NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'AA' rating for the Commonwealth of Pennsylvania's $750 million general obligation (GO) bonds, second series of 2013.
The bonds are expected to sell the week of Oct 22nd, 2013 through competitive bid.
In addition, Fitch affirms the 'AA' ratings on $10.9 billion in outstanding GO bonds and the ratings on bonds supported by commonwealth appropriations that are listed at the end of this release. The ratings on the appropriation-backed securities are linked to the commonwealth's GO rating.
The Rating Outlook is Negative.
SECURITY
The GO bonds are direct and general obligations of the commonwealth of Pennsylvania, with full faith and credit pledged.
KEY RATING DRIVERS
REDUCED FISCAL FLEXIBILITY: The 'AA' rating reflects the commonwealth's significant financial challenges including budgetary structural imbalance, a failure to boost the adequacy of pension funding, and the lack of a reserve cushion. The Negative Outlook reflects Fitch's view that growth in fixed costs could outpace projected revenue growth.
PENSION FUNDING DEMANDS: The funding levels of the commonwealth's pension systems, which have been historically adequate, have materially weakened, with annual contribution levels remaining well below actuarially required levels. Under current law, Fitch expects sizable statutory increases in contributions due to the systems over the next several years will consume much of future revenue growth.
ABOVE-AVERAGE LONG-TERM LIABILITIES: The commonwealth's debt ratios are moderate and at the median for U.S. stated rated by Fitch. However, the commonwealth's combined debt plus Fitch-adjusted long-term liabilities is above-average, and will likely continue growing given the current statutory schedule of persistent pension underfunding.
SOLID ECONOMIC PROFILE: Employment growth continues for the state's broad-based economy, though at a slower pace than the nation given Pennsylvania's less severe recessionary losses. Below-average demographics represent a long-term drag on economic growth, though potential development of the significant natural gas reserves could mitigate that concern.
RATING SENSITIVITIES
Maintenance of the 'AA' rating will require action over the next one to two years to make substantive progress towards addressing the state's structurally unbalanced budget, restoring reserves, and addressing the rapid growth of fixed costs, including for pension funding.
CREDIT PROFILE
Pennsylvania faces fiscal pressures in the form of a structurally unbalanced budget, depleted reserves, and a rapidly growing pension cost burden following years of underfunding and market-driven investment declines. Continued inability to address these concerns, or worsening of conditions, over the next one to two years could trigger further negative rating action. Offsetting this, the state benefits from a diversified and slowly expanding, economic base, and moderate tax burden.
STRUCTURAL IMBALANCE DESPITE REVENUE GROWTH
The commonwealth's tax revenues continue their recovery, though the enacted fiscal 2014 budget reverses progress towards eliminating the structural budget gap. For fiscal 2013, general fund revenues grew 3.5% year-over-year (YOY). The enacted fiscal 2014 budget forecasts baseline general fund YOY growth of 2.9%, though actual growth is projected at just 1.6% after accounting for tax law changes including the phased-in reduction of the capital stock and franchise tax. Despite these positive trends, the state again suspended a requirement to restore its depleted rainy day fund from fiscal 2013 ending general fund balance, and instead relied on nearly the entire $544 million projected balance to balance the fiscal 2014 budget. At the end of the current year, Pennsylvania expects to maintain just $5.6 million in general fund balance, representing its entire budgetary reserves. This would represent an extremely narrow 0.02% of estimated fiscal 2014 general fund revenues.
Income tax gains are driving recent revenue growth, while sales tax revenue growth lags, implying that results could be skewed by federal tax changes. Fiscal 2013 personal income tax (PIT) collections were up 5.3%, from fiscal 2012. In contrast, sales and use tax (SUT) collections were only up 1.4% from the prior year, and were 3.5% below the governor's January 2013 revised estimate. As in other states, Fitch believes acceleration of income into the end of calendar year 2012 to avoid federal tax increases enacted at the start of this year, and the end of the federal payroll tax holiday at the same time, are affecting collections. The enacted fiscal 2014 budget assumes continued growth in these revenue sources, though the PIT rate slows to 3.1% and SUT growth picks up to 3.8%. Through the first quarter of fiscal 2014, total general fund revenues are on target at 0.2% over the estimate, with both PIT and SUT slightly ahead of budget. The 2014 budget draws down on the strong fiscal 2013 general fund ending balance to support a 2.3% YOY increase to $28.4 billion, including a 2% ($122.5 million) increase for K-12 education.
Growing pension funding obligations are a main driver of the structural imbalance in the state's budget. As discussed further below, Pennsylvania's pension systems are significantly underfunded, and the commonwealth's current statutory funding schedule requires significant increases in employer contributions. For fiscal 2014, the commonwealth estimates pension costs will increase 46.2%, or $511.2 million, to $1.6 billion. This represents nearly 80% of the total spending increase in the budget, and the budget office projects the general fund contribution to increase at double digit rates through fiscal 2018 absent any substantive statutory pension reform. While state revenues will likely increase organically over that time period, under current law pension costs will likely capture the bulk of growth. With these looming expense increases, and without any meaningful reserves, the state's financial flexibility is significantly weakened.
