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Without Swift Action on a Fiscal Plan, State Faces More Credit Rating Downgrades as Early as June

Original photo by Duca di Spinaci, Creative Commons Licensing.

A Senate Finance Committee review Wednesday of the State’s credit rating and debt underscored the need to adopt a fiscal plan this year.

Standard & Poor’s downgraded the State’s credit rating in January 2016, warning it would downgrade the State further if legislators “do not enact measures to begin correcting the state’s fiscal imbalance.”

All three major rating agencies have now downgraded the State. All show the State’s credit outlook as negative.

“[T]he current slide in the State’s credit rating has been entirely based on the State’s diminished revenue generation due to depressed oil price and inability of the State to adopt a solution to the resulting unrestricted general fund structural deficit,” the administration of Gov. Bill Walker wrote in a Debt Affordability Analysis. “Based on the rating agencies’ negative outlook for the State, it is likely that additional credit downgrades will be incurred if a restructuring of the State’s fiscal resources in a clear fashion that provides for a balanced budget and demonstrates a long term viable state government funding solution isn’t adopted.”

In a hearing Wednesday, State Debt Manager Deven Mitchell told Senate Finance members that oil revenue is not expected to return to the levels that boosted the State’s credit rating.

“At this point, unrestricted general fund revenue is woefully short,” he said. But, he added, “There’s other revenue and other alternatives that the State has available to it to have a balanced budget, and that’s something that generally all the rating agencies acknowledge.”

The main alternative is use of Permanent Fund investment earnings.

Walker has reintroduced a bill (SB 26) that would partially fund government using 5.25 percent of the Permanent Fund’s average value over five years. This percent-of-market-value (POMV) model is designed to annually draw an amount ($2.5 billion) that still allows the Permanent Fund to grow.

Had the full legislature passed the Permanent Fund bill adopted by the Senate Finance Committee last year, Mitchell told members, it would have significantly bolstered the State’s credit outlook.

“If we can have a recognition that we’re not funding a budget using one-time savings; we’re funding a budget using resources that recur… However that’s accomplished gets us a long way down the road toward stability in our credit rating,” Mitchell told Senate Finance.

Without new taxes, drastic cuts, and/or tapping the Permanent Fund Earnings Reserve Account (ERA), Mitchell showed in a presentation that the State will continue to have annual deficits between $2.8 billion and $3 billion. The State’s main savings account will be exhausted to fund the Fiscal Year 2018 budget, and the ERA, from which Permanent Fund dividends (PFDs) are paid, will be drained four years later.

Mitchell said he expects a credit rating downgrade before the end of June if the legislature does not act.

“This session is kind of a line in the sand for additional potential rating action against the State, unfortunately,” he said.

“From my perspective, the administration has not responded to — in the governor’s words — a ‘crisis,’” said Senate Finance Co-chair Anna MacKinnon (R-Eagle River), quoting Walker’s State of the State Address. “Is there a recognition that the governor brought a budget in a $3 billion budget deficit situation that had very little in the form of reductions?”

Mitchell responded that the rating agencies have been watching years of struggle in Alaska government and know the State can solve its problems by reclassifying existing revenue. The FY 2018 budget is built on that premise.

“It’s just choices,” said Mitchell. “We have the wherewithal to solve our problem today. It just involves hard choices.”

State Highlights Positives in Talks With Rating Agencies

“It’s a continual battle because we don’t have a large state with a stable economy, with a lot of diversification. That’s what they want to see,” Mitchell said of the rating agencies. “They want to see a highly diversified economy with a very stable revenue flow that you rely on the same way every year and expenditures are equal to or less than revenues. We just don’t have that… Our primary revenue stream [oil] is just extraordinarily volatile. Our secondary revenue stream is investment income, and it’s also volatile.”

Mitchell said the Department of Revenue (DOR) tries to focus on the positives that have buoyed the credit rating in the past, the biggest of which are the State’s fiscal reserves and the $55 billion Permanent Fund.

“The Permanent Fund, in general, cannot be ignored as a credit strength,” Mitchell said, “and the earnings reserve, in particular, where it is available to solve a fiscal crisis in the event of, ‘There’s no other money to pay. What are we going to do?’ Well, the legislature can choose to appropriate it. They might not, but they can.”

DOR points out that the amount set aside for PFDs is also available for appropriation.

“That’s not saying that we want to use that revenue to fund state government and eliminate everything else; it’s saying that if you had to, you could. That’s a credit strength,” Mitchell asserted.

The administration has emphasized that the FY 2017 budget was $1.2 billion smaller than FY 2015.

It also holds up Walker’s FY 2017 vetoes — $430 million from oil and gas tax credits, $250 million from mega-projects, and $665 million from PFDs — as examples of controlled spending.

Mitchell got himself into a little trouble with Senate Finance when he said DOR tells rating agencies that the legislature supports those vetoes.

