Legislature(1995 - 1996)
03/29/1996 08:08 AM Senate FIN
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
SENATE BILL NO. 51
An Act relating to income of the permanent fund; and
providing for an effective date.
Co-chairman Halford directed that SB 51 be brought on for
discussion. Senator Rieger explained that the bill would
introduce the concept of real earnings into management of
the state's largest endowment account--the Alaska Permanent
Fund. Most endowments operate on a principle where earnings
considered usable are those that exceeded inflation in a
given year. These moneys are referred to as "real earnings"
in contrast to "nominal earnings" which reflect total cash
return to a fund compared to what is actually earned in
excess of inflation.
Given present dynamics and increasing numbers of proposals
for potential use of the permanent fund, the focus is on
total return, and inflation proofing is an afterthought.
Under a "real earnings" concept, inflation proofing becomes
the first priority. The remainder of the return is then
available for other use. That is how university endowments
and most other endowment funds operate. The first fiduciary
priority is to protect the principal. That would occur if
inflation proofing were automatic. The proposal contained
in the legislation is timely because the permanent fund has
enjoyed a banner "run up" over the past eighteen months.
"Real earnings" based on the new size of the fund are equal
to total return under the prior size of the fund. The time
is ideal to make the policy change without disruption in
what "people see when they look at what the return is and
what the legislature sees."
JIM KELLY, Director of Communications, Alaska Permanent Fund
Corporation, came before committee. He referenced
correspondence from the board of trustees indicating that
the board had discussed the legislation and did not intend
to take a position on the bill. The board is supportive of
any changes to existing law which would enhance board
ability to protect the principal of the permanent fund.
That portion of SB 51 which makes inflation proofing the
highest priority represents such a change.
Another portion of the bill, making a change in the dividend
formula by basing it on "real income" instead of net income,
falls outside the scope of the trustees' area of
responsibility.
The fiscal note for the bill is zero since changes
incorporated within the bill would have no operational
impact on the corporation.
Mr. Kelly explained that inflation proofing provisions were
enacted in 1982 at the request of the first board of
trustees. For the past fourteen years, each legislature has
taken a portion of annual income and appropriated it to
principal to protect the fund against inflation. Those
appropriations produced a cumulative total of $4.6 billion.
That action evidences the legislature's strong, long
lasting, and unwavering support for protection of principal.
The inflation rate for this year will be 2.82 percent, based
on the calendar year change and the consumer price index.
Since 1978, inflation has averaged 5.11 percent. The
expectation for the next five years is that it will average
"somewhere between 3.18 and 3.5 percent. As a percentage of
annual net income, inflation proofing has ranged from a high
of 55 percent (1991) to a low of 25 percent (1989). This
year, with high earnings of over $1 billion, inflation of
$400 million amounts to 24 percent. It is projected that
inflation proofing in future years will require
approximately 44 percent, on average. That is based on
assumptions that the fund will be able to earn a realized
return "on the order of 7.17 percent, and inflation will
average something like 3.18 percent."
For total principal of $15 billion, every one percent
increase in inflation requires approximately $150 million of
net income to be transferred to principal.
Mr. Kelly noted that the proposed legislation speaks to
"real income" and ensures that nothing but "real income"
would be distributed. With the exception of 1990 and 1991,
since conception of the fund, nothing but real income has
been distributed. The earnings goal of the corporation is
to beat inflation and produce real income at a rate of 3
percent. That 3 percent target is likely to be increased to
4 percent at the May 2, 1996, board meeting. The 3 percent
target was set when the permanent fund was largely into
fixed income investments. Over the years, the fund has
become more involved in equity investments which produce a
higher rate of return. Investment performance in the 1980s
and 1990s has been so good that it has beaten inflation by
5.5 percent in the nearly twenty years the fund has been in
existence.
Referencing a handout (copy on file in the committee master
file for SB 51), Mr. Kelly noted that the trustees are in
the process of setting asset allocations for the next year
and three-years hence. When this is accomplished,
assumptions regarding future earnings will likely change
based on capital market assumptions and new asset
allocations from the board. Based on the most likely choice
to be made by trustees, the total median return (cash plus
appreciation) over the next five years is 8.42 percent. If
the corporation is unable to gain appreciation because of
the market, the least that could be made would be a 4.68
percent median return.
