Legislature(2005 - 2006)SENATE FINANCE 532

02/23/2006 09:00 AM Senate FINANCE


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09:14:14 AM Start
10:37:59 AM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ Joint w/(H) Finance TELECONFERENCED
Presentation by Callan Associates -
Re: PFD Five-Year Forecast
                              MINUTES                                                                                         
                     SENATE FINANCE COMMITTEE                                                                                 
                      HOUSE FINANCE COMMITTEE                                                                                 
                         February 23, 2006                                                                                    
                             9:14 a.m.                                                                                        
                                                                                                                                
                                                                                                                              
CALL TO ORDER                                                                                                               
                                                                                                                                
Co-Chair Gary  Wilken convened the meeting at approximately  9:14:14                                                          
AM.                                                                                                                           
                                                                                                                                
PRESENT                                                                                                                     
                                                                                                                                
Senator Gary Wilken, Co-Chair                                                                                                   
Senator Con Bunde, Vice Chair                                                                                                   
Senator Bert Stedman                                                                                                            
Senator Lyman Hoffman                                                                                                           
Senator Donny Olson                                                                                                             
                                                                                                                                
Representative Kevin Meyer, Co-Chair                                                                                            
Representative Mike Chenault, Co-Chair                                                                                          
Representative Bill Stoltz, Vice-Chair                                                                                          
Representative Mike Kelly                                                                                                       
Representative Jim Holm                                                                                                         
                                                                                                                                
Also   Attending:  CARL   BRADY,   Chair,  Alaska   Permanent   Fund                                                          
Corporation,  Board  of  Trustees;  MIKE  BURNES,   Chief  Executive                                                            
Officer, Alaska  Permanent Fund Corporation, Department  of Revenue;                                                            
MICHAEL O'LEARY,  CFA, Executive Vice President, Callan  Associates,                                                            
Inc.; BOB  BARTHOLOMEW,  Chief Operating  Officer, Alaska  Permanent                                                            
Fund Corporation, Department of Revenue                                                                                         
                                                                                                                                
Attending  via  Teleconference:     There  were  no  teleconference                                                           
participants.                                                                                                                   
                                                                                                                                
SUMMARY INFORMATION                                                                                                         
^                                                                                                                               
                           Presentation:                                                                                        
             Alaska Permanent Fund Fiscal 2005 Summary                                                                          
                                By                                                                                              
                 Alaska Permanent Fund Corporation                                                                              
                      Callan Associates, Inc.                                                                                   
                                                                                                                                
9:15:59 AM                                                                                                                    
                                                                                                                                
CARL  BRADY, Chair,  Alaska  Permanent  Fund Corporation,  Board  of                                                            
Trustees, introduced  the members  of the Board. Mr. Brady  referred                                                            
to the 2005 passage of HB 215.                                                                                                  
                                                                                                                                
9:18:16 AM                                                                                                                    
                                                                                                                                
MIKE  BURNES,  Chief   Executive  Officer,  Alaska  Permanent   Fund                                                            
Corporation,  Department  of  Revenue,  presented  members  and  the                                                            
public with  a handout  titled: "Alaska Permanent  Fund Fiscal  2005                                                            
Summary" [copy on file].                                                                                                        
                                                                                                                                
9:18:47 AM                                                                                                                    
                                                                                                                                
Mr. Burns noted  that, in FY 05, the  total [Permanent] Fund  return                                                            
was 10.4 percent;  the real rate of  return after inflation  was 7.7                                                            
percent;  and the  balance in  the Fund,  as of June  30, 2005,  was                                                            
$29.96  billion, which  is an  increase over  FY 04  of almost  $2.6                                                            
billion.                                                                                                                        
                                                                                                                                
9:19:06 AM                                                                                                                    
                                                                                                                                
Mr. Burns observed  that the total  return for the first  six months                                                            
of FY  06 was  6.7  percent, which  equates  to 13.4  percent on  an                                                            
annualized  basis. The value of the  Fund on December 31,  2006, was                                                            
$32.2 billion,  which is a gain of $2.3 billion. The  Fund increased                                                            
an additional  $1.3 billion between  December 31, 2006 and  February                                                            
23,  2006.  The  realized   income,  which  is  used   for  dividend                                                            
calculations,  for the first six months was $1.3 billion;  the total                                                            
realized income for FY 05 was $1.75 billion.                                                                                    
                                                                                                                                
