Fitch Affirms Philadelphia, PA's GOs and IDR at 'A-'; Outlook Stable
--$1,505,575,000 general obligation (GO) bonds at 'A-';
--Issuer Default Rating (IDR) at 'A-'.
The Rating Outlook is Stable.
GO bonds are backed by the city's full faith and credit and are payable from an ad valorem tax without limitation as to rate or amount.
KEY RATING DRIVERS
Philadelphia's 'A-' IDR reflects the strength of the city's economic base and revenue growth prospects, somewhat offset by risks related expenditure constraints and a limited reserve cushion. The city's long-term liability burden is somewhat elevated but well within the capacity of its resource base to absorb. Philadelphia continues to take modest, but prudent steps to limit growth in the pension liability in particular, and eventually reduce it. Fitch expects the city's long-term liabilities to remain close to current levels, as the city has fully funded or exceeded annual pension contribution requirements. Philadelphia's comparatively constrained expenditure framework will pressure the budget, but expectations for solid revenue growth from a steadily growing economy should support these spending pressures. Long-term budget forecasting, active budgetary management, and close oversight from a state fiscal board help mitigate the risk of reserve levels that are well below those of most local tax-supported governments.
Economic Resource Base
Philadelphia serves as a regional economic center in the northeast, with a stable employment base weighted toward the higher education and healthcare sectors. Jobs expansion since the recession has been steady and strong, but low wealth levels and weak population growth persist and limit growth prospects. The population is estimated at 1.5 million.
Revenue Framework: 'aa' factor assessment
The income, property, and sales taxes that are Philadelphia's primary revenue sources will likely grow ahead of inflation but below national GDP given economic prospects. Philadelphia retains ample legal ability to raise revenues without specific commonwealth authorization.
Expenditure Framework: 'a' factor assessment
Philadelphia's recent expenditure growth has been measured reflecting active budgetary management efforts. The city faces manageable but persistent fixed cost growth pressures and has limited ability to flex its labor expenses given a highly unionized workforce and the statutory collective bargaining framework. The future trajectory of spending growth will likely exceed baseline revenue growth, requiring active budgetary management.
Long-Term Liability Burden: 'a' factor assessment
Long-term liabilities are somewhat elevated but still in the moderate range relative to Philadelphia's resource base due both to comparatively elevated debt levels and unfunded pension obligations.
Operating Performance: 'bbb' factor assessment
Budgetary management practices are strong, offsetting Philadelphia's very modest reserve levels and supporting the city's adequate ability to respond to changing economic and fiscal circumstances. Fiscal stress is likely in the event of a downturn, but the city has the tools and demonstrated ability to manage through and restore financial flexibility.
CHANGES IN FINANCIAL FLEXIBILITY: Sustained structural balance would improve reserve levels and aid the city's financial flexibility, while deficits beyond current projections that trigger deeper draws on reserves could trigger negative rating concern.
PENSION FUNDING IMPROVEMENT: Material reductions to the unfunded actuarial accrued liability or annual funding demands for the city's pension plan would be viewed positively. Significant movement, which Fitch does not currently anticipate, could support positive rating action.
Philadelphia has a diverse revenue base, with personal and business income and receipts taxes, property tax and sales tax each generating a significant portion of local revenues. The wage tax (essentially a personal income tax without a capital gains component) accounts for one third of general fund revenues, and the other key revenue sources noted above make up another third. An additional 10% of revenues are transfers in from the Pennsylvania Intergovernmental Cooperation Authority (PICA) and come from the wage tax, net of deductions for debt service on revenue bonds issued by PICA.
The wage tax has proven relatively resilient historically with limited declines. Growth has been slow, partially reflecting low wealth levels but also steady rate reductions implemented to enhance economic competitiveness. Property taxes have been stable through economic cycles as well, with more robust growth attributable to the city's position as a regional economic center. Other tax revenues have been more volatile due mainly to policy changes at the city and commonwealth levels.
