S&P Nudges Philadelphia's Credit Rating Downward

Philadelphia was dinged late last week with a credit downgrade, underscoring the heavy budget burden the city faces from public employee pensions and uncertainty about future education expenses.

S&P Global Ratings on Friday lowered the city's general obligation bond rating a notch to A, from A+. The new rating is still relatively strong, but it's a downgrade nonetheless. "The lowered rating reflects our view of the city's likely longer term credit trajectory as it continues to address the costs associated with managing its pension pressures and School District of Philadelphia" costs, S&P says in a report.

Municipal credit ratings matter because as they slip downward it signals to investors that a state or local government poses a greater risk of not being able to meet its financial obligations. This can result in lenders demanding higher interest rates for municipal debt, which cities and states issue to pay for costs like road and school projects.

Philadelphia is the nation's sixth most-populous city, with nearly 1.6 million residents, based on Census Bureau figures from last year. The city is also the poorest of the 10 largest cities in the U.S., according to budget documents issued by Mayor James Kenney's office. The estimated poverty rate there in 2016 was near 26 percent.

S&P describes Philadelphia's economy as "adequate," says it has good financial policies and practices in place, and that its fiscal performance has been improving. But the report notes: "Philadelphia's budgetary flexibility is very weak, in our view, which reflects more our view of its high fixed costs and our concerns regarding its ability to cut future expenditures or potentially raise additional revenue."

Chief among the city's fixed costs are public employee pensions. S&P recognizes that the city is undertaking pension reform efforts, which "position it well to address its significantly underfunded plans, such that we expect to see some improvement over the longer term."

But, in the near-term, the heft of the retiree benefits remains daunting.

A five-year financial plan for fiscal years 2019-23 that Kenney presented to the City Council on March 1 notes that pension costs are expected to consume about 15 percent of general fund expenditures in fiscal 2019, with payments projected to total $720 million.

That amount is greater than the $709 million in general fund spending the mayor has proposed for police in fiscal 2019 and it dwarfs the $259 million he's called for putting toward fire services. Total estimated general fund revenues for the year are about $4.6 billion.

The city’s annual pension contributions have grown 271 percent since fiscal year 2001. But pension fund health has eroded during that time—the funded level has dropped to under 50 percent from 77 percent.

Philadelphia's public pension system covers thousands of city employees and retirees.

The City of Philadelphia Municipal Retirement System had about 66,000 members in 2016, according to the system's latest actuarial valuation report. Of that total, about 28,300 were active workers.

"Benefits have grown much more quickly than the City’s revenues and other expenditures, meaning that more and more of the City’s budget is not available to pay for services," Kenney's five-year plan notes.

Meanwhile, Philly is in the process of retaking local control of its school system from what's known as the School Reform Commission, which has three of its five members appointed by Pennsylvania's governor. When the commission took the reins of Philadelphia's schools in 2001, the school district was mired in a financial mess and other problems.

Kenney's 2019 to 2023 fiscal plan says the school district faces a budget deficit of over $900 million during the next five years. It also outlines a funding package that would involve a $20 million increase in annual contributions from the city's general fund, along with a slate of tax policy changes—including a property tax hike—to raise an estimated $980 million for schools.

The S&P report says that if the school funding plan gets implemented as proposed that it, along with previous tax increases, could make it a tough for the city to raise taxes further in the coming years.

Among the bright spots for Philadelphia's fiscal outlook is a recent upticks in Philly's millennial population, a positive sign for economic development. But, at the same time, many parent-aged adults, often in their peak earning years, aren't sticking around—which means the city's tax base is weaker than it might be otherwise.

Kenney's administration has linked this trend back to school quality.

"The departure of parent-aged adults and school-aged children signals a potential lack of confidence in District schools and underscores the need for the Mayor to take accountability for the District and provide for its financial stability," the mayor's five-year fiscal plan says.

Asked for comment about the ratings downgrade, mayor's office deputy communications director Ajeenah Amir issued a statement. 

"The City has made substantial progress with a stronger than budgeted fund balance for the current fiscal year, pension reform and favorable economic metrics," Amir said. "However, we continue to face serious structural fiscal issues and we include plans to address those issues in the proposed Five-Year Plan."