Legislature(2005 - 2006)

05/05/2005 04:55 PM FIN


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     CS FOR HOUSE BILL NO. 215(FIN)                                                                                             
     "An  Act relating  to the  investment responsibilities  of  the                                                            
     Alaska  Permanent  Fund Corporation;  relating  to regulations                                                             
     proposed  and adopted  by the Board of  Trustees of the  Alaska                                                            
     Permanent  Fund Corporation  and providing  procedures  for the                                                            
     adoption  of regulations  by the  board; and  providing for  an                                                            
     effective date."                                                                                                           
                                                                                                                                
                                                                                                                                
This  was the first  hearing  for this  bill in  the Senate  Finance                                                            
Committee.                                                                                                                      
                                                                                                                                
MIKE  BURNS,   Chief  Executive  Officer,   Alaska  Permanent   Fund                                                            
Corporation,  Department of Revenue,  stated that the issue  at hand                                                            
is  the question  as  to "why  the  Prudent  Investor  Rule even  be                                                            
considered   as  the  primary  overarching   policy  governing   the                                                            
investment  of  the Alaska  Permanent  Fund."  The initial  step  in                                                            
addressing  this question  would be to review  the Alaska  Permanent                                                            
Fund Corporation  (APFC)'s "mission, which is to maximize  the value                                                            
of  the Permanent  Fund  through prudent  long-term  investment  and                                                            
protection   of  principal   to  produce   income  to  benefit   all                                                            
generations of Alaskans".                                                                                                       
                                                                                                                                
Mr. Burns read  portions of his written testimony  [copy on file] as                                                            
follows.                                                                                                                        
                                                                                                                                
     It is not difficult  to see the many challenges inherent in the                                                            
     Permanent  Fund's  mission and  equally easy  to see that  they                                                            
     often are  in conflict. Maximizing returns in  a manner that is                                                            
     prudent,  doing so over  the long-run  (indeed perpetuity)  and                                                            
     still  protecting   Fund  principle  while  at  the  same  time                                                            
     producing   and  distributing  substantial   levels  of  income                                                            
     annually  in perpetuity (across future generations)  is a major                                                            
     challenge  for those charged with investing the  Fund's assets.                                                            
                                                                                                                                
     For  several  hundred  years,  most  trustees   facing  similar                                                            
     challenges  have operated under a "prudent" policy  implemented                                                            
     by a simple  constraint: permit  the investment of fund  assets                                                            
     in  only those  instruments  which, when  viewed individually,                                                             
     were likely to produce  income and protect the nominal value of                                                            
     the fund.  These instruments were few and primarily  focused on                                                            
     fixed  income.   This  particular  foundation   for  a  prudent                                                            
     investment   policy  succeeded   in  some  respects,   but  has                                                            
     generally  failed  to meet the  full spectrum  of requirements                                                             
     such  as those  expressed in  the Permanent  Fun's Mission.  IN                                                            
     particular:                                                                                                                
                                                                                                                                
        · The predominate, and in some cases, exclusive use of                                                                  
          fixed income and related securities left the real corpus                                                              
          extremely vulnerable to inflation.                                                                                    
                                                                                                                                
     Over the last three  decades, trustees facing challenges highly                                                            
     similar,  and  in some  cases identical,  to  those facing  the                                                            
     Alaska  Permanent Fund, have  been abandoning the "restrictive                                                             
     list" foundation  for implementing a prudent  investment policy                                                            
     and  instead have  adopted  the Prudent  Investor  Rule as  the                                                            
     guiding policy for investment fund assets.                                                                                 
                                                                                                                                
Mr. Burns noted  that 44 of the 50 states in the United  States have                                                            
moved away from the restrictive or statutory lists.                                                                             
                                                                                                                                
     The  Prudent Investor  Rule's  underlying premise  is that  the                                                            
     primary  responsibility  of the fiduciaries  is to ensure  that                                                            
     the  estimated  risk  and  return  of the  total  portfolio  is                                                            
     appropriate  in light  of risk  tolerances  and the  particular                                                            
     objectives of the  assets. This focus on the least estimates of                                                            
     the  total  portfolio's  long-term   behavior  along  with  the                                                            
     development  of  modern  portfolio  theory   has fundamentally                                                             
     changed the foundation for "prudent" fiduciary behavior…                                                                   
                                                                                                                                