The $1.7 billion in income for the current year reflects an
11 percent return. With inflation of 2.8 percent, there has
been over 8 percent of real return. Markets go up and down
as does inflation. In terms of income available for
distribution, if the tradition of protecting principal is
maintained (through the proposed bill or not) the state has
available the "real income" of the fund. Mr. Kelly
reiterated that the goal is 4 percent. On a $15 billion
fund that amounts to $600 million a year. As the fund
builds to $20 billion, there would be $800 billion of
distributable income.
Senator Rieger pointed to both the $1.7 billion return and
unrealized gains of $2.2 billion. He then directed
attention to a tabulation evidencing best and worst case
projections of future earnings and explained that it
incorporates the $2.2 billion in unrealized gains. One
scenario reflects total use of all funding in the earnings
reserve and the other reflects no use of those moneys. The
Senator noted that in one scenario, transfer to the general
fund (even after payment of a $1,000 dividend every year)
"hits a billion dollars by the end of the run, per year."
In the other case, the dividend grows to "just under
$2,000," but no cash is used in the general fund. That
results in $23 billion in the earnings reserve account.
Real earnings in the future are consistent with total return
in the past. The question of inflation proofing and the
potential threat to inflation proofing from those who might
propose use of earnings beyond what goes into dividends is
guarded against by passage of SB 51.
Discussion of past year gains and application of the
dividend formula followed between Co-chairman Halford and
Mr. Kelly. Senator Rieger stressed that the proposed bill
does nothing to corporate capital gains.
Co-chairman Halford voiced his understanding that the bill
would take inflation proofing out of corporate income before
the dividend formula is applied. Mr. Kelly concurred. The
Co-chairman next noted projections that inflation proofing
in the future would require 44 percent of future income and
asked what that would do to the formula for dividends. Mr.
Kelly responded that of the money made each year,
approximately 10.5 percent goes to dividends. For the
present year it would amount to a $40 million reduction.
Since the dividend is calculated on a five-year basis, that
amount would be compounded over time. Transitional
provisions in the bill would count four years of net income
and one year of real income for the first year. The second
year would count three years of net income and two years of
inflation proofing reduced net income. The $40 million
reduction would thus be $80 million the second year, $120
million the third, $160 the fourth, and $200 million by the
end of five years.
Co-chairman Halford raised concern regarding dividends and
explained that he asked permanent fund staff to provide
projections based on the status quo versus the proposed
bill. He then directed attention to tabulations (copies on
file in the master file) and noted that the bill would
reduce the constant value of the dividend to $606.00 in 2001
versus a real value of $1,002 in that same year. The
reduction would occur under the proposed bill because the
pool of funds for the dividend would be reduced by removal
of inflation proofing moneys before the dividend is
calculated. Mr. Kelly concurred. Co-chairman Halford
reiterated that the real value of the dividend is reduced by
$400 in "just five years." He acknowledged concern in some
sectors that the dividend would grow to "some huge amount."
He then pointed to the graph he distributed and noted that
"the dividend never gets to $1,200, in real dollars, before
2006 . . . ."
Senator Randy Phillips concurred in need for protection of
the permanent fund. He suggested that the fundamental issue
is protection of the fund versus protection of the dividend.
Co-chairman Halford noted that the permanent fund dividend
protects the principal in the eyes of the public.
Senator Sharp voiced his understanding that the proposed
bill would not require greater amounts for inflation
proofing than those presently provided. Senator Phillips
reiterated that the question should be how best to protect
the fund. Senator Rieger's proposal would inflation proof
first and pay dividends later. The question is, "Do we
protect the dividends, or do we protect the permanent fund
itself." Co-chairman Halford noted that the legislature
could change the priority for dividends versus inflation
proofing without changing the dividend formula. The
proposed bill applies the existing formula after inflation
proofing is removed. That has the effect of "reducing the
dividends pretty drastically over time." The Co-chairman
noted that the original debate on priority of dividends
versus inflation proofing was "almost a draw in advocates
and supporters of the permanent fund." The question of
priority is different from the taking of inflation proofing
before dividends are calculated. Co-chairman Halford
advised that he did not have as strong a feeling about
priorities are he does about the reallocation resulting from
the proposed bill.
Senator Phillips voiced agreement with protection of
permanent fund principal. The question is how that might
best be done.