9:21:05 AM                                                                                                                    
                                                                                                                                
Mr.  Burns  referred to  the  new  authority  [given to  the  Alaska                                                            
Permanent  Fund   Corporation  (Corporation)]   under  HB  215.  The                                                            
Corporation  has  adopted  new  regulations   for  investments  with                                                            
consultation  of out-side  managers  (Callan Associates)  and  legal                                                            
counsel. The "prudent investor"  rule was defined and an attempt was                                                            
made to cover all possible  investment opportunities. The investment                                                            
regulations  are detailed and  complex, and  were driven by  the new                                                            
combinations of asset classes.                                                                                                  
                                                                                                                                
9:22:31 AM                                                                                                                    
                                                                                                                                
Mr.  Burns  explained that  a  new  confidentiality  regulation  was                                                            
adopted  and assured  members that  nothing in  the new regulations                                                             
"changes anything". Statutes  have been in place since the inception                                                            
of  the  Corporation   in  1980,  which  requires  confidentiality.                                                             
Regulation  only  enforces  the  policy.    There  are  three  asset                                                            
classes; real  estate is the first asset class. The  Corporation can                                                            
not negotiate  and compete with others  to buy real estate  if their                                                            
numbers are known to their  competitors. Once a purchase occurs, all                                                            
pertinent information is  listed on their website and made available                                                            
to the public.                                                                                                                  
                                                                                                                                
There  are  two areas  which  are  difficult  for  the Corporation:                                                             
private   equity  and  absolute   return,   which  deals  with   the                                                            
intellectual   property  of  the  investment  managers.   Mr.  Burns                                                            
observed that 75 - 80 percent  of the success in these asset classes                                                            
is in  the top  tier. Top  tier assets  have the  most intellectual                                                             
property   to  protect.   Statutes  require   them  to  honor   that                                                            
confidentiality.  He reiterated that  there is nothing confidential                                                             
today that was not confidential 25 years ago.                                                                                   
                                                                                                                                
9:25:23 AM                                                                                                                    
                                                                                                                                
Co-Chair  Wilken asked for  a definition  on "absolute return".  Mr.                                                            
Burns  explained  that  "absolute   return"  refers  to  hedge  fund                                                            
strategies  [managers  seek positive  returns  in both  up and  down                                                            
markets].  The Corporation  takes part  in 14  strategies. Most  are                                                            
non-directional  strategies.  Equity markets  are relative to  their                                                            
peers and bench marks.  A manager is hired to get a set return on so                                                            
many basis  points over the  London Interbank Offered  Rate (Libor).                                                            
Absolute  return is more  attractive than fixed  income and  is less                                                            
volatile.  There  is one  manager  or "gate  keeper"  that puts  the                                                            
Corporation into  partnerships and moves money depending  on what is                                                            
most attractive.                                                                                                                
                                                                                                                                
9:26:38 AM                                                                                                                    
                                                                                                                                
Mr. Brady  described  hedge funds  as a long-short,  market  neutral                                                            
transaction. He  gave the example of buying General  Motors long and                                                            
the Ford Company short.  The concept is a bond rate of return plus 2                                                            
- 3 hundred basis points.  The risk is relatively low; the upside is                                                            
not that great,  but it is a vehicle that many institutions  use. He                                                            
observed that 40 - 50 percent  of university investments are in this                                                            
class.                                                                                                                          
                                                                                                                                
9:27:35 AM                                                                                                                    
                                                                                                                                
Senator  Stedman  asked  for  further  explanation   of  the  London                                                            
Interbank Offered Rate and long and short investment strategies.                                                                
                                                                                                                                
9:28:37 AM                                                                                                                    
                                                                                                                                
MICHAEL O'LEARY,  CFA, Executive Vice President, Callan  Associates,                                                            
Inc., provided  information regarding  the London Interbank  Offered                                                            
Rate. He  explained that  Libor is a short  term, floating  interest                                                            
rate, a day-to-day interest  rate, and is the standard for borrowing                                                            
and  lending money  on  a short-term  basis.  He compared  it to  an                                                            
overnight borrowing  rate in the United  States. Libor is  evaluated                                                            
in dollars and provides  a high quality, risk-less investment. A lot                                                            
of floating rates are tied to the Libor.                                                                                        
                                                                                                                                
