Legislature(2005 - 2006)SENATE FINANCE 532

02/17/2005 10:00 AM Senate FINANCE


Download Mp3. <- Right click and save file as

Audio Topic
10:06:27 AM Start
11:13:33 AM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
-- Time Change --
+ Joint w/(H) Finance TELECONFERENCED
Presentation by the Alaska Permanent Fund
Board & Advisors
                              MINUTES                                                                                         
                               JOINT                                                                                          
                     SENATE FINANCE COMMITTEE                                                                                 
                      HOUSE FINANCE COMMITTEE                                                                                 
                         February 17, 2005                                                                                    
                            10:06 a.m.                                                                                        
                                                                                                                                
                                                                                                                              
CALL TO ORDER                                                                                                               
                                                                                                                                
Co-Chair Green  convened the meeting  at approximately 10:06:27  AM.                                                          
                                                                                                                                
PRESENT                                                                                                                     
                                                                                                                                
Senate Finance Members:                                                                                                       
Senator Lyda Green, Co-Chair                                                                                                    
Senator Gary Wilken, Co-Chair                                                                                                   
Senator Con Bunde, Vice Chair                                                                                                   
Senator Fred Dyson                                                                                                              
Senator Bert Stedman                                                                                                            
Senator Lyman Hoffman                                                                                                           
                                                                                                                                
House Finance Members:                                                                                                        
Representative Kevin Meyers, Co-Chair                                                                                           
Representative Mike Chenault, Co-Chair                                                                                          
Representative Bill Stoltze, Vice-Chair                                                                                         
Representative Mike Hawker                                                                                                      
Representative Jim Holm                                                                                                         
Representative Eric Croft                                                                                                       
Representative Bruce Weyhrauch                                                                                                  
                                                                                                                                
Also Attending:  SENATOR TOM WAGNOR; REPRESENTATIVE  HARRY CRAWFORD;                                                          
REPRESENTATIVE  KURT OLSON; REPRESENTATIVE  JAY RAMRAS; MIKE  BURNS,                                                            
Chief  Executive   Officer,  Alaska   Permanent  Fund  Corporation,                                                             
Department  of  Revenue;   MICHAEL  O'LEARY,  CFA,  Executive   Vice                                                            
President, Callan Associates;  DR. JERRY MITCHELL, Member, Permanent                                                            
Fund's  investment advisory  council  and former,  Chief  Investment                                                            
Officer, The Massachusetts Pension Fund;                                                                                        
                                                                                                                                
Attending   via  Teleconference:   There   were  no  teleconference                                                           
participants.                                                                                                                   
                                                                                                                                
SUMMARY INFORMATION                                                                                                         
                                                                                                                                
Presentation by the Alaska Permanent Fund Board and Advisors                                                                    
                                                                                                                                
10:07:55 AM                                                                                                                   
                                                                                                                                
MIKE  BURNS,   Chief  Executive  Officer,   Alaska  Permanent   Fund                                                            
Corporation,  Department of Revenue,  introduced the members  of the                                                            
Alaska Permanent  Fund Board of Trustees and consultants  present at                                                            
this  meeting and  gave  detailed backgrounds  of  the consultants'                                                             
accomplishments.                                                                                                                
                                                                                                                                
10:10:22 AM                                                                                                                   
                                                                                                                                
MICHAEL O'LEARY,  CFA, Executive Vice President, Callan  Associates,                                                            
gave  a presentation  titled, "Alaska  Permanent  Fund Corporation,                                                             
2005 Capital Market  Outlook" [copy on file] and reviewed  events in                                                            
the financial market of the past few years.                                                                                     
                                                                                                                                
     Page 2                                                                                                                     
     After a Slow Start, Capital Markets Enjoy Second Straight Year                                                             
     in the Black                                                                                                               
     [Chart showing rates of returns for the years 1999 through                                                                 
     2004 and the five-year average annual rate of return for the                                                               
     years 2000 through 2004 for the following several funds.]                                                                  
                                                                                                                                
Mr. O'Leary outlined the types of stocks included in the funds.                                                                 
                                                                                                                                
Mr.  O'Leary called  attention  to  the five-year  annual  rates  of                                                            
return pointing  out that  this no longer  includes the bull  market                                                            
that concluded  in  1999. The five-year  average  includes the  bear                                                            
market years  of 2001 and  2002, although  fortunately good  returns                                                            
were realized  in 2003 and 2004. He stressed the strong  performance                                                            
of bonds and  small cap stocks. The  inflation rate over  this five-                                                            
year period was approximately 7.7 percent.                                                                                      
                                                                                                                                
10:13:24 AM                                                                                                                   
                                                                                                                                
     Page 3                                                                                                                     
     The Current Economic Environment                                                                                           
     Steady Growth But Unsteady Sentiment                                                                                       
        · U.S. economy all of a sudden looked hot in 2004, but the                                                              
          expansion has been underway for several years, and growth                                                             
          has actually continued at an orderly, if unspectacular                                                                
          pace.                                                                                                                 
        · Jobs data finally turned around, and unemployment finally                                                             
          fell below 6%.                                                                                                        
        · Business spending was weak until recently, as many                                                                    
          industries are still plagued with overcapacity.                                                                       
        · Inflation remains a low level threat, despite what we                                                                 
          read in the headlines. Absent oil price pressures, core                                                               
          rate is around 2%.                                                                                                    
        · Interest rates are still extraordinarily low:                                                                         
             o Treasury bonds yields are not that far from their                                                                
                40-year lows.                                                                                                   
             o Fed policy still seems to work, at least on                                                                      
                consumers…                                                                                                      
        · Consumers have been tireless, and the federal government                                                              
          has been spending to boost the economy and for the war in                                                             
          Iraq. However…                                                                                                        
                                                                                                                                
