Fitch Rates Commonwealth of Pennsylvania's $834.45MM GOs 'AA'; Outlook Remains Negative

NEW YORK--()--Fitch Ratings has assigned an 'AA' rating for the following Commonwealth of Pennsylvania's general obligation (GO) bonds:

--$545 million first series of 2014;

--$289.45 million first refunding series of 2014.

The bonds are expected to sell on or about April 29, 2014 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 primarily reflects Fitch's view that growth in fixed costs could outpace revenue growth, pressuring Pennsylvania's financial profile.

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 determined annual required contribution (ARC) levels. Under current law, Fitch expects that sizable statutory increases in contributions payable to the systems over the next several years will consume much of future revenue growth and still remain below the actuarially determined ARC.

INCREASING LONG-TERM LIABILITIES: The commonwealth's debt ratios are moderate. However, the commonwealth's combined debt plus Fitch-adjusted pension 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. 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 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 any of these conditions, over the near term could trigger further negative rating action. Offsetting this, the state benefits from a diversified albeit slowly expanding economic base and moderate tax burden.

STRUCTURAL IMBALANCE; SLOWING REVENUE GROWTH

The commonwealth's tax revenues continue their recovery, though the enacted fiscal 2014 budget reversed 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. Actual state general fund tax collections through March 2014 trail the budget estimate by 1.1%, indicating the possibility of a revenue shortfall this fiscal year.

Reserves remain very light, providing minimal protection for Pennsylvania in the event of another downturn. For fiscal 2014 the state again suspended a requirement to restore its depleted rainy day fund from fiscal 2013 ending general fund balance, and instead relies on nearly the entire $544 million projected balance to balance the fiscal 2014 budget. After accounting for lapsed spending from fiscal 2013 and anticipated for fiscal 2014, Pennsylvania expects to end the current year with just $216 million in general fund balance, representing its entire budgetary reserves. This would represent a very narrow 0.7% of estimated fiscal 2014 general fund revenues. Continued revenue underperformance for the fiscal year could further erode that ending balance.

Personal income and sales and use tax (PIT and SUT, respectively) revenues remain the dominant drivers of commonwealth general fund revenues and their slowing growth pressures Pennsylvania's fiscal outlook. YOY PIT and SUT growth coming out of the recession had boosted general fund collections. But through the third quarter of fiscal 2014, PIT and SUT YOY growth rates of 2.4% and 1.5% generally lag prior year gains and are below budgeted estimates by 0.9% and 1.6%, respectively. 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 2013 affected collections for fiscal 2013 and could be a drag on current-year growth. April's revenue report, which historically includes significant PIT collections, should shed more light on fiscal 2014 revenues and Fitch will monitor the results closely.

The governor's proposed fiscal 2015 budget relies on drawdown of most of the estimated fiscal 2014 ending balance, rebounding revenue growth, and enactment of several key savings measures. As part of the executive budget, the governor forecasts fiscal 2015 YOY PIT growth at its highest level since before the recession (5.4%) and SUT growth of 3% which is well ahead of the current and prior year gains. Fitch views the revenue forecast as somewhat optimistic given Pennsylvania's slow pace of economic recovery from the recession. The budget also relies on legislative approval of significant pension reform measures in order to gain $170 million in general fund savings, and federal approval of the state's request to expand health insurance access under the federal Affordable Care Act to generate another $125 million. Fitch views approval of both measures as unknown at this point. The legislature failed to enact pension reform measures proposed by the governor last year. Fitch will monitor the progress of ongoing budget negotiations between the administration and legislature. Last year, the final budget agreement came just hours before the start of the new fiscal year.

PENSIONS PRESSURING FINANCIAL PROFILE

Growing statutory 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 has previously projected 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 in Fitch's view.

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, 2013 at 2.8% of 2013 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, with the goal of phasing in full ARC funding over the next several years. Fund leveled ratios 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 statutory 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 (as of June 30, 2013) 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 9.5% of 2013 personal income, above the median for U.S. states rated by Fitch.

During the 2014 legislative session, the governor is reportedly negotiating with the legislature on a package of pension reforms with the goals of reducing liabilities and providing short-term budgetary relief for state government and school districts in meeting annual funding costs. 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 years. As of June 30, 2013, the state's reported unfunded OPEB liability for its two largest plans (for state employees and teachers, and for state police) of $16.3 billion represented a moderate 2.8% of 2013 personal income. Those plans also have modest amount of pre-funding, with $153 million in actuarially valued assets.

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. While Pennsylvania's non-farm payrolls grew every year since 2009, the trajectory is slowing. In 2013, non-farm employment grew just 0.3% compared to 1.7% for the U.S. Similarly, Pennsylvania's March 2014 employment growth was just 0.2% YOY, compared to 1.6% for the U.S.

Factors affecting the commonwealth's longer term economic outlook include its relatively weak demographic profile as well as the boost that development of abundant natural gas resources could provide. 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 mining and related industries. While natural gas activity is subject to market-driven volatility, 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.

--$1.67 billion in Pennsylvania Commonwealth Financing Authority appropriation-backed debt at 'AA-' ;

--$257.3 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=827700

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Contacts

Fitch Ratings
Primary Analyst
Eric Kim, +1-212-908-0241
Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Laura Porter, +1-212-908-0575
Managing Director
or
Committee Chairperson
Douglas Offerman, +1-212-908-0889
Senior Director
or
Media Relations
Sandro Scenga, +1-212-908-0278 (New York)
sandro.scenga@fitchratings.com

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Contacts

Fitch Ratings
Primary Analyst
Eric Kim, +1-212-908-0241
Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Laura Porter, +1-212-908-0575
Managing Director
or
Committee Chairperson
Douglas Offerman, +1-212-908-0889
Senior Director
or
Media Relations
Sandro Scenga, +1-212-908-0278 (New York)
sandro.scenga@fitchratings.com