     In current  law, this  emphasis on the  whole portfolio  rather                                                            
     than individual investment  categories the fiduciary is said to                                                            
     have  " a duty to  evaluate investments  in the context  of the                                                            
     portfolio  as  a whole  while  the duty  to  select  reasonable                                                            
     levels  of risk are  targeted to the  fund and diversification                                                             
     itself becomes as a fiduciary obligation…                                                                                  
                                                                                                                                
     The relevant point  for the Alaska Permanent Fund is that it is                                                            
     quite possible  that either now or at some time  in the future,                                                            
     the inability  to access a broader  range of asset classes  may                                                            
     result  in the creation of a  Fund that contains either  excess                                                            
     risk or unnecessarily lower long-term returns.                                                                             
                                                                                                                                
Mr. Burns referred  Committee Members  to the "'Efficient  Frontier'                                                            
of Investments"  graph  on page four  of the  Alaska Permanent  Fund                                                            
Corporation handout titled  "Reducing Risk, Increasing Return" [copy                                                            
on  file].  The graph's  horizontal  axis  measures  risks  and  the                                                            
vertical  axis measures expected  returns.  The lower graph-line  in                                                            
the chart depicts the "Efficient  Frontier" for the Alaska Permanent                                                            
Fund "as  constrained by  the current statutory  list". Each  of the                                                            
dots on that line  reflects the "risk and return characteristics  of                                                            
different  asset  allocations".   The  square  mark  on  that  line,                                                            
referred to as "#8 March  2004 Target" is indicative of the risk and                                                            
return level of the Fund  today, which is a 7.83 percent return with                                                            
10.29 percent standard deviation.                                                                                               
                                                                                                                                
Mr. Burns  continued  that the upper  graph line  would reflect  the                                                            
Permanent  Fund's  portfolio  were  it instead  constrained  by  the                                                            
Prudent  Investor  Rule.  The  points  on  that  line  also  reflect                                                            
differing  asset allocation  categories. The  "green square"  on the                                                            
upper  graph  line  would reflect  the  7.83  percent  return  being                                                            
currently experienced.  Under the  Prudent Investor Rule  that level                                                            
would be  obtained with  lesser risk.  The level  of risk  currently                                                            
being  experienced  is reflected  on  the upper  line  by mark  "6";                                                            
however,  under the proposed  Prudent Investor  rule, that  level of                                                            
risk would be accompanied by a one percent increase in returns.                                                                 
                                                                                                                                
Mr. Burns  stressed  that, "the  constraints of  the statutory  list                                                            
today are  pushing us  in the direction  of higher  risks for  lower                                                            
returns and that is not what any of us are seeking".                                                                            
                                                                                                                                
[NOTE: Co-Chair Wilken assumed chair of the Meeting.]                                                                           
                                                                                                                                
6:31:32 PM                                                                                                                    
                                                                                                                                
Senator   Stedman,   referencing   the   differences   between   the                                                            
aforementioned  marks  "6"  and  "8", asked  "how  accurate  is  the                                                            
measurement  of that when  you have static  investments that  aren't                                                            
actively traded". He noted  that the Alaska State Pension Investment                                                            
Board (ASPIB)  had provided  testimony to  the effect that  standard                                                            
deviations were difficult  to estimate and therefore not included in                                                            
their reports.                                                                                                                  
                                                                                                                                
Mr.  Burns asked  whether  Senator  Stedman  was referring  to  real                                                            
estate or private equities.                                                                                                     
                                                                                                                                
Senator  Stedman clarified  that his  remarks  pertained to  private                                                            
equities.                                                                                                                       
                                                                                                                                
Mr. Burns explained  that the APFC includes "those  in our financial                                                            
projections  with  their  expected  internal  rate of  return."  The                                                            
determination  is that that is the most accurate manner  in which to                                                            
reflect it. Private equities,  at a level of $2,900,000, are a small                                                            
asset, and  at this time,  do not have much  affect. He pointed  out                                                            
that the graph depicts  "expected return and expected risk" based on                                                            
"historical factors for these asset categories".                                                                                
                                                                                                                                