Mr. O'Leary stressed that  the advisors at Callan and Associates are                                                            
not economists  and  this information  reflects  the organization's                                                             
perspective of the economy  and the future economy. This information                                                            
is  utilized   to   demonstrate   how  the   organization   develops                                                            
perspectives and  determines the range of risks and  how those risks                                                            
change.                                                                                                                         
                                                                                                                                
Mr. O'Leary relayed  that the advisors at Callan and  Associates are                                                            
in consensus that the economy  had recovered by 2004, and would have                                                            
solid growth  in 2005. There  is no reason  this would not  continue                                                            
into 2006.                                                                                                                      
                                                                                                                                
Mr. O'Leary  informed  that recovery  to date  has been  led by  the                                                            
consumer and that a large  "driver" has been the decline in interest                                                            
rates, which has supported  the housing sector and allowed consumers                                                            
to refinance and augment  income to maintain spending. This has been                                                            
beneficial in sustaining  the economy through the recession and into                                                            
recovery.                                                                                                                       
                                                                                                                                
     Page 4                                                                                                                     
     Leadership Passes from Consumers to Businesses                                                                             
        · With interest rates rising and tax cuts finished, the                                                                 
          consumer spending boom is over. Moderate gains in                                                                     
          employment and income will drive consumer spending.                                                                   
        · Housing markets have peaked by remain strong.                                                                         
        · Business equipment investment is surging in response to                                                               
          strong profits, growing markets, and technological                                                                    
          advances.                                                                                                             
        · Nonresidential construction is beginning to slow                                                                      
          recovery, restrained by excess capacity.                                                                              
        · Budget pressures on state and local government are easing                                                             
          as tax revenues rise, but federal stimulus is ending.                                                                 
        · Exports are rebounding in response to the dollar's                                                                    
          depreciation and renewed growth in foreign markets.                                                                   
        · Outlook for 2005 is "good by not great".                                                                              
                                                                                                                                
Mr.  O'Leary  commented  that the  "baton"  must  now be  passed  to                                                            
business investment to continue to grow the economy.                                                                            
                                                                                                                                
10:15:56 AM                                                                                                                   
                                                                                                                                
     Page 5                                                                                                                     
     The U.S. Expansion is Strengthening                                                                                        
     2004 Saw Best Growth Since the Late 1990s                                                                                  
     [Bar graph showing Real GDP, annual percent change for the                                                                 
     years 1990 through 2004.                                                                                                   
                                                                                                                                
Mr. O'Leary stated that  economic expansion was over four percent in                                                            
"real terms",  which "by  any standard  is a good  year". Growth  is                                                            
expected  to continue at  a slower rate this  year, but still  above                                                            
the economy's long-term trend.                                                                                                  
                                                                                                                                
10:16:32 AM                                                                                                                   
                                                                                                                                
     Page 6                                                                                                                     
     U.S. Economic Growth by Sector                                                                                             
     [Spreadsheet listing annual percent changes, and "direction of                                                             
     change" of several sectors for the years 2002, 2003 and 2004.]                                                             
                                                                                                                                
Mr.   O'Leary  detailed   that   consumption  would   be   moderate,                                                            
residential investment  would remain positive and grow, although the                                                            
rate of growth would slow.  Business fixed investment had "only last                                                            
year really picked up" and would continue to grow.                                                                              
                                                                                                                                
Mr. O'Leary continued that  the federal government activity would be                                                            
"less of a stimulative  factor" than in the past due to the need for                                                            
"decremental  fiscal stimulus". State  and local governments  "don't                                                            
feel flush",  however,  revenue is  "improving" and  is expected  to                                                            
continue to  improve. Some assistance  is expected from an  increase                                                            
in the rate of spending by state and local governments.                                                                         
                                                                                                                                
Mr.  O'Leary next  stated  that  the export  sector  activities  are                                                            
"attractive"  in that the percent  increase in exports the  previous                                                            
year  was "meaningful".  Hopefully,  continued  export growth  would                                                            
occur, particularly  with  the dollar "weakness"  making the  dollar                                                            
more  "competitive."  This  would  assist in  diminishing,  but  not                                                            
closing,  the  trade  deficit.  Simultaneously,   import  growth  is                                                            
expected  to decelerate.  Much  of  the spike  in import  growth  is                                                            
attributable to higher energy prices.                                                                                           
                                                                                                                                
10:19:25 AM                                                                                                                   
                                                                                                                                
     Page 7                                                                                                                     
     Employment Slowly Recovers                                                                                                 
     December 2004 employment remains 240,000 below its March 2001                                                              
     peak.                                                                                                                      
     [Bar graph showing annual percent change in payroll employment                                                             
     for the years 1998 through 2004.]                                                                                          
                                                                                                                                
Mr. O'Leary  explained this graph  supports the projections  made on                                                            
the previous page. Employment  growth has been "disappointing coming                                                            
out of  the recession"  but  has begun to  "get on  track" in  2004.                                                            
Expectation is for continued growth.                                                                                            
                                                                                                                                
10:19:56 AM                                                                                                                   
                                                                                                                                
     Page 8                                                                                                                     
     Industrial Production is Rebounding                                                                                        
     Capital Spending Follows GDP                                                                                               
     [Graph showing quarter percent changes of Real GDP, Equipment                                                              
     spending, and High Tech, for the years 1990 through 2004.]                                                                 
                                                                                                                                
Mr.  O'Leary stated  this  graph  demonstrates  a sharp  decline  in                                                            
spending  for  high  tech  and  equipment.  This  was  core  of  the                                                            
recession.  An increase  occurred  in 2004  for these  areas and  is                                                            
expected to continue.                                                                                                           
                                                                                                                                
10:20:34 AM                                                                                                                   
                                                                                                                                
     Page 9                                                                                                                     
     A Third Good Year for Corporate Profits                                                                                    
     [Bar graph showing percent changes for Profits with IVA & CCA                                                              
     for the years 1990 through 2004.]                                                                                          
                                                                                                                                