Mr.  O'Leary  clarified  that  the  use  of  "long"  in  context  of                                                            
investment means  the security is owned. "Short" refers  to the sale                                                            
of a security  that is not owned and is obligated  to deliver to the                                                            
purchaser as facilitated  through security lending. A broker is used                                                            
to sell  the security  short. The  broker borrows  the security  and                                                            
delivers it, so  that whoever bought the security  is the owner. The                                                            
short  seller,  or  their  agent,  receives   the  proceeds  and  is                                                            
responsible  for  closing   out  the  position  by  buying  out  the                                                            
security.  A security  is "short"  when the manager  thinks it  will                                                            
decline  in value.  Money is  made if  the value  declines when  the                                                            
position  is closed  out by  buying  it at  a lower  price. He  gave                                                            
further examples and summarized  that relative prices are the source                                                            
of the  return. He pointed  out that an  attractive return  could be                                                            
achieved regardless of  market performance if the long and short are                                                            
judged correctly.  Rising  market exposure  can be negated  by being                                                            
equally long and short.                                                                                                         
                                                                                                                                
9:33:05 AM                                                                                                                    
                                                                                                                                
Senator Stedman  noted that they would make money  if the stock goes                                                            
up when they are  long; and they would make money  if the stock goes                                                            
down and they are short.                                                                                                        
                                                                                                                                
9:33:14 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  added that the general  volatility would be  removed if                                                            
there is equal  weighting in both  positions. A matched trade  would                                                            
result in 4 or 5 percent over a risk-less short investment.                                                                     
                                                                                                                                
9:33:55 AM                                                                                                                    
                                                                                                                                
In response  to a question  by Co-Chair Wilken,  Mr. Burns  affirmed                                                            
that Libor could be compared to the federal fund rate.                                                                          
                                                                                                                                
9:34:00 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary gave a presentation:  "Economic & Capital Market Update"                                                            
[copy on file]. Each year  Callan does 5 year projections, which are                                                            
changed "at  the pace of  a glacier." The  focus is on making  long-                                                            
term forecasts;  they are not focused on what markets  would do this                                                            
year. Stocks are  expected to return more than bonds  and bonds more                                                            
than cash,  but they recognize that  at times bonds are better  than                                                            
stocks. A range of returns  are forecast around the central midpoint                                                            
return.  Ownership  equity  is much  wider  than high  quality  bond                                                            
investments.                                                                                                                    
                                                                                                                                
9:36:41 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary  observed  that  projections   on inflation   influence                                                            
judgments regarding  the level of short-term, cash  returns that can                                                            
be expected.  Over  the long-term,  cash  returns  have seldom  been                                                            
significantly in excess  of inflation; when short-term, cash returns                                                            
have been  over inflation  it has been due  to an overestimation  of                                                            
inflation.                                                                                                                      
                                                                                                                                
Mr. O'Leary  noted that  the same  approach is  taken in regards  to                                                            
fixed  investments;  they focus  on  the relationship  and  expected                                                            
return  between  stocks and  bonds;  they  also consider  large  cap                                                            
versus small cap  stocks, and domestic versus international  stocks.                                                            
                                                                                                                                
9:38:29 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary reviewed  the calendar period of return  for major asset                                                            
classes  over the  last  six years  (page 4).  The  six year  period                                                            
begins  with  the start  of  the  Bear  market.  The first  3  years                                                            
achieved  poor  returns;  the last  3  years  have been  a  recovery                                                            
period. He directed  member's attention to LB Aggregate  at a return                                                            
of  5.87  percent;  stocks only  returned  1.58  percent  using  the                                                            
Russell  3000  as a  measure  of the  broad  U.S. stock  market.  He                                                            
observed that  the ten year return is a reflection  of the long-term                                                            
relationship between stocks and bonds.                                                                                          
                                                                                                                                
9:40:32 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  noted that consumer spending  is the biggest  component                                                            
of the economy.  Consumer spending has carried the  economy, but has                                                            
probably done  better than there is  a right to expect. The  rate of                                                            
increase  in consumer  spending  has to  decline  according to  most                                                            
economists.  Savings are low or negative.  The beneficial  affect of                                                            
tax  cuts  in regards  to  dispensable  earning  are  largely  past.                                                            
Interest rates  are up, which is significant in terms  of the impact                                                            
on housing  and the ability to extract  equity from housing.  Energy                                                            
costs  are up. He  pointed out  that a  mild winter  in much of  the                                                            
country was helpful.                                                                                                            
                                                                                                                                