6:33:03 PM                                                                                                                    
                                                                                                                                
Senator Stedman  recalled  that the APFC  asset allocation  had been                                                            
increased by  five-percent the previous  year in order to  allow the                                                            
Fund "to have  more liquid assets classes" to help  it "increase its                                                            
return and,  in theory, decrease its  volatility at the same  time".                                                            
He asked whether that level had been obtained to date.                                                                          
                                                                                                                                
6:33:42 PM                                                                                                                    
                                                                                                                                
Mr. Burns replied that  that level has not been reached. He exampled                                                            
that the  University  of Alaska  Foundation has  specified that  18-                                                            
percent  of  its  assets  would  go into  what  is  referred  to  as                                                            
"alternative investments",  which "are basically basket  clause type                                                            
of investments"  to which Senator Stedman has referred.  Even though                                                            
the University  is having difficulty reaching the  18-percent, there                                                            
are  now commitments  to increase  that  level to  24-percent.  "You                                                            
don't  control  when the  money  goes out  the  door and  you  don't                                                            
control  when  it comes  back  on  some  of these  private  type  of                                                            
investments, so  you need to over-commit if you are  going to get to                                                            
your  target." APFC  Trustees,  through "the  powers  granted to  us                                                            
through  the   additional  basket   clause  made  a  commitment   of                                                            
$600,000,000 to private  equity". $240,000,000 of that $600,000,000,                                                            
allocation   has  been   committed,   and  of   that  $240,000,000,                                                             
"$2,900,000  is out the door. It is  a very lengthy process."  It is                                                            
necessary to  over-commit in order  to reach the level desired.  The                                                            
mechanism  to avoid  a situation  of over-commitment  is to  include                                                            
"contractual  obligations  and a  statutory limitation".  Those  are                                                            
necessary even  though "it would be highly unlikely"  for all of the                                                            
commitments "to be called at one time".                                                                                         
                                                                                                                                
6:35:20 PM                                                                                                                    
                                                                                                                                
Senator Stedman acknowledged.                                                                                                   
                                                                                                                                
[NOTE: Co-Chair Green resumed chair of the meeting.]                                                                            
                                                                                                                                
Senator Stedman  spoke to the "bigger issue" of the  underfunding of                                                            
the  Public Employees  Retirement  System  (PERS) and  the  Teachers                                                            
Retirement  System (TRS).  Efforts are being  taken to address  that                                                            
$5,700,000,000   under-funding   situation.   To   that  point,   he                                                            
questioned  whether this would be  the appropriate time to  consider                                                            
the  proposal being  advanced  in  this bill.  He suggested  that  a                                                            
better  time would be  to address  it in January  and February  2006                                                            
when the Committee  could review the  portfolio of the PERS  and TRS                                                            
Trust Assets and  the Permanent Fund (PF). He noted  that ASPIB does                                                            
not currently  operate under  the auspice of  a statutory list,  and                                                            
that they currently  "have more volatility, and they  seem to have a                                                            
little  higher return  on the  upside and  a lower  one on the  down                                                            
side."  He argued  that it would  be "a  nice fit"  for the  Finance                                                            
Committee to address  "this issue at the same time  because they are                                                            
very closely  related. The  education" that  would be gained  on the                                                            
part of both  the public and the Legislature  were those  efforts to                                                            
"run simultaneously" or in close sequence would be beneficial.                                                                  
                                                                                                                                
6:37:31 PM                                                                                                                    
                                                                                                                                
Senator Stedman noted that  the five-percent allocation increase the                                                            
Legislature  had provided  APFC through the  basket clause  does not                                                            
appear  to  be  "maxed  out yet"  so  a  delay  in  addressing  this                                                            
legislation would  not place "the PF at any major  disadvantage". He                                                            
"recognized"  that over  the last  decade the PF  has endeavored  to                                                            
move away from the statutory list.                                                                                              
                                                                                                                                