Mr. O'Leary expressed that  profit growth has been "tremendous", and                                                            
that  remarkable   changes  in  the   economy  are  the   result  of                                                            
improvement  in corporate  financial conditions.  Corporations  have                                                            
"plenty of  cash" or "liquidity" and  subsequently have the  ability                                                            
to  fund capital  expenditures,  increase  dividends,  and buy  back                                                            
stock if advantageous.                                                                                                          
                                                                                                                                
10:21:30 AM                                                                                                                   
                                                                                                                                
     Page 10                                                                                                                    
     Productivity Growth Has Boosted Corporate Profits, But Not                                                                 
     Wages                                                                                                                      
     [Graph showing percent of GDP of Wages and Salaries, and                                                                   
     Economic Profits for the years 1999 through 2004.]                                                                         
                                                                                                                                
Mr. O'Leary noted  this graph shows the growing discrepancy  between                                                            
profits  and  wages  and salaries.  Wages  and  salaries  "have  not                                                            
participated"  in  the recovery.  As  unemployment  rates have  been                                                            
reduced  and are expected  to decline  further,  wages and  salaries                                                            
should  "begin to  pick up". Also,  corporate  profit margins  would                                                            
continue to improve. This is a normal cyclical pattern.                                                                         
                                                                                                                                
     Page 11                                                                                                                    
     The Consumer Is Stretched                                                                                                  
        · Household net worth has recovered from its 200-02 drop,                                                               
          thanks to rising home prices and the last two years'                                                                  
          stock market rally. However, a low saving rate is                                                                     
          limiting asset accumulation.                                                                                          
        · Federal tax cuts have boosted disposable income growth                                                                
          for three years. Now tax burdens are likely to rise.                                                                  
        · Debt service burdens and the household financial                                                                      
          obligations ratio peaked in late 2001. But rising                                                                     
          interest rates will forestall further improvement.                                                                    
        · Net result will be a slowdown, but not a retreat.                                                                     
        · Rising employment and income will drive the next phase of                                                             
          the expansion in consumer spending.                                                                                   
        · Credit card delinquencies will decrease slightly as the                                                               
          job market improves.                                                                                                  
                                                                                                                                
Mr. O'Leary reiterated  that it is expected that consumer activities                                                            
would be less  of a factor in "taking the economy  forward". This is                                                            
because the consumer  is "pretty leveraged," primarily  through home                                                            
ownership.  Given the sharp increases  in the price of homes  across                                                            
the country there is concern regarding a "housing bubble."                                                                      
                                                                                                                                
10:23:25 AM                                                                                                                   
                                                                                                                                
     Page 12                                                                                                                    
     Home Prices Have Risen Sharply…Although Low Interest Rates                                                                 
     Mean That Homes Are Still "Affordable"                                                                                     
     A higher index means homes are more affordable.                                                                            
     [Graph showing the Affordability Index for Existing Single-                                                                
     Family Homes for the years 1972 through 2004.]                                                                             
                                                                                                                                
Mr.  O'Leary  noted  that  although  home  prices  have "absolutely                                                             
increased  at  a  very  significant   rate,"  the  impact  has  been                                                            
moderated  by the  decline  in interest  rates,  so  that homes  are                                                            
"essentially  as affordable today  as they were four years  ago-five                                                            
years  ago."  He acknowledged  that  individual  markets  have  home                                                            
values "out  of sync" and  could experience  a decline, but  this is                                                            
not a generalized condition.                                                                                                    
                                                                                                                                
     Page 13                                                                                                                    
     Inflation's (Temporary) Resurgence                                                                                         
        · Soaring energy costs, dollar depreciation, a synchronized                                                             
          (if modest) global expansion, and lean inventories have                                                               
          revived inflation.                                                                                                    
        · Global  commodity  prices also reached  peaks at  times in                                                            
          2004.                                                                                                                 
        · Consumer  prices surged at a 4.1% annual rate in the first                                                            
          seven months of 2004, while core inflation reached 2.4%.                                                              
          For the full year, inflation was closer to 3%.                                                                        
        · Despite  the headlines, this recent burst  of inflation is                                                            
          temporary.                                                                                                            
        · Slack  labor  markets and  rising productivity  will  keep                                                            
          unit labor cost increases in the 2% range.                                                                            
        · Oil  prices in the $40s (or the $50s)  don't mean the same                                                            
          now as in the early 1980s.                                                                                            
        · Supply   responses  will  eventually  bring   down  energy                                                            
          prices.                                                                                                               
        · Bottom  line: core inflation  will settle in the  2.0-2.5%                                                            
          range after 2004.                                                                                                     
                                                                                                                                
Mr. O'Leary stated the inflation outlook is important.                                                                          
                                                                                                                                
10:24:16 AM                                                                                                                   
                                                                                                                                
     Page 14                                                                                                                    
     Inflation Has Ticked Up…                                                                                                   
     Year-Over-Year Change in Consumer Prices                                                                                   
     [Graph showing the percent change of CPI All Urban Cons, and                                                               
     CPI-Core for the years 2001 through 2004.]                                                                                 
                                                                                                                                
Mr. O'Leary  informed that inflation  accelerated significantly  and                                                            
has increased  substantially from the prior year.  This is primarily                                                            
the result  of commodity spikes, especially  energy. Core  inflation                                                            
increased at a rate of 2.2 percent.                                                                                             
                                                                                                                                
10:24:58 AM                                                                                                                   
                                                                                                                                
     Page 15                                                                                                                    
     …But Headline Fears Are Overblown                                                                                          
     Year-Over-Year Change in Consumer Prices                                                                                   
     [Graph showing aforementioned detail for the years 1980                                                                    
     through 2004.]                                                                                                             
                                                                                                                                
Mr. O'Leary  demonstrated that in  a historic context, inflation  is                                                            
currently at a  low level.  The expectation for the  next five years                                                            
predicts the CPI  would increase at an approximate  2.6 percent rate                                                            
annually. That is unchanged  from the consultant's estimates for the                                                            
past three to four years.                                                                                                       
                                                                                                                                
