Fitch Rates $132MM New Jersey EFA Bonds 'A-'; Outlook Stable
--$104.435 million series 2016B;
--$27.505 million series 2016C.
The bonds are expected to price via negotiation the week of Oct. 3, 2016.
The Rating Outlook is Stable.
SECURITY
The bonds are special, limited obligations of the NJEFA; debt service is paid under a state contract between the state treasurer and the authority subject to annual legislative appropriation.
KEY RATING DRIVERS
State Appropriation: The 'A-' rating for the current NJEFA bond issue, one notch below New Jersey's 'A' Issuer Default Rating (IDR), reflects the state's pledge to make annual payments equal to debt service on this obligation, subject to appropriation by the state legislature.
The state's 'A' IDR incorporates a history of structurally imbalanced financial operations, persistent underfunding of its liabilities, an elevated debt burden, and economic performance that has only recently begun to show positive momentum following the national recession that ended in 2009. The rating also incorporates the strong control over revenues and spending inherent in a state's powers. The state's credit strengths, such as its high wealth and a diverse economy, are offset by an evidenced lack of consensus on reforms to its chronic deferral of liability funding that has progressively diminished its operating flexibility. Although recent court decisions have affirmed the state's legal authority to defer pension contributions, in the absence of reform Fitch expects that incremental pension contributions will consume the bulk of natural revenue growth for the next several years and remain a significant part of the state's budget going forward.
Economic Resource Base
New Jersey benefits from a broad economy and high wealth indices. Although the population is slower growing than average, personal income is among the highest of the states and its economy benefits from its geographic position in the heart of the dynamic northeast corridor.
Revenue Framework: 'aa' factor assessment
The state's revenue system is highly influenced by economic trends and slow growth has reflected the state's sluggish recovery from the recession. The state has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.
Expenditure Framework: 'a' factor assessment
Carrying costs are well above the U. S. state average and the state funded just 30% of its actuarially required contribution (ARC) in fiscal 2016. The state's broad expense-cutting ability is common to most U. S. states and the state has leveraged this attribute in response to unexpected revenue shortfalls. Given the need to fund sizable and increasing pension and other post-employment benefit (OPEB) expenditures, growth in expenditures is expected to be ahead of future revenue growth absent policy actions.
Long-Term Liability Burden: 'a' factor assessment
The state's liability burden, at 16.5% of personal income, is well ahead of the 5.8% U. S. state median and reflects the state's considerable debt load and unfunded pension liabilities (UAAL). Future capital needs and continued growth in the UAAL from insufficient contributions is expected to sustain this ratio at a high level and weigh on the state's credit.
Operating Performance: 'a' factor assessment
Financial operations are characterized by sizable spending pressures, and structural budget imbalance in the form of persistently inadequate contributions for liabilities.
RATING SENSITIVITIES
The rating is sensitive to changes in the state's approach to managing its fiscal and liability position. The Stable Outlook assumes a continuation of the state's current practices without material, corrective action to improve its overall financial and pension sustainability.
CREDIT PROFILE
The bonds currently offered are special obligations of the NJEFA, payable solely from payments received by the authority equal to debt service on the bonds from the treasurer of the state of New Jersey, subject to annual appropriation. The payments from the state to the authority are pursuant to a state contract between the two entities whereby the treasurer agrees to pay debt service on the bonds from amounts appropriated annually to the NJEFA. Proceeds from the series 2016 bonds will provide funds for various capital improvements for public and private institutions of higher education in the state.
New Jersey's high wealth and economic diversity have not spared it from an unusually weak economic recovery. The state has suffered negligible growth in key industries of trade, transportation and utilities; financial activities; and professional and business services; and continued declines in manufacturing that incorporated retrenchment in the pharmaceutical industry. An uptick in performance began in 2015 as both employment growth and the unemployment rate improved relative to national averages. Employment growth in 2015 registered 1.4% compared to 2.1% for the nation and as of July 2016 the state has almost regained its jobs lost in the recession, with job recovery standing at 96% versus the nation at 169%. Personal income per capita in New Jersey stands at 125% of the national level, third highest among the states.