“There were opportunities to reverse these, and they weren’t reversed,” Mitchell said of the vetoes. “We hold that up as an acknowledgment that the State’s in a situation that everybody sees as being important to rally on.”

Sen. Mike Dunleavy (R-Wasilla), who has a bill to undo the PFD veto, responded, “I could, but I won’t, sit here and say that the first year of the administration, we were told that we went too far in the Senate in our cuts. I could, but I won’t, say that there were new programs being introduced in the first year of the administration. But I won’t do that.”

“We could say that the capital project $250 million savings was cherrypicking projects that were almost fully funded, but we won’t say that, either,” MacKinnon added.

Mitchell told MacKinnon that the backlog of unpaid oil and gas tax credits does not seem to catch the attention of rating agencies because the credits are unique to Alaska.

If the Walker Administration highlights past budget cuts for rating agencies, would Walker support the Senate majority’s plan for an additional $750 million in cuts, asked Dunleavy.

Mitchell said he couldn’t speak for Walker, but, “Generally, a reduction of that magnitude would be something, again, that I personally would hold up and say, ‘That’s a credit strength.’ I don’t know how you couldn’t.”

Debt Manager: Pension Funding “Largest Single Liability of the State”

In addition to structural deficits, credit rating agencies point to Alaska’s pension liabilities. At $7,400, the State has the largest per capita liability in the country, Mitchell said.

“The pension funding has become… the largest single liability of the State. It’s the only liability that grows every year after [FY] ’18,” Mitchell told committee members. “That type of growth, it’s unique.”

As a guideline, DOR tries to make the amount of debt service five percent of projected revenue, with a limit of eight percent. This is in line with other highly-rated states, the Debt Affordability Analysis explains.

Because of declining revenue, the outstanding State debt payments, excluding pensions, are 7.5 percent of unrestricted revenue in the current fiscal year. Payments are expected to decline below the five percent target going forward.

Yet of the State’s $8 billion in outstanding debt, $5.8 billion comes from the unfunded liability to the two largest pensions, the Public Employees’ Retirement System (PERS) and the Teachers’ Retirement System (TRS).

If the unfunded pension liability is added to the annual debt payments, those payments represent over 25 percent of projected revenue, well over DOR’s limit of eight percent. Payments are expected to grow through FY 2039.

“That’s the biggest risk, in my view, is how to manage that future liability that we can all see sitting there on the table,” said Mitchell. “It cannot be ignored.”

MacKinnon agreed the unfunded liability is the “elephant in the room.”

State retirement assistance payments will total $11.2 billion between FY 2017 and FY 2039. Mitchell pointed out that the number increases in an “unsettling fashion” if the State does not realize an eight percent return, as is projected.

If the rate of return drops to seven percent over that period, the difference in FY 2036 assistance alone will match the $750 million the Senate majority is so keen to cut.

“Should I have a siren going off in my head right now to do something immediately, or realistically is the eight percent an expected return in the long term since we’ve realized that for 30 years?” asked Sen. Peter Micciche (R-Soldotna).

MacKinnon, who called the eight percent assumption “optimistic,” noted that it was set by the Alaska Retirement Management (ARM) Board based on past returns.

“Quite frankly, in private conversations — I believe it was public and recorded in their minutes — there was a conversation about reducing that interest rate return assumption,” she said.

A one-time appropriation of $3 billion to PERS and TRS in FY 2015 fully funded the retirement health care liability, but still left the PERS pension 77 percent funded and TRS 82 percent funded. MacKinnon was surprised by the ARM Board’s apparent decision to direct the deposit toward health care since the legislature has some control over health care costs through policy.

She will have representatives from the ARM Board before Senate Finance for questioning next week.

Because the State is carrying so much debt liability right now, not only does it impact the credit rating; it also limits borrowing for projects like the Alaska Liquified Natural Gas (AKLNG) pipeline.

“Due to the decline in State unrestricted general fund revenue since fiscal year 2014 and the projections for continued diminished state revenue for the next 10 years, the State already has more debt currently authorized or outstanding than is recommended in policy for the projection timeframe. The estimated additional debt capacity would need to be for highly essential projects to avoid negative credit action,” the Debt Affordability Analysis warns.

With a subtle plug for a Permanent Fund restructuring, it continues, “If the State adjusts revenue available for appropriation for budgetary needs to the point that there is a balanced budget, this capacity would increase.”

“I agree that if we do something to fix our revenue, we may have an opportunity to look at debt as a resource, but in our current condition, for the foreseeable future, we should be debt adverse [sic] if we don’t want it to impact the credit rating agencies’ view of the State of Alaska,” MacKinnon told committee members. “While debt is a tool, for Alaska right now, from my perspective, it should be used extremely judiciously.”

Thursday, Senate Finance will hear an overview of PERS and TRS from the Department of Administration, while House Finance will have its first hearing on the House version of Walker’s Permanent Fund restructuring bill.