END: SFC-96, #60, Side 1
BEGIN: SFC-96, #60, Side 2
Co-chairman Frank voiced support for use of "real income"
versus nominal income. He further spoke to the mitigating
effect of five-year averaging of dividends and inquired
regarding the impact of increasing the percentage from 21 to
25 percent. Senator Rieger noted that the increase would
represent a policy call for the legislature. He noted that
the corporation currently pays out 55 percent in dividends
rather than 50 percent as perceived by the public.
Senator Phillips asked that Mr. Kelly apply provisions of
the proposed bill to both past dividends and principal
amounts. Mr. Kelly advised that it would have had no effect
on the principal. He agreed to apply it to dividends from
inception in 1982 to the present time. Co-chairman Halford
reiterated that projections indicate that, over time, 44
percent of income would be required for inflation proofing.
If 44 percent is taken out of the formula before the
calculation is made, the dividend is reduced by that same 44
percent.
Senator Phillips again asked which of the two--inflation
proofing or dividends--would be the most effective in
protecting the principal of the fund. Co-chairman Halford
voiced his belief that both protect the fund. They are not
in conflict. The dividend and inflation proofing can be
paid. Over the history of the fund, there has continually
been a surplus. The legislature has deposited that surplus
into principal. That surplus could be used for other
activities.
FORMER REPRESENTATIVE ORAL FREEMAN next spoke via
teleconference from Ketchikan. He attested to the fact that
the permanent fund is working exactly as it was intended to.
There is no reason nor rationale for "tinkering or messing
with it when it's working great." The general public is
highly suspicious of changes in the fund.
Mr. Freeman referenced similar discussion of inflation
proofing in the late 1980s. At that time, he advised, he
posed questions regarding what would happen in a situation
where inflation equals earnings. If inflation proofing is
the first priority, all earnings would be used for that
purpose. The general public would soon question need for a
fund that produces no benefit for its people.
Mr. Freeman stressed that the dividend is the life insurance
policy for the permanent fund. When the fund loses the
confidence, backing, and support of the general public, the
permanent fund will disappear. He suggested that the
proposed bill is not worth the effort put into it.
In response to a hypothetical situation posed by Senator
Rieger, Mr. Freeman stressed that the second half of the
earnings of the permanent fund has taken care of inflation
since 1982 and has produced an excess of $2.2 billion. He
voiced his belief that the fund would be undamaged if
inflation proofing was short in a particular year since the
history of the fund indicates that would not happen year
after year. Co-chairman Halford remarked that moneys are
traditionally maintained in the earnings reserve account to
cover a shortfall in any particular year. Mr. Freeman
concurred.
Co-chairman Halford noted that Senator Rieger had prepared
an update based on nominal dollars using current income
numbers and requested that projections also be prepared
based on real dollars. Senator Zharoff asked if, at some
point, inflation proofing consumes all of the earnings.
Senator Rieger responded, "There's always a hypothetical
like that." He then explained that people have noted that
half is going to dividends and are wondering what is
happening with the other half. Proposals are offered with
increasing frequency concerning what to do with the other
half. Some of them will eventually garner enough support to
pass. When that happens, 100 percent of the nominal
earnings of the permanent fund will be spoken for. The
loser will be inflation proofing.
SB 51 reflects truth in advertising of what the permanent
fund is really achieving. At the present time, the fund
pays out half of the inflation component as a dividend.
That misleads the public into thinking that "this was only
half of the performance of the fund that is being paid."
The proposed change is timely because of fund performance.
The proposed bill could be effected without impacting "the
amount that is put on the table." Senator Zharoff noted
that the other half is not being spent. It "rolls right
into the corpus of the fund."
Co-chairman Halford voiced his belief that the public
understands that half the income is used for dividends while
the other half provides inflation proofing. He acknowledged
an advocacy that believes that some of the income should go
through government and "get spent through government." He
suggested that the combined effects of the proposed bill
would result in inflation proofing, a reduction in the
dividend formula, and a building account that would be used
to fund some governmental service. The public should
ultimately decide what services it wishes to buy. Senator
Sharp concurred. He suggested that inflation proofing first
and applying the dividend to half of the remainder would
cause the public to question the purpose for the remaining
half.
Co-chairman Halford suggested that the bill be held in
committee for updated projections. He said it could
possibly be heard again in the coming week.
ADJOURNMENT
The meeting was adjourned at approximately 11:00 a.m.
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