10:25:35 AM                                                                                                                   
                                                                                                                                
     Page 16                                                                                                                    
     The Fed is Moving Toward Neutral                                                                                           
     Interest Rate Increases Should Stay Gradual                                                                                
     [Graph showing the percents for Federal Funds Rate and 10-Year                                                             
     Treasury Bond Yield for the years 1994 through 2004.]                                                                      
                                                                                                                                
Mr. O'Leary  stated  this graph  demonstrates how  the federal  fund                                                            
rate has changed.  Short term interest  rates have been "incredibly                                                             
low" The "fed  and others were very concerned about  the possibility                                                            
of deflation a couple years  ago and pumped in massive liquidity and                                                            
took us to a position  where short term interest rates  in that one-                                                            
percent  range  were actually  negative  real  interest  rates."  He                                                            
explained that  if it were possible  to buy the CPI, money  could be                                                            
borrowed at an interest  rate of one-percent and the purchaser would                                                            
receive  a two  percent return.  He ascertained  that  the "fed"  is                                                            
"mindful  of the long term  concern about  inflation, but over  time                                                            
short term  interest rates  have tended  to be  pretty close  to the                                                            
rate of inflation, maybe plus a little."                                                                                        
                                                                                                                                
10:27:22 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary  remarked that  ten year treasury  yields have  actually                                                            
"not moved  at all." The  expectation is  that interest rates  would                                                            
rise as expansion  continues, but would not reach  the eight to nine                                                            
percent annual rate of a decade prior.                                                                                          
                                                                                                                                
10:28:03 AM                                                                                                                   
                                                                                                                                
     Page 20                                                                                                                    
     2005 Capital Market Preview:                                                                                               
     Keeping Those Expectations Low                                                                                             
        · The economic recovery will continue, but growth will                                                                  
          remain modest. Capital spending will ultimately follow                                                                
          GDP.                                                                                                                  
        · Fed has already shifted to tightening monetary policy.                                                                
        · The stock market recovery will be slow. Profits cannot                                                                
          outpace GDP, share prices cannot outpace earnings.                                                                    
        · Callan's outlook in a nutshell: expect a low inflation,                                                               
          low interest rate, low return environment.                                                                            
        · Low return expectations mean 8% nominal return                                                                        
          assumptions  may  be difficult to  achieve. Callan's  2005                                                            
          assumptions  won't likely generate an  expected return for                                                            
          a  60% stock/40% bond allocation  greater than  7.4 % over                                                            
          the  next five  years. To the  extent possible,  investors                                                            
          may   need   to  shift   their   focus  to   real   return                                                            
          expectations.                                                                                                         
                                                                                                                                
Mr. O'Leary  reminded that after the  presentation to the  Committee                                                            
the prior year,  the Members knew  the projections would  not change                                                            
this  year.  The consultant   has not  changed  projections  in  any                                                            
significant  for several  years. He  added that  low equity is  also                                                            
expected over the long term.                                                                                                    
                                                                                                                                
10:30:57 AM                                                                                                                   
                                                                                                                                
     Page 21                                                                                                                    
     Domestic Equity vs. Bond Yields                                                                                            
     [Graph showing percentages of S&P 500 Earnings Yield vs. 10-                                                               
     Year Treasury Yield for the years 1981 through 2004 and graph                                                              
     showing Ratio of S&P 500 Earnings Yield and 10-Year Treasury                                                               
     Yield for the same time period.]                                                                                           
                                                                                                                                
Mr. O'Leary referenced  the "fed model for valuation". This graph is                                                            
an attempt to  demonstrate the same information. The  earnings yield                                                            
is the  "reciprocal of  the PE ratio".  Since  the year 1981,  those                                                            
instances when  the earnings yield  of the S&P 500 was close  to the                                                            
ten-year treasury  suggested that  the stocks reasonably  valued. In                                                            
the last five  years, the combination of declining  stock prices and                                                            
declining interest  rates resulted  in the earnings yield  above the                                                            
income  yield  of  the  ten-year  treasury.   He  cautioned  of  the                                                            
situation of  the 1950s in which dividend  yield on stocks  exceeded                                                            
the  income yield  on treasury  obligations.  The  valuation of  the                                                            
stock  market  despite  the  two-year  recovery,  is  not  excessive                                                            
provided the anticipated "decent earnings growth going forward."                                                                
                                                                                                                                
     Page 22                                                                                                                    
     Bond Market Faces a Challenging Environment                                                                                
        · With inflation in check, investors poured money into                                                                  
          bonds  following the bursting of the stock  market bubble,                                                            
           driving prices up and yields to 40-year lows.                                                                        
        · Corporate (and particularly high yield) spreads widened                                                               
          through  2002, then staged  a remarkable comeback  in 2003                                                            
          and 2004.                                                                                                             
        · Long-term secular decline in inflation since early 80s                                                                
          fueled  bond market returns that may not be seen again for                                                            
          a long time.                                                                                                          
        · Looking forward, current yields and expectations for                                                                  
          inflation   and  interest  rates  drive  expected   future                                                            
          returns.  With low  current yields  and the potential  for                                                            
          rising  interest rates as  the economy expands,  prospects                                                            
          for  future bond  market gains  may have  faded. The  best                                                            
          case for bonds is a faltering economy.                                                                                
                                                                                                                                
10:33:12 AM                                                                                                                   
                                                                                                                                
     Page 23                                                                                                                    
     Domestic Fixed Income                                                                                                      
     Lehman Aggregate Index - Daily Yield to Worst from 1/1/01 to                                                               
     12/31/04                                                                                                                   
     [Graph showing Yield to Maturity percentages of every month                                                                
     from January 2001 through December 2004]                                                                                   
                                                                                                                                
