Legislature(2003 - 2004)
05/15/2003 08:45 AM Senate JUD
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* first hearing in first committee of referral
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= bill was previously heard/scheduled
SJR 18-CONST. AM: PF APPROPS/INFLATION-PROOFING
VICE CHAIR OGAN announced SJR 18 to be up for consideration.
MR. BOB STORER, Executive Director, Alaska Permanent Fund
Corporation, said they have always felt that inflation proofing
was an important issue in the Permanent Fund to make sure that
all generations benefit equally from it. To date, the fund has
been fully inflation proofed. The board has unanimously
recommended memorializing inflation proofing in the
constitution. They propose doing that by adjusting how much can
be appropriated in any single year to no more than five percent
of the total fund. That computation is based on five percent of
the five-year moving average of the market value of the Alaska
Permanent Fund Corporation. This formula is consistent with
about 70 percent of the foundations and universities across the
country. They believe they can earn a real rate of return over
time of five percent in excess of inflation.
He explained that the status quo only inflation proofs the
principal of the fund and it consists of royalty mineral money,
revenues, special appropriations and inflation proofing. The
Legislature has always inflation proofed the fund and the three
components are almost all equal. Right now the principal is
about $22 billion. They want to limit the amount that can be
appropriated from the real income of the fund over time. "Under
the status quo, the entire earnings reserve can be appropriated
and that can vary from year to year."
In other years, when the earnings reserve comprised about 25
percent of the fund, a quarter of the fund could have been
appropriated, but if that happened in the last couple of years
when the earnings reserve was actually negative, then there
would be nothing available for appropriation. He said that the
earnings reserve right now is about $2 billion, which is a
product of the last six weeks.
MR. STORER explained that there is more stability with this
methodology than using a realized income basis for what is
available for appropriation and the dividend is computed from
realized income. They are very comfortable saying they could do
this consistently.
SENATOR OGAN said he heard that the average draw on the
Permanent Fund was about four percent.
MR. STORER replied that on average, that's a reasonable
statement, but that it is a volatile number.
MR. BOB BARTHOLOMEW, Chief Operating Officer, Permanent Fund,
said the way the fund has been invested has changed a lot over
the last 20 years.
When the fund was first invested, it was 100 percent
in bonds and almost all of the earnings of the fund
was cash flow interest income. The formula was
designed to work that way. Twenty years later, we're
in stocks that have a lot of their return through
capital appreciation. We do get dividends, but the
majority of the return comes from the growth in the
value of the stock....So, early on when we say that
the payout for the dividend was roughly about 4
percent of the fund, all our income was coming in in
cash and we were paying it all out. Today, that
percentage is dropping because a lot of the growth
comes from the appreciation of assets and we don't
sell our assets. We hold on to real estate for a long
time; stocks that are in the index fund - we just hold
the index fund. We might hold it for 10 or 12 years.
All of that appreciation that's happening in assets
does not go into the dividend formula today. So that
dividend formula, how much cash income we have is a
percentage of our total income, is just dropping. By
switching to the payout of market value, we're
computing, and we recommend, that all the
distributions from the fund take into account the
entire fund and the change in value, which is both
your cash flow and your appreciation.
MR. STORER added that the fund is about 26 years old and was
created after the bear market of 1973 - 74. Very few public
funds were invested in the stock market. Basically, the thinking
was fixed income and then cobbled from there to go into equities
in the early 80s and international equities in around '88 - '89.
With equities you can expect a higher return, but more
volatility from year to year.
Using a smooth payout of the market value actually
creates less volatility than the realized income
methodology that we use right now - which goes to the
fifth item, which is predictability. What we have
learned and what we think is advantageous to decision
makers, be it the Permanent Fund or the Legislature,
is the look back provision. We are stating that it
should be the moving average of the five years of the
five prior fiscal years. The advantage to decision
makers in the Legislature [is that] when you come into
session in January, you will know exactly how much
money is available, be it for dividend, government,
etc. You will have that knowledge right there.
For those of us at the fund managing the assets, one
of the main things you try to do with the hidden costs
of the fund is transaction costs. When you're trading
your portfolio, if you think of it right now, we won't
know how much will be appropriated for the dividend
until the computation is completed on June 30. Three
weeks later, we'll have to have about one billion
dollars liquidated and moved over to the Department of
Revenue for processing in the dividend division. We
strive very hard to mitigate the effects of
transaction costs as much as possible. If we have
greater predictability on that fact, we will have the
knowledge to be able to address the liquidation in
some systematic way which will further reduce the
costs associated with liquidating those kinds of
assets....
SENATOR OGAN asked if they go with the five percent, what would
last year's dividend be versus what it's projected to be.
MR. STORER replied that they looked at that question and came up
with two answers. One is that there would be no change in the
dividend if the formula for computing the dividend remains the
same. There are two formulas, one based on realized income and
then one based on the POMV approach. They have strongly
encouraged the Legislature to change the formula of the dividend
in a manner consistent with this as well, although he is not
advocating that at this time.
He estimated that by using the 50/50 split the dividend would be
larger than it is currently until 2010 due to the market
volatility. But, the $1963 dividend from a couple of years ago,
would have been smaller.