Historical general fund revenue growth, after adjusting for a significant accounting change, has been robust but the growth also reflects tax policy changes including both rate increases and decreases. The city shifted certain federal and commonwealth grants from the general fund to the grants revenue fund beginning in fiscal 2012; these grants averaged $469 million between fiscal years 1999 and 2011, or roughly 10-15% of general fund revenues. Management provided Fitch with detailed breakouts of the revenues from prior years that allowed Fitch to adjust general fund revenues to a like-for-like basis by removing the affected revenues in earlier years.
Fitch anticipates solid general fund revenue growth going forward, absent future policy actions, ahead of inflation but somewhat below national economic growth. Significant policy changes implemented by the city include small but regular rate reductions in the wage tax, and business income and receipts tax (except for three years around the Great Recession, when the city held rates steady) and sales tax rate changes implemented by the commonwealth.
Philadelphia maintains ample legal authority to adjust revenues, other than the sales tax, under provisions of Pennsylvania's Sterling Act. The city has regularly utilized that ability to adjust wage and business income and receipts taxes to improve Philadelphia's economic competitiveness or provide additional budgetary flexibility.
Philadelphia pays for a wide range of public services but public safety represents the largest expenditure category (about half of spending), like many local governments. The city does not directly pay for education but does support the contiguous School District of Philadelphia (SDP) with direct appropriations and through other policy measures such as statutory allocations of specific taxes. In recent years, the city issued bonds to finance an SDP operating deficit and the commonwealth legislature permanently redirected part of the city's local sales tax levy to the district.
Spending growth absent policy actions will likely exceed projected revenue growth due to both a high demand for services given the city's low wealth levels, and moderate fixed cost burden. The newly implemented sugary beverage tax primarily funds new initiatives but could also support baseline expenditure needs in the future if growth exceeds expectations.
Philadelphia has solid expenditure flexibility with a moderate carrying cost burden of 14% in fiscal 2015, and a constraining work force environment. Pension costs escalated sharply in recent years due partially to actuarial adjustments to revise down the investment return assumption (to a still somewhat aggressive 7.75%) and apply findings from the most recent experience study. Growth should moderate going forward and remain in line with to marginally ahead of revenue growth, if actuarial assumptions are met. The city consistently directs any new and otherwise unallocated revenues to the pension fund, including in the current five-year plan through fiscal 2021. This could reduce the long-term liability burden and carrying cost over time.
The vast majority of city employees are unionized with most work terms established in multi-year contracts. Labor relations have been somewhat contentious historically with multiple recent contract negotiations ending in binding arbitration. Management retains very limited ability to alter contracts, though current wage and benefit terms are not a threat to fiscal stability. All contracts either ended this past fiscal year or will end this year. A recent agreement with the largest blue-collar union reflects positively on the administration's ability to maintain stable labor relations on reasonable financial terms. Salary increases are well within the city's fiscal capacity and the contract includes a stacked hybrid pension plan that is mandatory for new hires and could reduce costs over the long term if implemented with other unions.
The city's commitment to the school district represents an ongoing expenditure pressure point. SDP faces its own significant challenges (IDR of 'BB-'/Negative Outlook) and relies heavily on the city for fiscal support. Philadelphia has historically contributed to the school district via both direct appropriations and imposition of new taxes or allocations of existing taxes. SDP has no ability to set its own local tax policy.
Long-Term Liability Burden
Philadelphia's long-term liability burden of 20.9% of 2015 personal income is moderately high relative to its resource base with roughly equivalent levels of net tax-supported debt and Fitch-adjusted unfunded pension liabilities for its primary single employer plan (the city maintains a separate single employer plan for Philadelphia Gas Works, an independently operated enterprise unit, revenue bonds rated 'BBB+'/Outlook Stable by Fitch).
For the city's pension fund, market performance below recently reduced but still somewhat aggressive assumptions, and recent actuarial changes to revise down the return assumption and implement findings from an experience study primarily contributed to growth in the unfunded liability. The burden could moderate over the long term if actuarial assumptions are met and the city successfully rolls out plan changes across its labor bargaining units. But Fitch anticipates the burden will remain sizable. Other than a short-term deferral in fiscal 2010 and 2011 (which Philadelphia repaid within five years), the city has contributed at least the actuarially determined employer contribution for many years. The liability was re-amortized several years ago over a closed 30-year term, which reduced the annual cost. Positively, as noted above, the city typically adds any otherwise unallocated revenue to the pension fund to help reduce the liability.
