Fitch Ratings’ downgrade of Pennsylvania was hardly news to municipal bond credit analysts, who warned of such action if pension overhaul remained in gridlock.
“The bond market is noticing,” Tom Kozlik, a director at Janney Capital Markets in Philadelphia, said Wednesday, one day after Fitch lowered the state’s general obligation bond rating to AA from AA-plus with a negative outlook.
Fitch cited “the commonwealth’s failure to adequately address key fiscal pressures,” namely, inadequate pension funding, repeated structural imbalance and a gutted rainy-day fund.
According to Kozlik, Pennsylvania credit spreads to Municipal Market Data’s AAA curve are the highest they have been in years. The 10-year is now at 28 basis points above the MMD metric, up from a low of 15 basis points in the middle of 2011.
“There are several credit negatives stacked up against them that political actors have not fully addressed,” said Kozlik.
Pennsylvania budget secretary Charles Zogby, in a Bond Buyer interview last month, warned that a downgrade loomed if the state legislature remained stalled over pensions.
“The rating agencies see the fact that our finances are strained,” Zogby said.
Pennsylvania already had similar grades from the other two major rating companies.
Standard & Poor’s also rates the bonds AA while Moody’s Investors Service assigns an equivalent Aa2 rating. Both downgraded Pennsylvania last summer. S&P’s outlook is negative, Moody’s is stable.
“This could also be a harbinger of future action by other agencies,” Zogby’s press secretary, Jay Pagni, said Wednesday. “The secretary had warned about the potential implications of failure to act on pension reform and a number of other factors. Fitch outlined them pretty well.”
Gov. Tom Corbett in February, citing a $47 billion unfunded pension liability, proposed switching public pension systems to a 401(k)-style plan in fiscal 2015. But his proposal stalled in the state legislature, whose crowded plate this past session included Corbett’s transportation funding bill and a proposal to privatize state-run liquor stores. All three initiatives are at an impasse, with lawmakers in recess until the fall.
“It was a matter of time that the downgrade would happen and I am discouraged to see this news, although this is the type of news that is needed so the governor's office can fulfill their goals with pushing forward on pension reform and austerity with the general-fund budget,” said Villanova School of Business professor David Fiorenza, a former chief financial officer of Radnor Township, Pa.
Lawmakers, who approved a $28.4 billion budget right before the June 30 deadline, also debated emergency aid to Philadelphia’s school district and expansion of Medicaid under the federal Patient Protection and Affordable Care Act.
“There’s really no sense of urgency. They’re debating these other issues. But it seems to me that pensions are the number one thing they have to address to get this problem fixed,” said Rachel Barkley, an analyst at Morningstar Inc. “I think the pressures [Fitch] mentioned are very accurate. Pensions will be a key driver for the credit.”
Fitch and Standard & Poor’s this week issued special reports about state pension systems, both citing the ongoing credit risk of pension underfunding. According to S&P, Pennsylvania joins New Jersey, Illinois and Kentucky in receiving credit downgrades over pension management.
Pennsylvania has two employee pension funds, the State Employees’ Retirement System and the Public School Employees’ Retirement Systems. According to Fitch, the most recent reported funded ratio for the SERS system, as of last Dec. 31, is 59%. That drops to 56% using Fitch’s more conservative 7% discount rate assumption. For the PSERS system, said Fitch, the reported fund ratio is 66%. The ratio is 63% using the more conservative assumption.
Morningstar considers 70% a “fiscally sound” funding-level threshold.
Even though Pennsylvania increased its contributions after the legislature tweaked its pension laws in 2010, funding levels are expected to continue declining as they have in recent years. “They’re still contributing below the arc [actuarially required contribution],” said Barkley.
Fitch said Pennsylvania’s broad-based economy is a credit strength, and said continued development around its Marcellus Shale natural gas resources could drive economic expansion.
“A negative outlook is a negative outlook, but Pennsylvania still has a lot going for it,” Zogby said.
Richard Dreyfuss, a senior fellow with the Manhattan Institute free-market think tank, said even Corbett’s proposal fell short of grasping the unfunded liability. “We have yet to see a meaningful proposal. Fitch is on the money,” he said, adding that the Corbett proposal overemphasizes plan design.
The political stalemate doesn’t surprise Dreyfuss.
“There’s very little political upside to properly funding the state pension systems,” he said. “You either have to do it with new revenue, which involves raising taxes, or you cut programs, which instigates a firestorm. The political rate of return on a properly funded pension plan is pretty low.”
For instance, according to Standard & Poor’s, Pennsylvania, which has underfunded its arc over the past eight years, would require an additional $1.2 billion to fully fund its arc in fiscal 2014. “This is almost twice the actual growth in spending of $678 million in the 2014 budget, which already includes more than $200 million for pensions.”
Pennsylvania has about $11 billion in GO debt outstanding.