (63.8% funded). Continued weakness in the plan's affordability between 2015 and 2016 (45.1% funded) was driven by continued negative investment returns as well as actuarial assumption and methodology changes following a five-year experience study. Most recently in late 2016, the plan's assets fell sharply due to over $500 million in deferred retirement funds that were withdrawn from the plan through a deferred retirement option plan (DROP), exacerbating the plan's weakness. Under the current plan, contributions only cover roughly 60% of the money the pension system pays out each month to pensioners and beneficiaries. The city acknowledges that the plan as it stands is not affordable and given current assumptions and contribution rates could reach insolvency within a 10-year time horizon. The city has proposed a pension reform plan (see Pension section below) to the Texas Legislature for approval, but we recognize that the state legislature could modify, reject, or JANUARY 11,

7 develop its own plan and the city would have to abide by it. In addition to pension benefits, Dallas provides certain OPEB for retired employees. As of Sept. 30, 2015, the plan was not funded. The city contributed 54% of the annual OPEB cost, which amounts to $14.4 million. The city discontinued offering subsidized healthcare for employees hired after Jan. 1, The changes should improve the funding status of OPEB. Dallas' combined total pension and OPEB contributions amounted to $179.0 million, or 10% of fiscal 2015 governmental expenditures; however, had the city contributed the full ADC, the combined contributions would have equaled 12.0% of governmental expenditures. This also does not take into consideration the rising liability of the DPFP plan. In our view, the liabilities could create budget challenges over the medium-to-long term if the city does not make progress in successfully amending the DPFP plan. Strong institutional framework The institutional framework score for Texas municipalities is strong. Outlook The negative outlook reflects our view that Dallas faces near-term budgetary pressure due to increased costs for police and fire compensation, including pensions. Furthermore, the negative outlook reflects our understanding that the City's proposed plan to resolve the current pension situation is subject to modification and approval by the Texas Legislature prior to implementation. Deterioration over the next two years in the city's budget flexibility, performance, or liquidity could result in a downgrade. Similarly, uncertainty regarding future fixed cost expenditures could make budgeting and forecasting more difficult. To the extent that this translates into pension underfunding and continued structural imbalance, it could cause us to lower the rating. Additionally, if the city's debt service, pension, and OPEB carrying charge elevate to a level we view as very high and the city is not successful in implementing an affordable plan to address the large pension liabilities, we could lower the rating multiple notches. Should the debt and contingent liabilities profile improve and a credible and affordable plan to overcome Dallas' very large and growing pension liabilities is established, we could revise the outlook to stable. Pension Plans Dallas has developed a proposal for negotiations with DPFP. The city intends to take the proposal, which call for various structural changes to the plan, to the state legislature for approval. Revisions in the most recently published proposal include: Increasing city contributions to 34.5% of payroll from 27.5% and employee contributions to 13.5% from 8.5%, or 48.0% total combined, Eliminating both earned and future interest credits on DROP accounts, Changing to an age-based multiplier, and Decreasing the cost of living adjustment (COLA) to 2% from 4% of the original benefit. The ADC as of Jan. 1, 2016, was 72.7% of payroll, so without the other proposed changes, the proposed 48.0% total contributions (city + employee) would need to be increased by approximately 25% of payroll in order to fund the plan JANUARY 11,

8 over the same closed 10-year period. The 48% rate was calculated to fund the plan over a closed 30-year period, and so defers much of the cost into the future. The plan, with proposed changes, will look to resolve a $3.5 billion unfunded liability in 30 years if all assumptions are met. The actuarial assumptions include 2.75% annual growth in payroll (reduced from 4.00% as of 2016) and a 7.25% discount rate (reduced from 8.50% as of 2015). The proposal also calls for governance changes to mitigate any additional stress or delay with needed future adjustments. The DPFP Board has taken recent steps that affect the plan, including temporarily suspending further member withdrawals through DROP as well as liquidating a small portion of its investments with some asset managers that were responsible for smaller account balances. The board, however, has not agreed to the city's proposal for plan changes and the city anticipates potential litigation related to the proposed plan. One item of dispute is interest credited to retired and active DROP participants. In December 2016 plan members voted against raising employee and employer contributions and reducing COLAs and DROP interest, which arguably would have only benefitted the plan in the short term. The city and the board have stated that they will continue to work to find a solution to the growing challenge, yet no definitive way forward has been agreed on to date. A great deal of uncertainty about the plan's structure and potential changes still remains. Adding complexity to the funding challenges, DPFP is governed by state law and not city ordinance, which means changes will need to be formally adopted by state legislators. The city's proposal could be amended or modified during the legislative session. In addition, there is a lot of volatility underscoring the liabilities given the plan's low funded level, so the risk is high and not meeting the actuarial assumptions may have significant consequences. Continued poorly or underperforming investment returns could equate to an increasing liability despite significant positive changes to the plan's funding and benefits. The Supplemental Police and Fire Pension Plan includes officials in the fire and police departments who hold rank higher than the highest corresponding civil service rank available. This plan's funded ratio declined from 62% in the prior year to 50% as of the most recent valuation also due to changes in the assumed rate of return and decline in the actuarial value of assets. The supplemental plan is much smaller than Dallas' other plans and the city contributed $2.4 million, or 100%, of the ADC in JANUARY 11,

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