6:37:48 PM                                                                                                                    
                                                                                                                                
Mr.  Burns spoke  to the  timing  issue by  conveying  that APFC  is                                                            
convinced that the proposal  being forwarded "is the right concept".                                                            
In addition, APFC is convinced  that the current process is "hurting                                                            
the Fund's performance".  Yesterday, for example, the Fund increased                                                            
in value  for approximately  $250,000,000,  which is less than  one-                                                            
percent.  To that point,  he questioned  whether  waiting to  act on                                                            
this proposal would be  the right thing to do considering the Fund's                                                            
volatility.  "We would love  to be part of  the State's process  "of                                                            
re-thinking  how the State invests  its assets", however,  it should                                                            
be noted that,  were this legislation  adopted, it would  not become                                                            
effective until  January 1, 2006.  Adopting this proposal  now would                                                            
allow  time for  regulations  to be developed  so  that the  process                                                            
could  begin in  January.  It would  also allow  APFC  to develop  a                                                            
report "as  a precursor to how you  deal with the new" PERS  and TRS                                                            
Board and the PERS/TRS assets. That "would be very timely".                                                                     
                                                                                                                                
6:39:23 PM                                                                                                                    
                                                                                                                                
Senator Stedman  pointed out  that many of  the asset classes  being                                                            
considered  "are  already liquid".  Therefore,  he  questioned  "the                                                            
accuracy of pricing;  at best they're estimates".  The true value is                                                            
provided when the asset is liquidated.                                                                                          
                                                                                                                                
6:39:39 PM                                                                                                                    
                                                                                                                                
Mr. Burns agreed  to Senator Stedman's  comments as they  pertain to                                                            
"the real estate  side". Those prices  are re-evaluated every  other                                                            
or every third year. While  those changes in value are not reflected                                                            
in the  Fund's  financial  statements, they  are  considered in  the                                                            
Fund's performance.  "You don't know what real estate's  worth until                                                            
you sell it." Some of the  Fund's longer term liquid assets in terms                                                            
of the  Efficient Frontier",  as opposed to  assets we have,  again,                                                            
are historical performances  of these asset categories". Each dot on                                                            
the aforementioned  graph represents  "historical costs".  Therefore                                                            
rather than  reflecting performance,  the graph would present  asset                                                            
allocation.                                                                                                                     
                                                                                                                                
6:40:41 PM                                                                                                                    
                                                                                                                                
Senator  Stedman  stated  that  in  order  "to  calculate   standard                                                            
deviation, you have to  have a movement in price". Absent a movement                                                            
in price, "you  have to estimate or  guessimate it". Therefore  when                                                            
considering "inactively  traded security you've got daily monthly or                                                            
weekly  pricing"  which  could  be  used  "to  gauge  that  standard                                                            
deviation that moves over time".                                                                                                
                                                                                                                                
6:41:14 PM                                                                                                                    
                                                                                                                                
Mr. Burns agreed,  with the exception  being for instance  that such                                                            
things as private  equity "is a liquid,  it's not priced  daily, but                                                            
the standard deviation  is figured from its historical movement", or                                                            
"its actual movement over  time". There is enough history from which                                                            
to develop standard deviations  and historical returns for all these                                                            
asset classes.  The historical performance upon which  we are basing                                                            
asset allocation is "there for all the asset categories".                                                                       
                                                                                                                                
6:41:57 PM                                                                                                                    
                                                                                                                                
Senator  Stedman responded  "that, at  best it's  a smoothing  issue                                                            
with the price movements".  Absent movement in the market from which                                                            
"to actually gauge what  it is, you're going to have points when you                                                            
sell it and points when you buy it".                                                                                            
                                                                                                                                
Senator Stedman  reiterated that ASPIB, which does  not operate with                                                            
statutory  list constraints,  would appear  to have more  volatility                                                            
than the PF,  "with higher highs and  lower lows". He was  uncertain                                                            
as  to whether  the  Legislature  "wouldn't  be  better  served"  to                                                            
address these  situations "at a similar  timeframe" when  time could                                                            
be provided to thoroughly make a decision.                                                                                      
                                                                                                                                
6:43:18 PM                                                                                                                    
                                                                                                                                
Co-Chair Green  noted that "it has  been interesting … to  watch the                                                            
transition over the years  and how it's moved very slowly … from the                                                            
different  percentages  and the  changes  …. It  is  always a  tough                                                            
conversation."                                                                                                                  
                                                                                                                                