Revenue Framework
The personal income tax (PIT) provides the largest support of operations, totaling over 40% of fiscal 2016 operating fund revenues, with sales tax revenue providing the next largest share at 28%. The corporate business tax (CBT) and lottery fund are notably smaller contributors to revenues (7% and 3%, respectively, in fiscal 2016) but they are volatile, making forecasting difficult and contributing to uneven performance. Gaming revenue is now a very small contributor to the state's operations following significant retrenchment in the gaming industry in Atlantic City. Overall, recent revenue forecasts have been more conservatively derived than in years past, reducing unexpected revenue underperformance.
New Jersey's revenue growth over the past 10 years, through 2014, has been below growth in both U. S. GDP and inflation, incorporating the state's very slow momentum coming out of the recession. Absent more robust economic growth or tax policy changes, PIT and business tax trends are expected to generally follow this slow trend based on recent results and current forecasts for the economy. The recent termination of the tax reciprocity agreement with the state of Pennsylvania as a means to ensure a balanced fiscal 2017 budget is expected to result in an additional $180 million in recurring PIT revenue for the state. Most of the state's organic revenue growth is expected to be applied to support its sizable and growing pension liabilities.
The state's gaming revenues from the Atlantic City casinos, while a small share of operating revenue, are expected to continue to experience downward pressure in coming years, particularly if a ballot initiative is approved by voters this November that would expand casino gaming to northern New Jersey. The state would be expected to reap the financial benefit of a northern expansion even with significant gaming saturation on the east coast, although a portion of the state's tax revenues would be redirected to Atlantic City as part of the approval.
The state has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.
Expenditure Framework
As in most states, education and health and human services are New Jersey's largest operating expenditures. Education is by far the larger line item, including for higher education, as the state provides significant funding for local school districts and the public university and college system. Health and human service spending is the second largest area of spending, with Medicaid being the primary driver.
Expenditures for pensions approximated 3.9% of fiscal 2016 expenditures with the state contributing only three-tenths of the ARC. Full contributions - a $4.4 billion appropriation compared to the actual $1.3 billion appropriation - would have resulted in pensions consuming 12.8% of expenditures. The enacted fiscal 2016 budget reset the previous, multi-year phase-in schedule to full actuarial pension contributions to 2023. While the actual appropriation was above the fiscal 2015 level, it was far below the appropriation envisioned under an original phase-in reform in 2010 and well below the ARC. The state has appropriated $1.86 billion for pensions in fiscal 2017, equal to four-tenths of the ARC.
Given, the protracted phase-in of full ARC appropriations, the state estimates the systems' aggregate funded ratio will fall to a low of 39.2% in fiscal 2022, down from the 43.2% estimated one year ago. The steady deterioration in the funded status of New Jersey pensions is a negative rating factor and Fitch does not anticipate near-term passage of additional reforms that would improve the sustainability of the system. Positively, the state's Supreme Court, in June 2016, upheld a past reform that narrowed COLA provisions.
Based on the state's current statutory pension contribution ramp-up, in combination with escalating health care expenses for employees and retirees, the natural pace of expenditure growth is expected to be well ahead of expected revenue growth. This disparity presents a significant challenge to the state as it grapples with identifying funding sources to finance transportation capital needs and is likely to crowd out other spending priorities.
New Jersey has demonstrated an ample ability to adjust budgeted expenditures to meet changing fiscal circumstances, albeit sometimes by deferring spending, and the governor has strong executive authority to implement any necessary reductions to balance the budget. These powers were affirmed by another recent state Supreme Court decision, in June 2015, in which the court ruled that state financial obligations except for GO debt are subject to annual legislative appropriation unless approved by voters. The June 2015 ruling effectively voided prior pension reform efforts that included the earlier ARC escalation schedule.
The state's above-average cost pressures are reflected in a carrying cost metric of 10.9% of personal income that is well ahead of the 5.8% U. S. state median. The metric incorporates the state's sizable debt load and pension ARC as well as considerable OPEB pay-go expenditures.
Long-Term Liability Burden
New Jersey's debt levels are high for a U. S. state, and ongoing capital demands for school construction, environmental protection and transportation remain large. Net tax-supported debt alone as of June 30, 2016 equated to 6.9% of 2015 personal income; a reduction from prior years as a result of more limited debt issuance and growing personal incomes. Unfunded pension liabilities attributable to the state are also well above average. Fitch has estimated New Jersey's net tax-supported debt and adjusted, unfunded pension obligations attributable to the state, at 16.5% of 2015 personal income, vs. a state median of 5.8%.
