U.S. PUBLIC FINANCE ISSUER IN-DEPTH 5 April 2017 Connecticut (State of) Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management Contacts Marcia Van Wagner 212-553-2952 VP-Sr Credit Officer marcia.vanwagner@moodys.com Genevieve Nolan 212-553-3912 VP-Senior Analyst genevieve.nolan@moodys.com Although still one of the wealthiest states in the United States, Connecticut (Aa3 negative) is grappling with challenges to the sustainability of its finances. Growing fixed costs from pension, retiree health care and bonded debt liabilities are crowding out services and forcing difficult political choices, placing pressure on the state's credit quality. State lawmakers are considering measures that will make the fixed cost pill somewhat easier to swallow, but will not be able to avoid a lengthy period of constrained spending choices. » Connecticut's high fixed costs limit budget flexibility. The state's payments for debt service, pension contributions and retiree health costs are among the highest of the 50 states at about 30% of revenue in fiscal 2016. These costs are a significant contributor to the state's credit quality being below its peers and will continue to grow, even as a tepid economy suppresses state revenue growth. In fiscal 2016, Connecticut's debt burden and adjusted net pension liabilities accounted for 9% and 22% of GDP, respectively. Initiatives to more sustainably fund its liabilities will further increase fixed costs by $400 million in fiscal 2018, reducing funds available to provide state services. » The state's economy has entered a “new normal” of slow job and income growth. The state's finance sector has faltered, having shed 11% of its jobs since 2007, and the non-finance sectors have failed to pick up the slack; manufacturing is in long decline and growth in the service sector is lackluster. Economic growth is further stymied by population loss: Connecticut was one of only four states to lose population annually since 2013, a credit negative. These trends are reflected in tax collections. Increased defense spending proposed by the Trump administration, if it materializes, will buttress the state's defense-related manufacturing and could help reverse these trends but may do little to strengthen revenues from very high-income earners concentrated in the state's finance sector. » Structural changes to improve state budget will hurt downstream entities. Governor Dannel Malloy's proposed executive budget seeks structural changes in state employee compensation and aid to municipalities that would cut $1.36 billion from the budget in fiscal 2018. Large recurring actions will be necessary for the state to stabilize its finances and would be credit positive. On the other hand, the proposal would reduce state aid on net to about 130 out of 169 towns in the state, with varying degrees of credit impact. Nicholas Samuels 212-553-7121 VP-Sr Credit Officer nicholas.samuels@moodys.com Emily Raimes VP-Sr Credit Officer emily.raimes@moodys.com 212-553-7203 Timothy Blake 212-553-4524 MD-Public Finance timothy.blake@moodys.com U.S. PUBLIC FINANCE MOODY'S INVESTORS SERVICE Connecticut's highest-in-nation fixed costs limit budget flexibility Connecticut's combined expenditures for employee pension contributions, retiree health insurance and debt service command roughly 30% of the state's $18.9 billion non-federal governmental revenues. The state's fixed costs ranked highest of the 50 states in our most recent state pension medians report. In fiscal year 2016 these costs reached $5.6 billion and are slated to grow to more than $7 billion by fiscal 2019, commanding nearly 35% of the state's general fund budget by fiscal 2019 (see Exhibit 1). High fixed costs reduce budgetary flexibility and weigh heavily on the state's credit profile. Exhibit 1 Outsized Fixed Costs Projected at Nearly 35% of General Fund by 2019 40% % of General Fund Revenues 35% 30% 25% 20% 15% 10% 5% 0% FY 2014 FY2015 FY 2016 FY 2017 FY 2018(p) FY 2019(p) Sources: Connecticut Office of Policy Management, SERS actuarial valuation, Moody's Investors Service Large fixed costs are a product of its high debt burden and significant net pension liabilities. The state's $23.3 billion of outstanding net tax-supported debt is about 9% of state GDP and ranks highest by this metric in our most recent debt medians report. The state finances projects that are commonly funded by lower levels of government in other states, contributing to its high relative debt position. Connecticut's combined state and local debt position is closer to average, according to US Census data. Unlike the Moody's state median, however, Connecticut's debt outstanding is increasing in absolute terms and as a percent of personal income. The state's adjusted net pension liability (ANPL) of about 22% of GDP is among the highest of the states and stems from historical underfunding of the pension