Mr. O'Leary  outlined highlighted  dates of the end of each  year on                                                            
the  graph.  This  demonstrates   that  the  overall  rate  has  not                                                            
fundamentally  changed, despite significant volatility.  The current                                                            
yield on the bond market  is a "very good naive" predictor of future                                                            
returns.                                                                                                                        
                                                                                                                                
10:34:49 AM                                                                                                                   
                                                                                                                                
Representative   Croft  commented   that  the  graphs  indicate   an                                                            
optimistic  future   and  asked  if  this  is  because   stocks  are                                                            
undervalued.                                                                                                                    
                                                                                                                                
Mr. O'Leary  replied that  the relative  valuation difference  could                                                            
change by increased  interest rates, by increased  stock prices with                                                            
interest rates  the same, or earnings collapsing,  in which case the                                                            
earnings yield would decline.                                                                                                   
                                                                                                                                
Representative  Croft asked if this occurred in the  1960s or 1970s.                                                            
                                                                                                                                
Mr. O'Leary  replied  that the world  has changed  since the  1950s.                                                            
During that  time the dividend yield  on stocks was higher  than the                                                            
income  yield on treasuries.  Some  analysts say  the 1980s were  an                                                            
aberration.  A  relationship  has always  existed  between  interest                                                            
rates  and price-to-earnings  ratios.  If interest  rates are  high,                                                            
price earnings ratios would be low.                                                                                             
                                                                                                                                
Representative  Croft surmised  that the  portfolio balance  between                                                            
fixed income and stock should have more investment in stock.                                                                    
                                                                                                                                
Mr. O'Leary agreed that  according to the information presented this                                                            
would be a reasonable conclusion.                                                                                               
                                                                                                                                
10:37:39 AM                                                                                                                   
                                                                                                                                
Senator Bunde noted that  a nominal return rate of eight percent has                                                            
been conventional  wisdom.  He asked if the  information on  Page 20                                                            
indicates that expectation has changed.                                                                                         
                                                                                                                                
Mr. O'Leary  responded that the Permanent  Fund expected  return the                                                            
prior  year was 7.6  percent. The  eight-percent  figure is  derived                                                            
from an  assumption of five  percent real  return and three  percent                                                            
inflation.  The real return  expectation has  not changed,  although                                                            
the inflation rate has changed.                                                                                                 
                                                                                                                                
10:38:42 AM                                                                                                                   
                                                                                                                                
     Page 25                                                                                                                    
     2005 Capital Market Projections                                                                                            
     [Spreadsheet listing Summary of 5-Year Capital Market                                                                      
     Projections (2005-2009) by asset class.]                                                                                   
                                                                                                                                
Mr. O'Leary stated this  graph indicates the projected annual return                                                            
for each  asset category,  and also provides  the projection  of the                                                            
previous  year.  He  reminded  that the  consultant  never  makes  a                                                            
specific point  projection, rather  projects a range of returns.  He                                                            
detailed line items on  the spreadsheet to demonstrate this. Stocks,                                                            
over the long  term, have tended to  return 5.5 to seven  percent in                                                            
real returns.  Last year stocks actually  returned approximately  11                                                            
percent, which reflects  the projections. Bonds and real estate have                                                            
remained relatively unchanged.  However, because bond returns are so                                                            
low, investors  are "looking to other things" to attempt  to improve                                                            
their  overall  fund  return  without  "ratcheting  up"  the  equity                                                            
exposure further, due to concern about volatility.                                                                              
                                                                                                                                
Mr. O'Leary informed  that equity exposure of 60 plus  percent range                                                            
for major  public funds,  such as pension  funds, is typical.  Fixed                                                            
income  exposure  is  comprised  at  approximately  25  percent  and                                                            
pension   funds  are  making   use  of   nontraditional   investment                                                            
approaches, including absolute  return strategies, farmland, timber,                                                            
and other resource exposure.                                                                                                    
                                                                                                                                
DR. JERRY  MITCHELL, Member,  Permanent  Fund's investment  advisory                                                            
council  and former,  Chief Investment  Officer,  The Massachusetts                                                             
Pension  Fund, referenced  a handout titled,  ""Asset allocation  of                                                            
the Massachusetts  Pension Reserves Investment Trust  Fund" [copy on                                                            
file.]  He compared  the Massachusetts  Pension Fund  to the  Alaska                                                            
Permanent  Fund. Both funds  have the same  challenges to  determine                                                            
what asset classes to make  investments to achieve the best possible                                                            
return at the  most acceptable level  of risk. The Alaska  Permanent                                                            
Fund  has   a  balance   of  approximately   $30  billion   and  the                                                            
Massachusetts  Pension Reserves Investment  Trust (PRIT)  Fund has a                                                            
balance of approximately $36 billion.                                                                                           
                                                                                                                                
Dr. Mitchell joined the  PRIT in the year 2001 with the mandate from                                                            
"a  very  supportive"   board  and   "active"  investment   advisory                                                            
committee was  to increase the number of asset classes  the fund was                                                            
invested in.  This mandate was given  because the board intended  to                                                            
reduce  the volatility  of  the fund  and  ensure that  those  asset                                                            
classes that could  provide a higher return than the  ordinary stock                                                            
market  or bond market,  had participation.  In  1990, the PRIT  had                                                            
five  asset classes,  which  did not  change significantly  until  a                                                            
sixth asset  class was added in the  year 2000. At the end  of 2004,                                                            
the PRIT was invested in ten asset classes.                                                                                     
                                                                                                                                
10:45:46 AM                                                                                                                   
                                                                                                                                
     What has the PRIT Fund done?                                                                                               
     1. Increased asset classes from 5 to 10.                                                                                   
     2. Increased sub-asset classes to 15.                                                                                      
     3. Increased less liquid investments.                                                                                      
     4. Increased non-correlation of asset classes.                                                                             
     5. Est. return 8.3 %, est. risk 11.5 %                                                                                     
                                                                                                                                
