Fitch Rates Alaska's $2.3B Pension Obligation Bonds 'AA'; Outlook Negative

NEW YORK--()--Fitch Ratings has assigned a 'AA' rating to approximately $2.3 billion of Alaska Pension Obligation Bond Corporation (APOBC) pension obligation bonds (POBs), series 2016 (taxable). The par amount is subject to change, dependent on market conditions.

The bonds are scheduled to sell via negotiation on or about Oct. 26, 2016.

The Rating Outlook is Negative.

SECURITY

The bonds are secured by annual appropriations from the state of Alaska pursuant to a funding agreement between the APOBC and the state acting through its department of administration (DOA). Funds available for this appropriation include all legally available funds of the state, including those from the state's general fund (GF).

KEY RATING DRIVERS

Link to State IDR

The rating on the bonds is one notch below the state's 'AA+' Issuer Default Rating (IDR), reflecting the need for annual legislative appropriation. The APOBC is a government instrumentality of the state, housed within the state's department of revenue (DOR). The rating reflects the state's general credit standing, sound legal structure and the statutory authorization for these bonds.

Economic Resource Base

Alaska's economy is largely based on the development and application of its abundant natural resources, the production of crude oil and natural gas deposits, prominent fishing industry, and mining and tourism. An estimated one-third of the state's gross state product is attributed to the drilling, production, and economic multiplier effects of the turbulent oil and natural gas sectors; a primary source of vulnerability for the state. Rapid deterioration in crude oil prices over the past two years has led to rig closures and reduced natural resource employment. The state's recent unemployment rate was equal to 139% of the nation's and has climbed on an annual basis since 2013, prior to the severe, global decline in oil prices. The federal government is a large employer and a key driver of the state's economy (an estimated 36% of the state's economy is derived from federal employment.)

Revenue Framework: 'a' factor assessment

Fitch expects the state to continue to derive an outsized proportion of its operating revenues from taxation, leasehold interest, and royalty payments related to petroleum development. These narrow revenue sources will continue to reflect the economic volatility tied to the extensive natural resources sector, impeding the development of a more predictable financial performance. The state has complete control over its revenues, with an unlimited independent legal ability to raise operating revenues as needed.

Expenditure Framework: 'a' factor assessment

The state maintains solid expenditure flexibility with a manageable burden of carrying costs for liabilities and the broad expense-cutting ability common to most U.S. states. As with most states, Medicaid remains a key expense driver, and Fitch believes the state will be challenged in meeting increased expenditures due to insufficient expected revenue growth.

Long-Term Liability Burden: 'aa' factor assessment

On a combined basis, the state's net tax-supported debt and unfunded pension obligations are well above the median for U.S. states as a percentage of personal income, driven primarily by sizable unfunded pension obligations for the closed public employees and teachers systems, including portions of both systems' liabilities associated with local and school employees. Net tax-supported debt is below average for a state. Other post-employment benefit (OPEB) obligations are sizable but nearly fully funded. Both pension and OPEB liabilities are constitutionally protected benefits.

Operating Performance: 'aa' factor assessment

The state's strong management of its financial operations and extraordinarily sizable reserve balances has historically offset volatility in its revenue sources; however, the state ended fiscal 2016 with its fourth consecutive operating deficit and a sizable deficit is expected in fiscal 2017. Available reserves are forecast to remain strong at the end of fiscal 2017 under various scenarios although eventual depletion is expected absent revenue reform, sharp expenditure reductions, or a return to more robust oil prices; a scenario that Fitch's views as unlikely through the medium term. While the state's permanent fund is robustly funded, the principal may only be accessed through an amendment to the state constitution, which is a limiting factor.

RATING SENSITIVITIES

LINKAGE TO STATE OF ALASKA: The rating on the pension obligation bonds is sensitive to movement in the state's IDR, to which it is linked.

NEGATIVE OUTLOOK: Failure to enact measures to improve fiscal balance will put negative pressure on the state's IDR and linked ratings.

CREDIT PROFILE

The bonds currently offered are special obligations of the APOBC, payable solely from payments received by the corporation from the state and equal to debt service on the bonds. The payments to the corporation from the state are pursuant to a funding agreement between the two entities, subject to annual legislative appropriation, resulting in a rating that is one notch below the state's 'AA+' IDR. The DOA has pledged to include in the state's annual budget all payments required by the agreement and the bond indenture, including that in each fiscal year it will request that the DOR provide a loan to the corporation should insufficient funds have been appropriated to make a funding payment. POBs were specifically authorized by the state legislature in 2008, providing that certain conditions were met, as part of the Retirement Cost Funding Act.

Proceeds of the POB will be deposited to the state public employees' retirement system (PERS) defined benefit (DB) trust and the teachers' retirement system (TRS) DB trust, to bolster funded ratios for these plans, with the goal of lowering future required actuarial contributions to the system. Given that POB debt is expected to replace existing unfunded pension liability, Fitch views the transaction as having limited impact on the state's liability profile.