systems. Compounding the effects of underfunding, the state's assumption of pension costs in support of local governments is a significant contributor to its outlier status. Only a handful of states take on the full burden of paying for teacher pensions. In Connecticut, teacher pension contributions alone accounted for nearly $1 billion, or more than 40% of the state's total $2.5 billion in pension contributions in fiscal 2016 (see Exhibit 2). This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 5 April 2017 Connecticut (State of): Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management U.S. PUBLIC FINANCE MOODY'S INVESTORS SERVICE Exhibit 2 Teacher Pension Contributions Boost State Fixed Costs FY 2016, billions of dollars OPEB Contribution, $0.65 Debt Service, $2.52 TRS Contribution, $0.98 SERS Contribution, $1.50 Sources: Moody's Investors Service, Connecticut audited financial statements, CT Office of Policy Management Pension and other post-employment benefit (OPEB) reforms implemented in 2011 will help contain the long-term growth of those liabilities. However, to amortize the state and teacher plan pension liabilities by 2032, which the reforms require, contributions would need to escalate rapidly from levels that already pressure the state budget. To partially address this looming ramp-up in contributions, the state negotiated an agreement with its bargaining unit to extend the amortization schedule for the state pension system to 2046 while shifting to a funding approach that is in other ways more conservative. This agreement results in greater long-term affordability of pension contributions but does not prevent them from escalating over the next few years and applies only to the State Employees Retirement System (SERS) and not the Teachers' Retirement System (TRS). The state has adopted more conservative actuarial assumptions for TRS, boosting funding requirements in fiscal 2018 nearly $280 million. An OPEB funding agreement, in which state employees contribute to an OPEB trust fund, will also improve the long-term outlook but requires the state to match employee contributions starting with a $120 million contribution in fiscal 2018. “New normal” economy: Connecticut will not grow its way out of liabilities Connecticut's high wealth is a paramount credit strength; the state's per capita personal income was 143% of the nation's in 2015. However, Connecticut's economy had a very slow recovery from the financial crisis, a period that saw slower than usual growth at the national level. Yet while the nation has regained and exceeded its pre-recession peak employment, Connecticut employment still falls short, with 2016 employment just 1% – or 20,000 jobs – shy of the 2008 peak. Slow growth is credit negative because it limits the state's revenue-raising capacity and tax revenue growth, requires more painful spending choices, and prevents accumulation of reserves. The state's budget office projects continued slow growth, with output growing an average of 1.6% annually through 2020 compared to national growth of 2.3%. Job growth is expected to remain below 1% per year as well. Absent an unexpected significant shift in trajectory, the state's economy will not lessen the burden from high fixed costs. While slow employment growth has been typical of the state for decades, slow income growth has not. For the decade prior to the financial crisis, Connecticut's total personal income grew at an annual average pace of nearly 5% while income nationally grew at a 4.1% rate. Since 2010, when job growth began to turn around, personal income has grown only 2.2% per year, much more slowly than the nation (see Exhibit 3). 3 5 April 2017 Connecticut (State of): Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management U.S. PUBLIC FINANCE MOODY'S INVESTORS SERVICE Exhibit 3 Connecticut Personal Income Lags US Since 2010 Pre-2008 Since 2010 6% 5% Growth 4% 3% 2% 1% 0% CT Personal Income CT Jobs US Personal Income US Jobs Sources: Moody's Analytics, US Bureau of Economic Analysis, US Bureau of Labor Statistics Tepid growth has contributed to the state's faltering demographic profile. Since 2013, population has declined each year as residents move out in search of jobs elsewhere or to retire, further dampening the demand for goods and services in the state. Connecticut is one of only four states with annual population decline since 2013. Two historical drivers of the state's economy and income growth have failed to keep pace since the recession. Finance and insurance employment is off more than 11% since 2007 and manufacturing has tumbled nearly 17% over the same period. While the state's longer-term loss of manufacturing jobs roughly mirrors the nation, the recent employment performance of the finance and insurance sector does not and compares unfavorably with neighboring New York (see Exhibit 4). Exhibit 4 State's Finance and Insurance