9:42:17 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary observed that  the ability of the consumer to spend is a                                                            
function of income,  which is a function of jobs.  Employment growth                                                            
has  been  strong.  During  the  recovery  period,   employment  was                                                            
initially  slow, but has  picked up and the  number of jobs  created                                                            
has been high.  Employment growth must continue to  support consumer                                                            
spending growth.                                                                                                                
                                                                                                                                
9:42:48 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary noted  that consumption  has  grown  more rapidly  than                                                            
income. Global  Insight projections  show the reverse. He  concluded                                                            
that the pace of growth in spending must diminish.                                                                              
                                                                                                                                
9:44:03 AM                                                                                                                    
                                                                                                                                
In response  to  a question  by Representative  Kelly,  Mr.  O'Leary                                                            
clarified that Global Insight  projected that the country would flip                                                            
from consuming more than income grew to the reverse.                                                                            
                                                                                                                                
9:44:56 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  referred to research  by Alliance Bernstein,  contained                                                            
on  page  9 of  the  handout.  The  numbers  depict  the  growth  of                                                            
mortgages  in  excess of  new  housing investments.  The  values  of                                                            
mortgages for each calendar  year were reviewed for the value of the                                                            
mortgages relative  to the value of  new real estate investment.  He                                                            
summarized that, in FY  05, $350 billion in mortgages were issued in                                                            
excess  of the  value of  housing investments;  this  refers to  the                                                            
amount of  money that came  out of housing  into consumers'  pockets                                                            
for other  uses  and accounts  for a  large amount  of the  personal                                                            
consumption  expenditures. Consumers  would not  be able to  sustain                                                            
that level  of spending  if their  ability to  take money out  their                                                            
houses went away.                                                                                                               
                                                                                                                                
9:47:06 AM                                                                                                                    
                                                                                                                                
Co-Chair Wilken summarized  that the total for those that used their                                                            
equity mortgages  to finance  other spending  was $350 billion.  Mr.                                                            
O'Leary  observed  that there  has  been a  lot of  appreciation  on                                                            
housing, but that consumers  may feel as if they still have the same                                                            
level of equity.                                                                                                                
                                                                                                                                
9:48:13 AM                                                                                                                    
                                                                                                                                
Co-Chair Chenault  asked for information on interest  only loans and                                                            
how  they apply.  Mr.  O'Leary explained  that  if a  new  homeowner                                                            
purchased a home  through a interest only loan, they  would have net                                                            
new investment  in the amount of the  home and it would not  show up                                                            
in the above calculations.                                                                                                      
                                                                                                                                
9:48:54 AM                                                                                                                    
                                                                                                                                
Co-Chair  Chenault  pointed  out that  consumption  money  would  be                                                            
available,  at some  point in time,  with interest  only loans.  Mr.                                                            
O'Leary agreed  and added  that a traditional  mortgage would  allow                                                            
less spending on other items.                                                                                                   
                                                                                                                                
9:49:31 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary continued to  evaluate research by Alliance Bernstein on                                                            
new housing  investment,  which  increased by  $650 billion  in  a 9                                                            
month  period during  2005. Net  increase  in mortgage  debt was  $1                                                            
trillion in the same period,  with $350 billion in equity extracted.                                                            
He pointed out  that this important source of growth  in the economy                                                            
is not forecasted  to go away, but  would be less powerful  and less                                                            
beneficial  in the  future,  resulting in  a reduction  of  consumer                                                            
spending.                                                                                                                       
                                                                                                                                
9:50:43 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary  noted  that  the  real  price  of  oil  has  increased                                                            
tremendously  but  is below  where  it was  in  the 1970's.  From  a                                                            
consumer's  perspective, the  increase becomes  a real reduction  in                                                            
the consumer's ability to spend.                                                                                                
                                                                                                                                
9:51:33 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary reviewed  the CPI of all urban consumers,  which was 3.4                                                            
percent and noted that  core inflation has been at 2.2 percent. Most                                                            
economists  and many in finance focus  on core inflation  because it                                                            
has less volatility and  noise than the broader rate, but noted that                                                            
permanent changes  in food and energy prices work  their way through                                                            
to the core rate.                                                                                                               
                                                                                                                                