Mr. Burns  stated that when  discussing "the  valuations of  some of                                                            
these assets…"  it must be  noted that the  PF is not solely  basing                                                            
the standard  deviation on  how the PF assets  perform, but  also on                                                            
the information  of APFC's  consultant who  has a universe of  a 110                                                            
funds similar  to the PF. "It's how  these assets perform  over that                                                            
universe." He "agreed completely  with the assessment that as we get                                                            
into these in  small amounts, our experience won't  be that additive                                                            
to what  the universe  is for  quite a  while, but  the universe  is                                                            
there  and,  for  our purposes  and  planning,  it's  a  very  valid                                                            
timeframe and returns."                                                                                                         
                                                                                                                                
Co-Chair  Wilken recalled this  being the third  time that  APFC has                                                            
asked this  Committee to  change the Statute  that controls  how the                                                            
Fund could be invested.  Both of the previous requests were approved                                                            
and the Fund continues,  "to exceed all of our expectations".  While                                                            
being  appreciative of  Senator  Stedman's concerns,  he  calculated                                                            
that a one percent  change that would equate to $300,000,000  a year                                                            
or  $6,000,000 a  week,  could be  lost  were this  legislation  not                                                            
advanced.  That would fund  a lot of education  needs in the  State.                                                            
Therefore delaying  this legislation  a year would cost the  State a                                                            
significant amount of money.                                                                                                    
                                                                                                                                
Mr.  Burns  affirmed   that  Co-Chair  Wilken's  calculations   were                                                            
correct. "Time  is not your friend  on this." Delaying this  process                                                            
would not  correct "what  all of our experts  and consultants"  have                                                            
concluded we are  doing to ourselves. "This fund is  very deliberate                                                            
in its  approach to  things", and  therefore, a  lengthy process  is                                                            
involved. This  issue has been discussed for quite  a while and APFC                                                            
is "convinced that this is the right thing to do".                                                                              
                                                                                                                                
6:46:39 PM                                                                                                                    
                                                                                                                                
Senator Stedman  argued against the  correctness of the math,  as it                                                            
is dependent  on the  market. Were  the market  to advance  "sharply                                                            
higher", he would  expect the returns to be larger.  Were the market                                                            
to continue flat  or to decline, as reflected by ASPIB's  portfolio,                                                            
the results  might be "average  or worse".  Therefore, the  movement                                                            
from  the  point  at  which  the  policy  was  implemented  "to  the                                                            
measuring point"  would be a factor.  "Markets do not always  go up"                                                            
and  were  the  measurements   taken  "on  an  up  day   that's  one                                                            
measurement period"  and were they taken on a "down  day" that would                                                            
be another period. "It's not a linear relationship."                                                                            
                                                                                                                                
Mr. Burns concurred  that markets move both ways.  He had considered                                                            
Co-Chair Wilken's  remarks to reflect  "the opportunity"  that might                                                            
be there.                                                                                                                       
                                                                                                                                
Co-Chair Wilken  remarked that that  is a measure of risk.  However,                                                            
he  noted  that,  as  reflected  on  the  aforementioned   Efficient                                                            
Frontier graph that the  State would not be changing its risk factor                                                            
were this legislation  adopted. "The  fluctuation up and  down would                                                            
be the same regardless"  of whether the status quo  was continued or                                                            
changed to the asset allocation being proposed.                                                                                 
                                                                                                                                
Mr. Burns affirmed  that changing  to the proposed asset  allocation                                                            
would not alter the standard  deviation. "What is equally important"                                                            
to note  is that the point  at which the  proposed allocation  would                                                            
achieve  the same  yield  as the  status quo,  as  reflected by  the                                                            
"Expected  Return" point  on the  proposed asset  allocation  graph-                                                            
line, would  be a point of reduced  risk. This would provide  "quite                                                            
an opportunity".                                                                                                                
                                                                                                                                
Co-Chair  Wilken  voiced  appreciation  for  the  inclusion  of  the                                                            
language reflected at the  bottom of page four on the aforementioned                                                            
handout that reads as follows.                                                                                                  
                                                                                                                                
     Increasing  the  Fund's  investment  options  would  allow  the                                                            
     Trustees  greater  flexibility  in managing  the  Fund for  the                                                            
     benefit  of all  Alaskans, whether  it is  for greater  return,                                                            
     lower risk or both. This is especially important as the                                                                    
     Legislature begins to contemplate the use of Fund earnings for                                                             
     more than just the dividend program.                                                                                       
                                                                                                                                