Long-term debt is issued for capital needs and has been managed particularly closely in recent years as evidenced by the gradual decline in outstanding amounts. More significant issuance is likely under the current administration to finance new initiatives but will be funded with revenues from a recently enacted sweetened beverage tax.
The city does have variable-rate debt and swap exposure, but Fitch does not view it as a material rating concern. Approximately 15% of outstanding direct debt is swapped to a fixed rate with various counterparties. Philadelphia is required to post collateral if its GO rating falls below investment grade. A swap policy outlines when swaps can be entered into and sets stringent guidelines around counterparty credit exposure with swap agreements required to include a provision allowing the city to terminate if counterparties fall below 'A' category ratings. Philadelphia also has modest exposure to variable-debt put risk with 6% of outstanding direct debt supported with letters of credit. If the letters are triggered, amortization would accelerate, and Fitch anticipates the city would consider refinancing the debt given its solid market access.
Philadelphia's reserve levels are relatively modest and would likely be drawn down through a downturn, but expected to recover. To address budget gaps, Fitch anticipates the city would instead rely primarily on its superior budget flexibility. Likely revenue measures include halting currently planned reductions in wage and business income and receipts tax rates, and likely expenditure measures include headcount reductions and furloughs. Philadelphia took such steps during the Great Recession.
Close monitoring of the city's fiscal performance by PICA, a state appointed financial oversight board created in 1991, provides additional assurance the city would act relatively quickly to address changing economic circumstances. State law requires Philadelphia's mayor to annually submit five-year financial plans and quarterly intra-year updates to PICA for their review and certification. The five-year plans must resolve any projected deficits and be certified accordingly by PICA. The quarterly reports are used by PICA to assess the city's compliance with its active five-year plan. If PICA certifies non-compliance, the city would lose access to any commonwealth funding including a significant share of state-collected tax revenues, providing strong incentive for the city to comply and maintain fiscal performance in line with PICA's expectations for long-term balance.
Philadelphia has an extensive statutory and policy-based framework for timely and proactive budget management throughout the economic cycle, revolving around PICA's reporting and certification requirements. But Philadelphia's efforts to rebuild flexibility during periods of economic recovery remain somewhat inconsistent. Fund balances improved in the years following the Great Recession, but have been drawn down in recent years to meet recurring needs, despite economic and revenue growth. The current five-year plan anticipates additional reserve drawdowns through fiscal 2018.
Philadelphia's liquidity is comparatively limited but stable and adequate for its fiscal needs given the superior level of budget flexibility and close monitoring from PICA. The city, or a related entity, has demonstrated clear and consistent market access, having issued tax and revenue anticipation notes virtually every year since fiscal year 1972
Philadelphia ended fiscal 2016 on June 30 with estimated revenues 2% ahead of the enacted budget, with growth across all major tax categories reflecting the city's solid economic performance. After final accounting, Fitch anticipates the city will report an available general fund balance of at least the projected $106 million (2.7% of general fund revenues) stated in the current five-year financial plan. PICA approved the plan this summer. While it includes steady draws on an already limited fund balance for several years, the plan also includes scheduled gradual reductions in wage and business taxes that the city could slow, halt or even reverse depending on economic circumstances. Philadelphia also tends towards conservative revenue and expenditure forecasts. The projected fiscal 2016 available general fund balance in last year's five-year plan was just $70 million (versus the currently projected $106 million).
The fiscal 2017 budget includes a sweetened beverage tax, an administration priority, to finance a range of new initiatives including expanded pre-kindergarten and community infrastructure investment. At full implementation, the city estimates the tax will generate $90-$100 million annually. The budget, and five-year financial plan, also reflects the new labor contract signed with the largest blue collar union, DC 33 (representing approximately one-fourth of the city's workforce). The contract includes a mix of notable wage increases (2.5% - 3% annually) and pension changes to increase employee contributions and bring new employees into a mandatory stacked hybrid plan that limits the city's exposure to defined benefits by capping the eligible salary.