NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the rating on the Commonwealth of Pennsylvania's general obligation (GO) bonds to 'AA-' from 'AA.'
In addition, Fitch downgrades the ratings on bonds supported by the commonwealth's annual appropriation pledge and bonds otherwise capped at the state's GO rating, which are listed at the end of this release. The ratings on these bonds are linked to the commonwealth's GO rating.
The Rating Outlook is revised to Stable from Negative.
SECURITY
The GO bonds are direct and general obligations of the commonwealth of Pennsylvania, with full faith and credit pledged.
KEY RATING DRIVERS
CONTINUED FISCAL IMBALANCE DRIVES DOWNGRADE: The downgrade to 'AA-' reflects the commonwealth's continued inability to address its fiscal challenges with structural and recurring measures. After an unexpected revenue shortfall in fiscal 2014, the current year budget includes a substantial amount of one-time revenue and expense items to achieve balance and continues the deferral of statutory requirements to replenish reserves which were utilized during the recession. The commonwealth's rapid growth in fixed costs, particularly the escalating pension burden, poses a key ongoing challenge, although Fitch expects budgetary planning and management to mitigate these pressures in a manner consistent with the 'AA-' rating.
PENSION FUNDING DEMANDS: The funding levels of the commonwealth's pension systems have materially weakened as a result of annual contribution levels that have been well below actuarially determined annual required contribution (ARC) levels. Under current law, contributions are projected to reach the ARC for the two primary pension systems by as soon as fiscal 2017, but the budgetary burden will increase, crowding out other funding priorities.
INCREASING BUT STILL MODERATE LONG-TERM LIABILITIES: The commonwealth's debt ratios are in line with the median for U.S. states. 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 pension underfunding for at least the next few years. Fitch views Pennsylvania's long-term liability burden as manageable at the 'AA-' rating so long as the commonwealth adheres to its funding schedule, or enacts reforms that do not materially increase liability or annual funding pressure.
SOLID ECONOMIC PROFILE: Employment growth continues for the state's broad-based economy, but 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. Overall, the state's economy provides a solid base for future potential revenue growth to help manage ongoing expenditure pressures.
RATING SENSITIVITIES
ADDRESSING FIXED-COST PRESSURES: The 'AA-' rating is sensitive to the commonwealth's continued ability to address increasing fixed-cost pressures, particularly for pensions. Fitch anticipates the commonwealth will meet at least its statutory obligations through some combination of adequate funding at the expense of more discretionary budget items, structural expenditure reform, or revenue increases, and any movement away from those commitments would be a credit negative
MOVE TOWARD SUSTAINABLE BUDGETS: Given the magnitude of Pennsylvania's structural budget gap, Fitch anticipates some continued use of non-recurring items in upcoming budgets, but at a declining rate. Failure to make progress toward structural balance could trigger negative rating action.
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. The 'AA-' rating reflects those issues, as well as Fitch's expectation that the commonwealth will respond to those pressures adequately, while also beginning to make progress toward structural budgetary balance. Pennsylvania benefits from a large, diversified and expanding, albeit slowly, economic base and moderate tax burden which provides some capacity to match expenditure growth.
STRUCTURAL IMBALANCE; ONGOING BUDGETARY RISK
The commonwealth's tax revenues continue their slow recovery, though fiscal 2014 ended well short of budgeted expectations (0.1% actual growth versus 2% budgeted), adding to the state's fiscal pressures. As in several other states, Pennsylvania's fiscal 2014 personal income tax revenues grew at a much slower rate than anticipated, largely due to the acceleration of income into fiscal 2013 attributable to a federal income tax increase. Sales tax revenues also came in below the enacted budget, but to a lesser degree. The revenue shortfall totaled just over $500 million which the commonwealth responded to primarily through broad-based expenditure reductions, reflecting positively Pennsylvania's active budgetary management.
Pennsylvania's enacted fiscal 2015 budget relies heavily on one-time items to achieve balance. In total, the budget includes a significant $2 billion in one-time items on a $29 billion budget, or approximately 7%. Pennsylvania did recently receive federal approval of its proposed alternative to Medicaid expansion under the Affordable Care Act (Healthy PA) which was assumed to provide $125 million in budget savings beginning this year. Fitch views the budget's revenue forecast of 3.6% general fund tax revenue growth as somewhat aggressive in light of fiscal 2014 performance (0.1% growth) and the trend of generally moderate economic growth coming out of the recession. Pennsylvania's Independent Fiscal Office (a legislative office charged with providing independent revenue and economic analysis) forecasts are largely in line with the official commonwealth forecast developed by the administration and used in the budget.
In addition to the possibility that revenue growth could lag expectations, several one-time sources included in the current budget are at risk, so Fitch anticipates some level of mid-year balancing actions may be required by the commonwealth. While not insignificant, Fitch views these risks as manageable for the commonwealth either through expenditure or revenue actions. Commonwealth officials note that they have already frozen $50 million in spending to address budget risks. The potential for a moderate level of added budgetary stress and continued, though declining, use of one-time items in upcoming budgets is incorporated into the 'AA-' rating.