Dr. Mitchell  outlined the  first two items  on this list.  The sub-                                                            
asset  class  includes  large  capitalization   equities  and  small                                                            
capitalization   equities;  distressed   debt,  regular   and  below                                                            
investment grade US bonds  and emerging country bonds for high yield                                                            
bonds. The PRIT also emphasized  less liquid investments because the                                                            
theory  and practitioners   results suggested  that  willingness  to                                                            
accept  a less liquid  investment  should receive  a higher rate  of                                                            
return. An  institution or individual  who required access  to money                                                            
immediately  would not invest in this  manner; however, large  funds                                                            
similar to the  Alaska Permanent Fund and the Massachusetts  pension                                                            
fund could afford to make these less liquid investments.                                                                        
                                                                                                                                
Dr. Mitchell  stated  that when the  PRIT increased  asset and  sub-                                                            
asset  classes,  it also  increased  the  non-correlation  of  asset                                                            
classes. Different  aspects of the economy affected  the earnings of                                                            
different  investments.  The  intention  was  that  as one  type  of                                                            
investment was rising,  another would rise more slowly and avoid the                                                            
shocks  experienced if  all investments  were made  in US stocks  or                                                            
bonds.                                                                                                                          
                                                                                                                                
10:48:04 AM                                                                                                                   
                                                                                                                                
Dr. Mitchell spoke to the  estimated return and estimated risk. That                                                            
is utilizing  estimates similar to  those described by Mr.  O'Leary.                                                            
The  8.3  percent  return  was  established  due  to  the  actuarial                                                            
assumption of 8.25 percent.                                                                                                     
                                                                                                                                
Dr. Mitchell stated  that diversification is beneficial  because the                                                            
asset class that  would be the best performer is unknown.  Therefore                                                            
multiple   asset  classes   provide   greater   protection   against                                                            
volatility.                                                                                                                     
                                                                                                                                
Dr. Mitchell  exampled less  liquid investments  as timber,  venture                                                            
capital  and  leveraged  buyout  partnerships.  Less  liquid  assets                                                            
provide  a bonus  because they  could not  be sold  for a period  of                                                            
time.                                                                                                                           
                                                                                                                                
     Goals                                                                                                                      
     1. Meet 8 1/4 percent actuarial return target.                                                                             
     2. Reduce risk by increasing non-correlation.                                                                              
     3. Continue to diversify.                                                                                                  
     4. Benefit from less liquid, higher return asset classes.                                                                  
     5. Use indexing in public markets where appropriate.                                                                       
                                                                                                                                
Dr. Mitchell in certain  asset classes, such as large capitalization                                                            
of US  stocks,  it is difficult  for  active managers  to "beat  the                                                            
index" It could be done,  but those managers are difficult to locate                                                            
and  employ. For  these  asset  classes,  the PRIT  determined  that                                                            
instead of  focusing on securing such  a manager, it would  index 80                                                            
percent  of that allocation  with  two active  managers "running  20                                                            
percent."                                                                                                                       
                                                                                                                                
Dr.  Mitchell  compared   this  to  the  finding  that   with  small                                                            
capitalization  and  emerging market  international  stocks,  active                                                            
managers  could regularly  outperform  the index.  As a result,  the                                                            
PRIT is 100 percent  active in its emerging markets  investments and                                                            
80 percent active in small capitalization US stocks.                                                                            
                                                                                                                                
Dr. Mitchell characterized  the use of an index to that of a club to                                                            
provide incentive to managers  to work harder. Active managers would                                                            
be threatened  with the possibility that the funds  could be removed                                                            
from their oversight.                                                                                                           
                                                                                                                                
10:51:50 AM                                                                                                                   
                                                                                                                                
Senator  Stedman asked  if  the Massachusetts  pension  plan has  an                                                            
"asset liability mismatch".                                                                                                     
                                                                                                                                
Dr.  Mitchell  replied that  the  Massachusetts  plan  is a  defined                                                            
benefit plan that is approximately 70 percent funded.                                                                           
                                                                                                                                
Senator Stedman asked if the plan has a target of 100 percent.                                                                  
                                                                                                                                
Dr. Mitchell answered  it does, although it is uncertain  whether it                                                            
could be achieved.                                                                                                              
                                                                                                                                
Senator Stedman  asked if efforts are made to protect  the PRIT from                                                            
this mismatch  or if a total rate of return is anticipated  to solve                                                            
the total liability issue.                                                                                                      
                                                                                                                                
Dr. Mitchell  qualified that  the Massachusetts  fund is unusual  in                                                            
that  the  management  of  the  asset  is  overseen  by  a  separate                                                            
governmental  entity  that   the entity   that  oversees  payout  of                                                            
benefits. He was involved  with the entity to manage the funds, with                                                            
the directive to manage the funds in the best manner possible.                                                                  
                                                                                                                                
Senator  Stedman asked  which entity  establishes  the 8.25  percent                                                            
target.                                                                                                                         
                                                                                                                                
Dr. Mitchell  responded that the benefit  payout agency establishes                                                             
this with the assistance of an actuarial consultant.                                                                            
                                                                                                                                
Senator  Stedman  clarified  that  the  PRIT  does  not  submit  its                                                            
projections to the benefit payout agency for review.                                                                            
                                                                                                                                
Dr. Mitchell  answered, "no",  an independent  board controls  asset                                                            
allocation. The  actuary report is consulted and the  funding status                                                            
of the plan is considered.                                                                                                      
                                                                                                                                
Senator Stedman  asked if  the asset liability  mismatch has  always                                                            
existed.                                                                                                                        
                                                                                                                                
Dr. Mitchell  replied  it has and  informed that  when the PRIT  was                                                            
founded,  the  funding  level  was  approximately  20  percent.  The                                                            
Massachusetts  Legislature  separated  the  investment  and  benefit                                                            
payout  entities  to insulate  the investment  management  from  the                                                            
pressures of previous administrations.                                                                                          
                                                                                                                                