SENATOR THERRIAULT said the calculation of the dividend is a
completely separate issue than what he is proposing. He is just
proposing a smoothing method for the cash that is available.
MR. STORER replied that is correct.
SENATOR THERRIAULT said because of the market valley we are in,
if they switched the dividend calculation to a smoother model,
it would result in higher...
TAPE 03-48, SIDE B
...it would not allow the valley to be as deep.
MR. STORER replied that is correct; it would smooth out and
lines would cross at 2010.
SENATOR THERRIAULT asked what surety he could give them.
MR. STORER answered that they do a lot of modeling of the
probabilities of achieving a goal. Every quarter they take all
the known information about the fund and look forward 10 - 15
years. They model it through 326 different permutations of
different returns, inflation, etc. They also look at a 90
percent probability of it occurring at ten percent probability,
etc. He is suggesting a median case of all the permutations.
MR. BARTHOLOMEW added that under current formulas and with the
recent extreme volatility, the earnings reserve could go to
zero. If that happens, there is no assurance; there could be a
zero distribution. The POMV, as proposed, would assure a payout
every year. There is actually more assurance and more
predictability with the proposed change.
MR. STORER added that although predictability is important, one
of the key things about this proposal is the discipline it
brings during the bull market phases. Imposing the limit in the
bull markets leaves reserves for the bear market times and one
can comfortably distribute a predictable amount of money however
the Legislature deems appropriate.
SENATOR FRENCH asked if they had adopted the POMV model at the
outset of the fund, how big would the fund be today.
MR. STORER replied that the key to the answer is that there was
only one year in which the fund was 100 percent in fixed income
and they paid out more than five percent. "The fund would be the
same size."
MR. BARTHOLOMEW said the main difference would be that we
wouldn't have the risk of going to zero on June 30 that we have
now. He elaborated that the fund made $1.1 billion in April and
that's why we've gone from almost no dividend up to there being
enough money for a dividend. "That's the kind of volatility you
don't want to have subject to your payout method."
MR. STORER added that we have benefited from an extraordinary
bull market during the entire period and the real earnings have
been in excess of six percent during that whole period as well.
SENATOR FRENCH said this assumes that the fund makes eight
percent per year. In years that make less than eight percent,
with a five percent payout, he asked whether that would make the
fund go down.
MR. STORER answered yes; they are assuming that they can earn
about eight percent over time and that historically inflation
has been about three percent. That's how they came up with the
figures for demonstration purposes. We are in a period now where
our returns are negative and inflation is modestly up he said.
SENATOR FRENCH asked what a period of deflation would do to the
model.
MR. STORER replied that there have been two extremes back
through 1926: one is deflation and the other is higher
inflation.
Both would have an impact on the fund. The higher
inflation period, at least the last time commodities
rose and so there would probably be higher income
coming to the state....One of the keys in portfolio
construction is diversification. So, we have about
half of the fund invested in equities and the balance
is in primarily high quality fixed income securities
and real estate. If deflation was over a short period
of time, then we would not be able to achieve our
goal, I believe. We'd make money in bonds, but there
would be an impact on the stock market. But then the
assumption is that we would come out of that and we
would achieve our goals again. If you go back to the
extreme of the depression, then you're going to have a
5 or 10-year problem. We can't get around that
aspect....
MR. BARTHOLOMEW thought Senator French's point was one of the
key policy decisions facing the Legislature when they are
looking at this proposal. For the benefit of assuring there will
be a payout every year, the fund is taking on the risk that in
some short term period it could get spent down a little bit,
with the idea that it would be built back up in the future. The
benefit of that is that you don't have a $22 billion fund that
provides nothing to the state and what would that mean to the
economy and to the citizens.
SENATOR FRENCH asked if using this model would moot the Attorney
General's pending decision on what earnings are.
MR. BARTHOLOMEW said that opinion would have an affect until
November 2004.
SENATOR THERRIAULT asked them to comment on the proposal to
simply freeze the statute that was first put into place when the
fund was invested only in bonds.
MR. STORER responded that with regard to the dividend payout,
it's not really compatible with contemporary investment
thinking. It would create a problem longer term.
SENATOR THERRIAULT asked him to comment on the potential
scrutiny from the IRS.
MR. STORER replied that there were a lot of discussions in the
80s about the taxability of the fund. To keep a low profile, one
of the things they did was make it distinct that the Permanent
Fund Corporation managed the assets of the fund and that any
appropriations would occur on a year to year basis through the
legislative process. The corporation was constructed in a way to
keep that autonomy as well. Legal opinions have always said
there is a risk if the dividend was memorialized in the
constitution so it was not for a government purpose.
CHAIR SEEKINS inserted that he intended to hold SJR 18 through
the interim for further work.
MR. STORER commented that he didn't think that SJR 18 increased
the risk of the fund being attacked by the IRS. However, SJR 19
talks about placing a dividend commitment into the constitution
and would present a question.
SENATOR THERRIAULT said he understood and agreed with him.
CHAIR SEEKINS said they would hold SJR 18 for further work.
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