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Pennsylvania Rating at Risk as Pensions Go Untamed: Muni Credit

Pennsylvania Governor Tom Corbett
Governor Tom Corbett is urging legislators to return to the Capitol to address liabilities that account for 63 cents of every new dollar in revenue. Photographer: Andrew Harrer/Bloomberg

Pennsylvania legislators broke for the summer without addressing pension costs that will rise by 38 percent to $65 billion in 2018. They may return to find a cut to the state’s credit rating.

Standard & Poor’s will decide in the next few months whether to lower Pennsylvania’s AA rating, the third-highest level of investment grade, based on its handling of finances and pensions, analyst John Sugden in New York said in a telephone interview. Fitch Ratings is considering a similar move, with a cut “certainly more likely than not,” said Eric Kim, a director at the company, which also grades Pennsylvania AA with a negative outlook.

“They’re doing a lot of the things that would trigger a downgrade,” said Kim, who is based in New York.

A ratings cut may result in higher borrowing costs for the state, which saw its lawmakers leave Harrisburg without voting on a plan backed by Governor Tom Corbett that would shift some of the burden of funding retirement benefits to new state and school workers. Another concern is that the spending plan for the year that began July 1 may not balance expenditures with revenue in what Fitch’s Kim considers a sustainable manner.

Illinois Breakthrough

Moody’s Investors Service gives an equivalent Aa2 grade to Pennsylvania, a step below its average state ranking of Aa1.

“As of now, we have no change to the rating or outlook,” David Jacobson, a Moody’s spokesman, said in an e-mail.

More than five years after the last recession ended, states are still struggling to fund their pension commitments. The average public system had about 72 percent of the money needed to meet retirement obligations in 2013, according to the Center for Retirement Research at Boston College.

The $3.7 trillion municipal bond market applauded after Illinois lawmakers broke through decades of gridlock in December to pass a measure addressing the worst-funded state pension system.

The extra yield investors demand to own 10-year Illinois bonds rather than benchmark munis fell to as little as 1.09 percentage points in May, from 1.87 percentage points the day legislators approved the fix. Spreads have since widened to 1.4 percentage points after the state Supreme Court ruled on July 3 that health-insurance premium subsidies are benefits that can’t be diminished or impaired, potentially jeopardizing the pension legislation.

$11 Billion

Corbett is urging legislators to return to the Capitol to address liabilities that account for 63 cents of every new dollar in revenue. The 65-year-old Republican, who’s running for re-election in November, supports a plan for new state and school employees that incorporates both a defined-benefit system and a defined-contribution approach similar to a 401(k).

Such a move could save $11 billion over 30 years, according to the state’s Public Employee Retirement Commission, which reviews proposed legislative changes to pensions.

For now, Pennsylvania is benefiting from an environment in which rates are hovering close to generational lows, said Justin Hoogendoorn, managing director at BMO Capital Markets in Chicago. Investors demand about 0.35 percentage point over benchmark munis to own Pennsylvania 10-year bonds, compared with the 0.34 percentage point average seen since January, data compiled by Bloomberg show.

Recurring Expenses

“If outflows were significant enough in the market, which we’ve started to see, and we do start to see some spread widening, Pennsylvania is going to be more prone to getting caught in the credit-widening impact, the longer they leave this problem unsolved,” Hoogendoorn said.

Pennsylvania is also struggling to balance recurring expenses with revenue as it lags behind the U.S. economic recovery. Its burden of debt and unfunded pension obligations totals 9.5 percent of 2013 personal income, compared with the median of 6.1 percent nationwide, according to Fitch’s Kim.

Pennsylvania ranks 43rd across the U.S. in jobs growth from the start of 2013 through the first quarter, according to the Bloomberg Economic Evaluation of States index. S&P expects employment to grow by 0.9 percent this year, below the national projection of 1.6 percent.

It’s listed 44th among states in economic health in a May report by Paul Mansour, the head of municipal research at Conning & Co., which oversees $11 billion in local-government debt, including Pennsylvania’s.

Ratio Decline

The state is “very vulnerable” to a ratings downgrade to a level that more closely matches Hartford, Connecticut-based Conning’s internal grade equivalent to AA- or Aa3, he said.

“When you have high debt burdens and high pension burdens, those things don’t go away quickly,” Mansour said. “I don’t see a catalyst for improvement for Pennsylvania in the near future.”

Pennsylvania administers two pension plans, covering about 700,000 people. In 2013, the combined funded ratio dropped to 62 percent from 75 percent in 2010, and S&P expects it to continue falling, the company said in April. Analysts attributed it to the weak performance of the state’s portfolio, contributions falling short of actuarial requirements and improved benefits granted when the systems were fully funded.

“The longer that the state goes without addressing this liability, the larger the liability becomes and the more pressure they can find down the road on their finances and on their rating,” S&P’s Sugden said.

One-Time Fixes

Pennsylvania’s budget also “seemed to rely more on one-time revenue fixes than in the past,” Sugden said.

In the $29 billion spending plan, officials transferred about $550 million from other funds, such as one investing tobacco settlement dollars and others providing small-business loans, said Jay Pagni, a spokesman for Corbett.

Corbett signed the budget on July 10 while stripping about $72 million from the Republican-led legislature’s operations and earmarks. He admonished lawmakers for leaving without dealing with “the biggest fiscal challenge facing Pennsylvania -- our unsustainable public pension system.”

House Majority Leader Mike Turzai told reporters the governor’s actions were “about politics.” Pennsylvania’s top Republican senators said in a statement that linking pension reform to cuts “is not a successful strategy.” The senate is set to return on Sept. 15.

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