Senator  Stedman  understood  that  "the  Efficient  Frontier  is  a                                                            
dynamic instrument"  and would change  according to the measurement                                                             
period  being considered.  "It's not  static line."  The line  would                                                            
appear different according to the time period.                                                                                  
                                                                                                                                
6:49:43 PM                                                                                                                    
                                                                                                                                
Mr.  Burns  clarified  that  the  Efficient   Frontier  chart  being                                                            
referenced  "is not  a point  in time,  that is  an accumulation  of                                                            
time; those are historical  numbers". He was uncertain as to whether                                                            
the graph  depicted the  scenario for  either the  past five  or ten                                                            
years.                                                                                                                          
                                                                                                                                
Senator Stedman  understood that to  be the case. His point  is that                                                            
the line would change for any ten-year rolling average.                                                                         
                                                                                                                                
Mr. Burns concurred  that the slope  of the line on the graph  would                                                            
change according to the timeframe.                                                                                              
                                                                                                                                
Senator  Stedman  agreed  that, "theoretically,   these investments                                                             
should produce  and allow the portfolio  to receive a higher  return                                                            
for less volatility".                                                                                                           
                                                                                                                                
Mr. Burns responded that that is exactly the point.                                                                             
                                                                                                                                
6:50:43 PM                                                                                                                    
                                                                                                                                
Senator  Olson  asked how  significant  the  three-percentage  point                                                            
standard  deviation   reflected  on  the  aforementioned   Efficient                                                            
Frontier graph is when compared to other investment scenarios.                                                                  
                                                                                                                                
Mr. Burns responded  that the standard deviation in  relationship to                                                            
today's 10.29 percent return would be "pretty significant".                                                                     
                                                                                                                                
Senator Olson  asked how the three percent standard  deviation would                                                            
compare to other similar investment portfolios.                                                                                 
                                                                                                                                
Mr.  Burns   communicated  that  the   PF  portfolio  is   a  fairly                                                            
"conservative asset mix".  It is very different from a pension fund,                                                            
which has fixed  liabilities. While  he did not consider  the Fund's                                                            
standard deviation to be  "out of line", he expressed that it is out                                                            
of line  when considered  the return it is  generating. "That's  the                                                            
ratio" that should be considered.                                                                                               
                                                                                                                                
6:52:06 PM                                                                                                                    
                                                                                                                                
Senator Stedman  commented that the portfolio's assets  have evolved                                                            
to  a  60-percent   equities  and   40-percent  bonds  balance.   He                                                            
understood  that  since the  market  experienced  "turbulent"  times                                                            
around the year 2000, there  has been a tendency "for asset managers                                                            
to look out  away from the equity  markets that are traded"  on such                                                            
things as the  New York stock exchange and to "try  to go into other                                                            
asset  classes to  tone down  the volatility"  and  to achieve  more                                                            
diversitility.                                                                                                                  
                                                                                                                                
6:53:03 PM                                                                                                                    
                                                                                                                                
Mr.  Burns affirmed  this  to be true.  The  PF has  a very  diverse                                                            
portfolio  including  investments in  worldwide  equity markets;  in                                                            
small, mid,  and large  capitalized markets;  and emerging  markets.                                                            
Efforts are exerted  to achieve a good balance. He  anticipated that                                                            
"the  bigger  change"  would  be  the  shift   "to  absolute  return                                                            
strategies" rather than  fixed income markets in an effort to remove                                                            
volatility.                                                                                                                     
                                                                                                                                
AT EASE 6:54:00 PM / 6:54:23 PM                                                                                             
                                                                                                                                
Co-Chair  Wilken  moved  to  report the  bill  from  Committee  with                                                            
individual recommendations and accompanying fiscal notes.                                                                       
                                                                                                                                
AT EASE 6:54:42 PM / 6:56:35 PM                                                                                             
                                                                                                                                
There  being  no  objection,  CS  HB  215(FIN)   was  REPORTED  from                                                            
Committee  with zero fiscal  note #1  dated April  8, 2005 from  the                                                            
Department of Revenue.                                                                                                          
                                                                                                                                
6:56:53 PM                                                                                                                    
                                                                                                                                
AT EASE 6:57:21 PM / 7:12:54 PM                                                                                             
                                                                                                                                

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