Senator Stedman  asked if a risk tolerance  change, or risk  premium                                                            
adjustment, has occurred since the 1999 market "crash".                                                                         
                                                                                                                                
Mr.  O'Leary  replied  that  investors  did not  obtain  the  equity                                                            
premium  anticipated.  Callan  expectations  of premium  return  for                                                            
equities have  remained at 5.5 to  seven percent real return,  which                                                            
has been the long-term record.                                                                                                  
                                                                                                                                
Senator Stedman  restated his question, asking if  in 1999 investors                                                            
were "more  on the top end  of the range  and today they're  more at                                                            
the low end of the range."                                                                                                      
                                                                                                                                
Mr.  O'Leary   answered,  "Undoubtedly   yes"  because  the   public                                                            
expectation  of future  returns for  the equity  market was  "double                                                            
digit"  of 15 to  17 percent. Four  percent inflation  added  to 6.5                                                            
percent  real  return  provides  10.5  percent  return.  Callan  has                                                            
consistently  anticipated the "lower  end". At this time  last year,                                                            
"we were a  roaring bull compared  to what others were saying,  when                                                            
in fact,  the  assumption was  essentially  were it  had been."  The                                                            
style of Callan  forecasts have been  to change little from  year to                                                            
year; others may change  their forecasts more, possibly by reviewing                                                            
a different timeframe.                                                                                                          
                                                                                                                                
Mr. O'Leary furthered  on the question Senator Stedman  posed to Dr.                                                            
Mitchell  regarding public  entities. The  experience of Callan  has                                                            
been  that the  discount  rate used  on the  pension  "side" in  the                                                            
public sector has been  eight percent on average and has not changed                                                            
significantly.  The funded  status of public  pension funds  changed                                                            
from  essentially  fully funded  status  to  becoming significantly                                                             
underfunded  for  three  primary   reasons.  The  first  being  some                                                            
combination of  benefit enhancements and or contribution  reductions                                                            
because the  funds had been well funded.  The second reason  was the                                                            
unrealized  decline  that the  expected  earnings return  for  three                                                            
years during the  bear market provided negative returns  rather than                                                            
positive returns  of eight or more  percent. Over three years,  this                                                            
results in a 24 percent  difference in earnings. The third factor is                                                            
the decline in interest  rates. When the value of future benefits is                                                            
discounted  utilizing a  lower interest  rate,  the liabilities  are                                                            
larger. Higher interest  rates would improve the funding status. The                                                            
only method  to achieve  higher liability  matching is high  quality                                                            
fixed  investments;  however,  these  provide  significantly   lower                                                            
returns and result in higher costs.                                                                                             
                                                                                                                                
Senator Stedman  commented that it  is difficult therefore  to match                                                            
unfunded liabilities.  He surmised  the current historic  low yields                                                            
would further  hamper this  effort. He posed  a question of  whether                                                            
the   overall  policy   for   risk   control  should   be   reviewed                                                            
periodically.                                                                                                                   
                                                                                                                                
Mr. O'Leary  affirmed the  policy should  be reviewed. The  findings                                                            
would  vary  for different  systems  dependant  upon  the  inflation                                                            
sensitivity  of  each  system.  A  system  containing   health  care                                                            
benefits  as a  significant  portion of  liabilities  would be  more                                                            
sensitive to inflation.                                                                                                         
                                                                                                                                
Senator  Stedman then  spoke  to the  present historical  years  and                                                            
lower expectations  for equities of  approximately 7.4 percent  over                                                            
the  next five  years.  He  noted that  the  Permanent  Fund has  no                                                            
unfunded  liability, but rather  a requirement  to pay dividends  in                                                            
the event of realized gains.                                                                                                    
                                                                                                                                
Mr. O'Leary  stated the Permanent  Fund has a real return  target of                                                            
five percent.  He explained that a actuarial advisement  of an eight                                                            
percent return for a pension  fund includes an inflation expectation                                                            
of 3.5  to four percent  over 40 years.  Therefore a typical  public                                                            
pension fund has  a goal of a greater than 4.5 percent  real rate of                                                            
return.  The Permanent Fund  consistency of  year-to-year return  is                                                            
important given  the constitutional  provisions stipulating  that in                                                            
the  event  of  significant  volatility,   the  ability  to  provide                                                            
distribution is eliminated.                                                                                                     
                                                                                                                                
Senator Stedman  asked if the real return expectations  have changed                                                            
significantly since 1999.                                                                                                       
                                                                                                                                
Mr.  O'Leary answered  they  have  not. He  noted that  the  current                                                            
policy governing  the Permanent Fund  target allocation produces  an                                                            
expected  real return  of five percent.  This amount  has varied  by                                                            
tenths of percents from one year to another.                                                                                    
                                                                                                                                
Senator  Stedman   expressed  concern  with  the  unfunded   pension                                                            
liability of the  Public Employees Retirement System  (PERS) and the                                                            
Teachers  Retirement  System  (TRS)  and  the target  rate  of  8.25                                                            
percent established  in 1998 or 1999. Since that time,  changes have                                                            
occurred  in the  economy and  the market  rate. If  that rate  were                                                            
reduced  the liability would  increase. He  questioned whether  this                                                            
rate should be reviewed.                                                                                                        
                                                                                                                                
Mr. O'Leary remarked  that the discount rate would  be utilized as a                                                            
portion  of the actuarial  set  of assumptions  through discussions                                                             
with  the actuary  and  the PERS  and TRS  boards  of directors.  He                                                            
stressed the importance that the set of assumptions be balanced.                                                                
                                                                                                                                
Senator  Stedman learned  from discussions  with Mercer Consulting,                                                             
the actuary for  the PERS and TRS plans, that the  8.25 percent rate                                                            
was not achieved  from review of historical market  projections, but                                                            
rather  from asset  allocation information  provided  by the  Alaska                                                            
State Pension  Investment Board (ASPIB).  Mercer Consulting  did not                                                            
independently set the discount rate.                                                                                            
                                                                                                                                