Both PERS and TRS are cost-sharing multiemployer systems that provide pension and post-employment health care (OPEB) benefits to eligible retirees of the state, local governments and school districts. Although the state's unfunded pension liabilities are sizable relative to income resources, the state has worked to curtail the growth of obligations. Both plans were closed to new employees as of June 30, 2006, and employees hired since then are enrolled in defined contribution plans. As the DB plans are closed and accrued benefits are guaranteed by the state's constitution, no additional benefit reforms are currently anticipated by Fitch, although changes in actuarial or economic assumptions are possible.

Funded ratios have improved materially given the state's 2015 deposit of $3 billion in excess operating resources into the systems. The pension funded ratios for TRS is 76.9%, and for PERS is 67% as of their June 30, 2015 valuations, based on the systems' 8% return assumptions. These ratios exclude the OPEB obligations for DB participants, which are nearly fully funded under current assumptions.

All participating governments, including the state, local governments and schools, are required to contribute a fixed percentage of their payroll to Alaska's pension systems. Additionally, the state contributes a separate, variable non-employer contribution (NEC) over the fixed threshold for its own employees and all other participating governments, sufficient to match the actuarial rate determined annually by each system. This provision provides contribution stability to local governments and schools while exposing the state to the risk higher contributions in the event of adverse system experience. Issuance of the POBs would change neither the fixed employer contributions nor the state's statutory requirement to pay the NEC. Actuarial contributions are based on a closed 25-year amortization period as of June 30, 2015.

STATE ANNUAL CASH FLOW SAVINGS ANTICIPATED

The state forecasts significant annual cash flow savings from this financing based on reducing its NECs. Assuming issuance of $2.3 to $3.3 billion in par, and depending on the impact of actual investment experience on pension invested assets, the NEC for PERS and TRS, which is budgeted at $216 million in fiscal 2017, is expected to be reduced to under $50 million in fiscal 2018. Based on long-term investment return scenarios including at a lower, 7% return assumption, the residual NEC would rise until the maturity of the POB in 2039. When combined with the fixed debt service on the POB, the transaction would still provide substantial annual cash flow savings relative to projections without the POB. The maturity schedule of the POB approximates the closed period amortization for the systems' UAALs.

Fitch cautions that achieving even a 7% return assumption over time carries risk given recent market performance and the historically low interest rate environment. As the POB structure seeks to maximize cash flow savings relative to current assumptions, the investment returns on the POB proceeds must exceed the cost of borrowing for this issue over time to result in savings. Given the state's responsibility for the NEC, the risk of long-term underperformance would be carried by the state.

STATE OF ALASKA IDR

Alaska's 'AA+' IDR reflects the state's maintenance of very substantial reserve balances and conservative financial management practices to offset significant revenue volatility linked to oil production from the North Slope and global petroleum price trends. For many years, the state focused on expected declines in production at its oil fields, prudently dedicating a substantial share of its past oil tax revenue to reserves to ease anticipated revenue loss due to the declines. However, the steep drop in crude oil prices beginning in late 2014 exceeded expectations and significantly reduced tax revenues to the state, requiring sizable use of reserves to fund operations in fiscal years 2015 through 2017.

The state's enacted budget for fiscal 2016 funded unrestricted general fund (UGF) expenditures of almost $5 billion, a 19% reduction as compared to fiscal 2015. The budget incorporated expected soft crude oil prices and was supported by a planned $2.7 billion draw from reserves. Actual crude oil prices that were below forecast combined with actions taken by the governor and legislature resulted in a larger $3.9 billion budget gap (75% of the UGF budget). The state funded the gap by drawing on reserves, bringing the reserve balance at year-end to $14.4 billion, equal to 2.8x the UGF budget.

The enacted UGF budget for fiscal 2017 totals $4.4 billion, a 16% reduction from fiscal 2016. The enacted budget continues the state's reliance on reserves to fund operations as most revenue raising proposals and a proposed funding shift related to the state's Permanent Fund Earnings Reserve (PFER) were not approved. The legislature did approve changes to the state's tax credit structure for crude oil and natural gas production to provide savings in future fiscal years, but at a cost of $430 million to the fiscal 2016 budget. The enacted fiscal 2017 budget incorporated the governor's veto of one-half of the statutorily-determined permanent fund dividend distribution, reducing the distribution from the PFER by $665 million. Considering these and other measures, the state anticipates a reserve draw of $3.17 billion (73% of the UGF budget) to fund operations. Due to the reduction in expenditures, reserves at the end of fiscal 2017 are expected to total $12.3 billion, equal to 2.8x the UGF budget.

For further information on the state, please see 'Fitch Downgrades Alaska's IDR to 'AA+'; Outlook Negative' dated June 14, 2016, available at 'www.fitchratings.com'.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.

Applicable Criteria

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/site/re/879478

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Contacts

Fitch Ratings
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Marcy Block
Senior Director
+1-212-908-0239
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Douglas Offerman
Senior Director
+1-212-908-0889
or
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Karen Krop
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+1-212-908-0661
or
Media Relations
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Marcy Block
Senior Director
+1-212-908-0239
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Douglas Offerman
Senior Director
+1-212-908-0889
or
Committee Chairperson
Karen Krop
Senior Director
+1-212-908-0661
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com