9:52:38 AM                                                                                                                    
                                                                                                                                
Co-Chair  Wilken clarified  that the core rate  is minus energy  and                                                            
fuel. Mr. O'Leary affirmed                                                                                                      
                                                                                                                                
Mr.  O'Leary  observed  that the  inflation  picture  constitutes  a                                                            
change; inflation has decreased  over the last 20 years. He believes                                                            
that inflation  has  been in a  "sideways" period.  He acknowledged                                                             
that there  might be a bias toward  be slightly higher [inflation].                                                             
The  current U.S.  account  deficit is  projected  at $900  billion,                                                            
which is a substantial  portion of the GDP (gross domestic product).                                                            
                                                                                                                                
9:53:55 AM                                                                                                                    
                                                                                                                                
Co-Chair Wilken  questioned what has driven this trend.  Mr. O'Leary                                                            
explained that  the U.S. economy has been stronger  than most in the                                                            
world, with  a lot of outsourcing,  which results in a poor  balance                                                            
of trade. Trade  and the money flow  are reflected. There  have been                                                            
high deficits  that must  be financed. Foreign  investors have  been                                                            
willing to finance U.S.  obligations, partially because of high U.S.                                                            
interest rates,  which are better  than other countries.  He thought                                                            
that  foreign  investment  in our  treasury  debt has  exceeded  the                                                            
issuance in the past two years.                                                                                                 
                                                                                                                                
9:55:18 AM                                                                                                                    
                                                                                                                                
Representative  Stoltz  asked the  affect on  housing extraction  if                                                            
interest  rates   increase.  Mr.  O'Leary  explained   that  further                                                            
increases in interest rates  would tend to have a negative affect on                                                            
new housing  activity and it would  be more difficulty for  existing                                                            
homeowners to  refinance, which would slow down related  industries.                                                            
He summarized that it would  be a negative for economic activity. He                                                            
felt that interest rates were reaching a plateau.                                                                               
                                                                                                                                
9:56:51 AM                                                                                                                    
                                                                                                                                
Senator  Bunde observed  that  the state  of Alaska  is planning  to                                                            
embark on the  largest construction project that the  world has ever                                                            
seen in terms  of cost. He acknowledged  that interest rates  may be                                                            
flattening,   but  asked  for  further   speculation  on   financial                                                            
conditions in relation to the $20 billion gas line project.                                                                     
                                                                                                                                
9:57:46 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  noted that the  economy is "collectively  happy  to see                                                            
it"  as  a  reliable   source  of  energy  supply.  Business   fixed                                                            
investment is  an important source of economic growth.  He could not                                                            
speak to the details. He  was optimistic that inflation would remain                                                            
reasonably  stable. A recession is  not forecast for the  next 2 - 5                                                            
years. He felt that the economic environment was reasonable.                                                                    
                                                                                                                                
9:59:32 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  looked at inflation  during the  60's and 70's  and the                                                            
subsequent  deceleration of inflation  during the 80's and  90's. He                                                            
pointed out that  since 2000, inflation has been reasonably  stable.                                                            
The five year inflation forecast is at 2.75.                                                                                    
                                                                                                                                
10:00:24 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary  explained  that the total  return,  on a calendar  year                                                            
basis, for the Lehman bond  index is comprised of earned income, and                                                            
market  price changes  during  the year.  He noted  that the  income                                                            
component  diminished,  as  the  general  level  of  interest  rates                                                            
declined. Price volatility has also declined.                                                                                   
                                                                                                                                
10:01:16 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary addressed the  Lehman aggregate bond index from, January                                                            
2001  through  the  end  of  2005,  which  ended  at  5.08  percent.                                                            
Forecasts  are  based on  what  investors  collectively  think.  The                                                            
current yield on the bond  market is a good forecaster of the next 5                                                            
year total  return.  He expected that  investment grade bonds  would                                                            
return approximately 5 percent over the next five years.                                                                        
                                                                                                                                
10:02:19 AM                                                                                                                   
                                                                                                                                
Mr.  O'Leary referred  to  the calendar  returns  for  the S&P  500.                                                            
Stocks have  returned, in  nominal terms, 10  - 11 percent  over the                                                            
long-term,  but  there  has been  a  great deal  of  volatility.  He                                                            
stressed  how volatile the  return can be  on a year-to-year  basis,                                                            
but added that there are more positives than negatives.                                                                         
                                                                                                                                