Under the GASB 67 standard for pension systems, in the aggregate, the state's seven systems covering retired state employees and teachers have assets sufficient to cover only 37.5% of projected liabilities as of June 30, 2015. For the two largest plans, covering state and local public employees and teachers, the new disclosure reports that assets equaled only 38.2% of liabilities for state employees (PERS), and only 28.7% of liabilities for teachers.
Moreover, six of the seven state plans under GASB 67 currently report specific depletion dates for when assets set aside to fund benefits are expected to run out. The state employees' and teachers' plans forecast depletion dates in 2033 and 2027, respectively. Plan liabilities payable after the depletion dates are discounted at a 3.8% muni bond index rate, rather than the 7.9% rate assumed for investment returns, elevating the reported liability.
The state's UAAL for OPEB has substantially increased in recent years. Between the July 1, 2013 and July 1, 2014 actuarial valuations, the UAAL increased by 22.7%, from $53 billion to $65 billion. The state attributes the increase to three primary factors: pay-go funding rather than prefunding accrued liabilities, new mortality assumptions extending life expectancies, and higher prescription drug costs. While Fitch views OPEB as a more flexible obligation when compared to pensions, the significant escalation in this liability is a concern.
Operating Performance
New Jersey's likely response to cyclical downturns largely rests with its willingness to reduce expenditures given its limited financial cushion and sensitivity to increasing tax rates. The state's economic performance through the recent recession closely matched that of the nation as a whole and was reflected in sharp revenue declines in fiscal years 2009 and 2010. To achieve budgetary balance, the state applied cash balances and reduced expenditures, including making no appropriation for pension contributions in fiscal years 2010 and 2011, a retreat from previous progress to restore structural balance and address long-term liabilities.
The state does not maintain a separate rainy day fund and views its operating fund balance, equal to 1.6% of operating appropriations at the end of fiscal 2016, as its budgetary cushion. Fitch believes this level of fund balance, reduced from a 2.5% level in fiscal 2015 due to revenue underperformance in the just-ended fiscal year, provides only limited margin of operating flexibility given the state's historical experience with revenue cyclicality. The state anticipates a modest increase in the balance in fiscal 2017 to 1.9% of appropriations.
Historically, state financial operations have been characterized by persistent underfunding of liabilities, aggressive forecasts of revenues and a lack of consensus on short and long-term solutions to support more sustainable finances. These negatives were compounded by unusually slow performance during the current economic recovery. In its more recent fiscal years, Fitch believes revenue forecasts have become more conservative, and have resulted in more balanced financial performance despite an unanticipated revenue shortfall in fiscal 2016 that was partly offset by a reduction in expenditures and by reducing anticipated supplemental appropriation needs.
However, the state remains unable to address a number of challenges. These include its liability situation, resulting in a continued escalation of costs and further increasing unfunded pension liabilities and the reauthorization of its transportation capital program, resulting in the suspension of state-funded construction projects throughout the state.
Current Developments
Fiscal 2016 is estimated to have recorded 0.3% operating revenue growth from fiscal 2015; a 2.2% deviation from expected operating revenue in the 2016 enacted budget. The revenue gap reflects PIT and CBT results that were 3.5% and 12.7% below expectations, respectively. Sales taxes grew by 5%, a level that was 2.6% above expectations. The state was able to counter the revenue shortfall by lapsing appropriations and by applying $267 million of its fund balance. Ending fund balance of $557 million, equal to 1.6% of appropriations, is down from 2.5% of appropriations in fiscal 2015.
The state's $34.5 billion operating budget for fiscal 2017 is a 1.7% increase from appropriations in fiscal 2016 with a large share of the growth occurring in pension contributions, up by $554 million (42.4%). Appropriations are expected to be supported by 4.3% operating revenue growth, incorporating 2.9% of expected organic revenue growth and various tax revisions. The revenue increase includes growth of 3% in the sales tax; 4.3% in the PIT; and 5.8% in the CBT. Actual PIT revenue growth may include the termination of the Pennsylvania tax reciprocity agreement; however, the additional revenue will partly offset $250 million in unspecified employee health benefit savings included in the enacted budget that the administration views as uncertain. As a result, the governor had held back certain appropriations until more certain funding sources had been identified.
While the forecast appears to be supported by the currently improved economic situation, with employment growth of 1.8% in July 2016 ahead of the national 1.7% rate of growth, Fitch remains cautious on the state reaching its forecast goals given the recent revenue gap in fiscal 2016.
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