PENSIONS PRESSURING FINANCIAL PROFILE
Growing statutory pension funding obligations are a main driver of the structural imbalance in the state's budget and will require either a growing commitment of state fiscal resources, or a structural reform to drive down costs. Under the current statutory framework, Fitch expects commonwealth general fund pension contributions will increase significantly in fiscal years 2016 and 2017 before growth rates ratchet down thereafter. Both of the state's primary pension systems project Pennsylvania will contribute the full ARC by fiscal 2017 following over a decade of underfunding. At that point, Fitch expects growth in annual funding increases will decline to be more in line with overall budgetary growth. Similarly, projections provided by each of the systems for their respective funded ratios (a proxy for unfunded liabilities) weaken moderately over the next several years but begin improving by fiscal 2019.
Without structural expense reform, or broad revenue increases, pension costs will consume a larger share of state resources and limit the commonwealth's overall fiscal flexibility. In fiscal 2015, commonwealth contributions will increase over $600 million from the prior year to $2.7 billion on a $30 billion general fund budget (9.1%). Based on the statutory framework and the pension systems' historical data and actuarial projections for contributions, Fitch anticipates increases for fiscal 2016 and 2017 will be similar though somewhat lower. While substantial, Fitch views the anticipated increases in annual contributions and unfunded liabilities laid out in the current statutory framework as within the commonwealth's capacity to absorb at the 'AA-' rating level. The governor has been a strong advocate for structural pension reform, although no proposal to date has gained legislative traction. Fitch will evaluate any enacted measures on their ability to improve the commonwealth's fiscal capacity and long-term liability profile.
LONG-TERM LIABILITIES ABOVE AVERAGE
Pennsylvania's debt burden is moderate and at the median for U.S. states rated by Fitch. The state issues primarily GO debt, with over 60% 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. Annual contributions have been below actuarially required levels for many years and investment performance lagged expectations during the recession, triggering growth in unfunded liabilities. 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. Funded level ratios for the primary pension systems, the State Employees' Retirement System (SERS) and the Public School Employees' Retirement Systems (PSERS), have declined in recent years, and continued declines are likely at least for PSERS given that even the increased statutory contributions will be below the ARC for several more years.
The most recent reported funded ratio for SERS (as of Dec. 31, 2013) is 59.2%, dropping to 56.1% using Fitch's more conservative 7% discount rate assumption - both ratios are actually up slightly from the 2012 valuation (58.8% reported and 55.7% Fitch-adjusted). For PSERS, the reported funded ratio (as of June 30, 2012) is 66.3%, or a Fitch-adjusted 62.9%. 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 9.8% of 2013 personal income, above the median for U.S. states.
Under current law, both pension systems project some weakening of funded ratios, and growth in unfunded liabilities, until commonwealth contributions reach the ARC. The 'AA-' rating incorporates this projected growth, which Fitch anticipates will keep the total long-term liability burden at an above-average though manageable level for Pennsylvania.
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 a 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. The commonwealth's peak-to-trough decline in seasonally adjusted monthly payrolls was just 4.5%, vs. a national decline of 6.3%.
While Pennsylvania's non-farm payrolls grew every year since 2009, the trajectory has slowed. In 2013, non-farm employment grew just 0.3%, down from 1.1% in 2011 and compared to 1.7% for the U.S. in 2013. Pennsylvania's August 2014 year-over-year (YOY) employment growth of 1% remains below the national YOY gain of 1.8%, but payrolls in the state do appear to be gaining some modest momentum. The three-month moving average for YOY employment growth in Pennsylvania reached 1.1% in August, up from 0.4% in December.
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 as well as attracting industries focused on low-cost energy such as manufacturing. 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 downgrade of the commonwealth's GO rating, Fitch has downgraded the following ratings that are supported by commonwealth appropriations and therefore linked to the commonwealth's GO rating, or otherwise capped at the state's GO rating. The Outlook on all of the ratings is Stable:
--$904.9 million in Pennsylvania Turnpike Commission motor license fund-enhanced turnpike subordinate special revenue bonds to 'AA-' from 'AA' (for additional information, please see 'Fitch rates $59.8MM PA Turnpike Comm Motor License Fund-Enhanced Bonds 'AA'; Outlook Negative,' April 11, 2014);
--$1.67 billion in Pennsylvania Commonwealth Financing Authority appropriation-backed debt to 'A+' from '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 to 'A' from '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) to 'A+' from 'AA-';
--Pennsylvania School Credit Enhancement Intercept Program to 'A+' from 'AA-';
--Pennsylvania School Credit Enhancement Direct-Pay Intercept Program to 'A+' from '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.
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=879314
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.