Sector Job Growth Flounders Post Recession While New York Paces Nation 2004 = 100 CT NY US 110 105 100 95 90 85 80 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Sources: Moody's Analytics, US Bureau of Labor Statistics The finance and insurance sector's economic output – 11% in 2015 – is disproportionate to the jobs it provides, less than 7% of the state's total employment. This is reflected in the sector's above-average wages: in 2015, the annual average wage in Connecticut's finance and insurance sector was nearly 2.5 times the average for the state's entire private sector. Nationally, the sector pays less than twice the average wage. Because wages are so high, job losses in these sectors have been amplified through economic multiplier effects and contribute to weak tax revenue growth (see Exhibits 5 and 6). 4 5 April 2017 Connecticut (State of): Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management U.S. PUBLIC FINANCE MOODY'S INVESTORS SERVICE Exhibit 5 Exhibit 6 Finance Sector Share of Connecticut Economy Slides Since 2009 Weak Tax Collections Reflect Finance's Smaller Role Annual share of Gross State Product Annual % change 20% 18% 16% 15% 14% 10% 12% 10% 5% 8% 0% 6% -5% 4% -10% 2% 0% 2004 -15% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 FY 2004 FY 2009 FY 2014 FY 2019(p) Sources: Moody's Investors Service, Connecticut Office of Policy Management Sources: Moody's Investors Service, US Bureau of Economic Analysis A potential bright spot for the state would be increased defense spending proposed by the Trump Administration. Defense contractors landing the largest defense-related prime contracts include United Technologies Corp. (A3 stable), General Dynamics Corp. (A2 stable) and Northrop Grumman (Baa1 stable). The state's defense contractors are concentrated in submarines and rotary wing aircraft. According to data cited by the governor's office, the state ranked fifth in prime contract awards in 2015 and second in awards per capita. While the industry offers well-paying jobs, it has a much smaller impact on the economy than the finance sector. Defense spending is estimated to account for 4.6% of 2015 state GDP. Proposed structural changes could stabilize credit, hurt downstream entities Governor Dannel Malloy's executive budget proposes extensive structural changes that would shift and reorder state aid to local governments and demand significant cost savings from collective bargaining agreements for state employees (see Exhibit 7). Proposed labor savings and shifting local government pension contribution comprise most of the governor's $1.36 billion proposed gap-closing program. A program of this magnitude that results in recurring savings would go a considerable way towards stabilizing the state's credit profile. Exhibit 7 Labor And Municipalities Feature Heavily in Governor's Proposed Budget Savings All Other 19% Collective bargaining 51% Municipal Share TRS 30% Source: Governor Malloy's Recommended Budget for the FY 2018-FY 2019 Biennium The governor's budget pegs labor savings at $700 million, which could consist of a wage freeze and benefit changes. With the timeline uncertain for hammering out an agreement and its ratification by union members, changes may not take place in time to be incorporated into the enacted fiscal 2018 budget. 5 5 April 2017 Connecticut (State of): Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE The relationship between the state and municipalities would also change significantly if the governor's proposal to shift one-third of the cost of contributing to the TRS to local governments is passed. This would be combined with a restructuring of K-12 education aid and packaged with creation of a local government option to levy property tax on certain tax-exempt properties. On net, roughly 130 of the state's 169 municipalities would lose state funds under this initiative. If the package is adopted as proposed, it will have mixed effects on local government credit, depending on whether they are net gainers or losers in the reshuffling of aid and their underlying credit strengths. 6 5 April 2017 Connecticut (State of): Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management U.S. PUBLIC FINANCE MOODY'S INVESTORS SERVICE Moody's Related Research Sector In-Depths: Softening Investment Expectations Signal Accelerating Budget Pressure from Pensions, February 2017 Medians: Low Returns, Weak Contributions Drive Growth of State Pension Liabilities, October 2016 Medians: Total Debt Remains Static in 2015, May 2016 Sector Comment: Connecticut Restructures Pension Contributions, a Credit Positive, December 2016 7 5 April 2017 Connecticut (State of): Weak Economy, High Fixed Costs Test Connecticut's Fiscal Management U.S. PUBLIC FINANCE MOODY'S INVESTORS SERVICE © 2017 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). 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