Mr. O'Leary noted  that ASPIB determines an expected  rate of return                                                            
target  when setting  investment policy  with a  shorter time  rise.                                                            
That  shorter  time  rise  target  is  significantly  based  on  the                                                            
information  provided  by Callan  and  Associates.  The ASPIB  asset                                                            
allocation  is somewhat more aggressive  than that of the  Permanent                                                            
Fund in terms of equity commitment.                                                                                             
                                                                                                                                
11:07:36 AM                                                                                                                   
                                                                                                                                
Co-Chair Wilken  commented this is  the seventh presentation  he has                                                            
attended from Callan and Associates.                                                                                            
                                                                                                                                
     Page 18                                                                                                                    
     Surplus Reverts to a Massive Federal Budget Deficit                                                                        
     [Bar graph showing Federal and State & Local surplus and                                                                   
     deficits for the years 1990 through 2010.]                                                                                 
                                                                                                                                
     Page 19                                                                                                                    
     The U.S. Current Account Deficit: Over $600 Billion as Far as                                                              
     the Eye Can See                                                                                                            
     [Bar graph showing Current Account Deficit and line graph                                                                  
     showing Deficit as % of GDP for the years 1980 through 2008.]                                                              
                                                                                                                                
Co-Chair Wilken  asked about the notations reading  "*2005+ forecast                                                            
- Global  Insight"  on these  graphs,  specifically  the meaning  of                                                            
global insight.                                                                                                                 
                                                                                                                                
Mr. O'Leary  replied that Global Insight  is a business entity  that                                                            
provided  the projections  used to demonstrate  future years  on the                                                            
graphs.                                                                                                                         
                                                                                                                                
Co-Chair Wilken  announced a proposal  for a long-term fiscal  plan.                                                            
He asked  the Permanent Fund  trustees and  legislators to  review a                                                            
handout titled,  "Senate Bill 88, A Bridge to Development,  A Policy                                                            
on General  Fund  Revenue  Shortfall, February  15,  2005" [copy  on                                                            
file]. He requested critique  of this proposal and offered to give a                                                            
presentation to the trustees.  He expressed, "This is the start of a                                                            
long road" and  added, "This group here is the group  that would set                                                            
the course  for a long  term fiscal plan,  whatever that happens  to                                                            
be."                                                                                                                            
                                                                                                                                
Representative  Stoltze appreciated  the presentation. He  asked the                                                            
expectation  from  the trustees  of  the  legislature  now that  the                                                            
committees had received this knowledge.                                                                                         
                                                                                                                                
Mr. Burns responded  that the Corporation would give  a presentation                                                            
specifically  related to  the statutory investment  list is  "doing"                                                            
either  to  help or  impede  the Funds  progress  in  providing  the                                                            
expected returns.  The Corporation  intended to propose legislation                                                             
to amend the  statutory investment  list. The same returns  could be                                                            
achieved at less risk,  or higher returns could be realized with the                                                            
same level  of risk if  the Corporation were  not encumbered  by the                                                            
current statutory investment list.                                                                                              
                                                                                                                                
11:12:17 AM                                                                                                                   
                                                                                                                                
Co-Chair  Wilken  remarked that  the  Senate Finance  Committee  has                                                            
never denied  a request of  trustees for  legislation to amend  Fund                                                            
management  procedures. He attributed  this to the expertise  of the                                                            
trustees. He  asked if removal of  allocation restrictions  could be                                                            
implemented over a period of time of possibly five years.                                                                       
                                                                                                                                
11:12:53 AM                                                                                                                   
                                                                                                                                
Representative  Hawker clarified that  Mr. Burns testified  that the                                                            
same level of return could be achieved with less risk.                                                                          
                                                                                                                                
Mr. Burns replied that statistics indicate this is possible.                                                                    
                                                                                                                                
11:13:33 AM                                                                                                                   
                                                                                                                                
Senator Stedman  used an assumption that the allocation  the defined                                                            
benefit plan is operating  has greater stock exposure and subsequent                                                            
wider dispersion than the  Permanent Fund. However, he held a "lower                                                            
risk  tolerance" for  the benefit  plan fund  than he  held for  the                                                            
Permanent  Fund. The  Permanent Fund  would grow  in perpetuity  and                                                            
provide  dividends  in amounts  possible,  but the  pension plan  is                                                            
required to provide payments.                                                                                                   
                                                                                                                                
Mr. O'Leary  opined  that in "a  comparative sense"  the ASPIB  risk                                                            
tolerance  has  been  more  conservative  than  the  typical  public                                                            
pension  fund.  However, the  Permanent  Fund  has been  "much  more                                                            
conservative".  He noted that  30 percent of  assets of other  major                                                            
endowments  of over  $1 billion  are  allocated to  investments  the                                                            
Permanent  Fund  is  prohibited  from  participating  in,  with  the                                                            
exception of the  basket provision. The Permanent  Fund may actually                                                            
be "sub-optimizing"  return  that could  be produced  over the  long                                                            
term.  If the  current rate  of return  is desired,  the  volatility                                                            
could  be reduced  if the statutory  investment  list were  changed.                                                            
Also, it  could be determined  that the current  level of risk  were                                                            
acceptable,  the portfolio  altered  and the  Fund  could achieve  a                                                            
higher expected  rate of  return. The ability  to maintain  a higher                                                            
return policy  in the event of a year  or two in which the  earnings                                                            
reserve  fund was  insufficient to  provide any  distribution.  This                                                            
nearly occurred a couple years prior.                                                                                           
                                                                                                                                
ADJOURNMENT                                                                                                                 
                                                                                                                                
Co-Chair Green adjourned the meeting at 11:17 AM                                                                                

Document Name Date/Time Subjects