PENSIONS DRIVE UP LIABILITIES
Pennsylvania's debt burden is moderate and at the median for U.S. states rated by Fitch. The state issues primarily GO debt, with 62% retired within 10 years. Net tax-supported debt ratios have risen but remain very manageable as of June 30, 2012 at 2.8% of 2012 personal income.
Unfunded pension obligations now represent the dominant share of the state's long-term liabilities. Pennsylvania's pension systems had historically been adequately funded. However, annual contributions have been below actuarially required levels for many years and investment performance lagged expectations during the recession. Pursuant to statute, sharp jumps in required contributions began in fiscal 2011. Funding levels for the State Employees' Retirement System (SERS) and the Public School Employees' Retirement Systems (PSERS) have declined in recent years, and continued declines are likely given that even the increased contributions are expected to be below the ARC. The most recent reported funded ratio for SERS (as of December 31, 2012) is 59%, dropping to 56% using Fitch's more conservative 7% discount rate assumption. For PSERS, the reported funded ratio is 66%, or a Fitch-adjusted 63%. The commonwealth is responsible for an estimated 59% of the PSERS liability and 100% of SERS. The burden of the commonwealth's net tax-supported debt and adjusted unfunded pension obligations equals 10% of 2012 personal income, above the median for U.S. states rated by Fitch.
At the start of the 2013 legislative session the governor proposed reforms that would affect both current and new employees but not current retirees. The legislature did not adopt the governor's proposal or any other pension reform measures in the spring session, though discussions continue into the current legislative session. As has generally been the case with pension reforms across the country, any changes are likely to confront legal challenge.
Fitch notes that the state's OPEB liabilities are relatively manageable, following several significant reforms in recent year. As of June 30, 2011 (latest data available), the state's unfunded OPEB liability for its two largest plans (for state employees and teachers, and for state police) of $15.3 billion represented a moderate 2.8% of 2012 personal income. Those plans also have modest amount of pre-funding, with $130.6 million in actuarially valued assets.
CHALLENGED MANAGEMENT ENVIRONMENT
The commonwealth had been reducing its structural budget gap as the economy recovered, but progress appears to have stalled and even reversed. After two years of declining use of fund balance and other one-time revenues, the enacted fiscal 2014 budget assumes drawdown of nearly all of the fiscal 2013 ending general fund balance and another suspension of reserve funding. Without pension reform, or significant revenue improvement, structural budget balance will likely require another round of spending cuts or new tax increases, or a combination. Given the austerity budgets adopted during the recent recession, and the current state leadership's opposition to tax increases, this will be a particular challenge.
In addition to pension reform, the governor is advocating several other significant proposals regarding transportation funding, increased education funding through privatization of the state's liquor stores, and expanded health insurance access under the Affordable Care Act and Medicaid reform. To date, state leaders have failed to reach consensus on any of these initiatives, though discussions are all ongoing with the legislature.
BROAD-BASED ECONOMY A CREDIT STRENGTH
Pennsylvania's economy, historically dominated by manufacturing, has diversified and is growing slowly as the state recovers from the recession. Prior to the downturn, the economy posted consistent annual employment growth despite continued manufacturing losses. Employment in 2008 was flat as U.S. employment fell, and once the recession hit Pennsylvania it was less severe and shorter than for the nation as a whole. With growth in the last three years, Pennsylvania nonfarm employment in 2012 was 99% of 2007 levels, compared to 97% for the U.S. as a whole. August 2013 employment growth in the commonwealth was a low 0.7% YOY compared to 1.7% for the U.S., with the relative underperformance reflecting in part the commonwealth's less severe downturn.
Demographic factors could limit future growth, but the potential for significant economic development around the state's abundant natural gas resources could drive economic expansion. The commonwealth is among the nation's oldest states, with a median age of 40.5 versus the national median of 37.4. State population growth has lagged the national trend for several decades, indicating the potential for a smaller future workforce. Offsetting these trends, the state could benefit from continued development of the Marcellus Shale natural gas deposits, and eventual development of the Utica Shale, which may bring additional jobs in the mining and related industries. While natural gas activity has tempered in the short-term somewhat due to lower prices, the abundance of supplies still presents a significant economic opportunity for the state.
In conjunction with the affirmation of the commonwealth's GO rating, Fitch has affirmed the following ratings that are supported by commonwealth appropriations and therefore linked to the commonwealth's GO rating. The Outlook on all of the ratings remains Negative.
--$1.42 billion in Pennsylvania Commonwealth Financing Authority appropriation-backed debt at 'AA-' ;
--$267 million in Pennsylvania Economic Development Financing Authority (PEDFA) Convention Center Project, series A of 2010 and series B of 2010 (Federally Taxable - Direct Subsidy - Build America Bonds) bonds at 'A+';
--$676 million in Pennsylvania State Public School Building Authority federally taxable revenue bonds series 2010A, 2010B, 2011A, and 2011C (Qualified School Construction Bonds - Direct Subsidy) and series 2010C and 2011B, and 2011 D (Qualified Zone Academy Bonds-Direct Subsidy) at 'AA-';
--Pennsylvania School Credit Enhancement Intercept Program at 'AA-';
--Pennsylvania School Credit Enhancement Direct-Pay Intercept Program at'AA-'.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from IHS Global Insight.
Applicable Criteria and Related Research:
--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).
Applicable Criteria and Related Research:
U.S. State Government Tax-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=805188
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