10:03:51 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary  spoke to the  long-run, average  price earnings  ratios                                                            
for the  stock  market, which  is based  on reported  earnings,  not                                                            
projected  earnings.  By  the  end of  FY  05, they  were  near  the                                                            
average,  way below where  they were before  the "bubble burst".  He                                                            
pointed out that,  while the stock market has gone  up; profits have                                                            
grown at a faster rate.                                                                                                         
                                                                                                                                
10:05:00 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary  compared the valuation  of equities in relationship  to                                                            
the  yield on  10  year treasury  bonds.  This  was a  useful  tool,                                                            
through most of the 80's  and 90's, in determining relative value of                                                            
stocks to bonds.  Using this as one measure, stocks  look relatively                                                            
attractive versus bonds.                                                                                                        
                                                                                                                                
10:05:59 AM                                                                                                                   
                                                                                                                                
Mr.  O'Leary  summarized   that  their  five  year  capital   market                                                            
projections  are basically  unchanged  from those  made a year  ago.                                                            
Estimated inflation  has increased  to 2.75 (a 15 point basis  point                                                            
increase  from  last  year).  Short  term  cash  returns  were  also                                                            
increased  due to rising  interest rates. Bond  rates were set  at 5                                                            
percent. Domestic  equity returns  in aggregate (Russell  3000) were                                                            
left unchanged  at 9 percent. Real  estate was held at 7.6  percent.                                                            
Private  equity was  held at 12  percent. International  stocks  did                                                            
better than domestic  stocks in the previous year,  so they slightly                                                            
narrowed the  expected return for  international stocks relative  to                                                            
U.S. stocks from 9.25 to 9.20.                                                                                                  
                                                                                                                                
10:07:40 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary referred  to the projected standard deviation  column on                                                            
page 22 of  the handout, which is  a measure of risk and  volatility                                                            
of returns.  Emerging markets are  very volatile; the projection  is                                                            
almost  33 percent volatility,  which  is almost  twice the rate  of                                                            
U.S. stocks.                                                                                                                    
                                                                                                                                
10:08:40 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary concluded  that an efficient frontier  was developed and                                                            
compared  using the  projections of:  expected return,  risk,  and a                                                            
correlation  of the two. There are  a number of mixed scenarios.  He                                                            
observed that  a 6.5 percent return might be expected  on a low risk                                                            
strategy. On the  other end of the spectrum, 14.27  percent would be                                                            
consistent with a high risk return.                                                                                             
                                                                                                                                
The Permanent  Fund policy, which was adopted in November  2005, has                                                            
an expected return of 7.77.  This is consistent with a targeted real                                                            
return of approximately 5 percent, given their assumptions.                                                                     
                                                                                                                                
10:09:51 AM                                                                                                                   
                                                                                                                                
Senator Hoffman  observed  that were corrections  to the markets  in                                                            
the early 1990s.  He questioned if there is a housing  bubble in the                                                            
U.S., and whether it would be corrected.                                                                                        
                                                                                                                                
10:10:21 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary  responded that  there are clear  areas where there  has                                                            
been too much building  in response to extraordinary increase in the                                                            
price [of housing].  He concluded that in these areas,  "it could be                                                            
painful for  the people that  were doing the  building". He  did not                                                            
see a national  bubble that needed to be burst. He  anticipated that                                                            
the rate  of increased prices  would diminish,  and added that  they                                                            
have  already diminished,  resulting  in a  slow down  of sales.  He                                                            
concluded  that housing  is still comparatively  affordable  because                                                            
interest rates  have remained level.  Those dependent on  adjustable                                                            
rate mortgages are being "squeezed out of that market".                                                                         
                                                                                                                                
10:11:51 AM                                                                                                                   
                                                                                                                                
Senator  Stedman noted  that  a Board policy  change  resulted  in a                                                            
redirection of assets and  changed the way dividends are calculated.                                                            
Realized  returns are  needed to increase  the dividend  due  to the                                                            
change. He questioned  if management style has changed  to a percent                                                            
of market  value  approach, as  opposed  to one  that would  realize                                                            
greater income toward dividends.                                                                                                
                                                                                                                                
10:13:15 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary maintained  that the focus has been on  the total return                                                            
over  the fifteen  years  he has  worked  with the  Fund.  Statutory                                                            
limitations  have restricted  the  number of  options or  approaches                                                            
that could  be used. He  didn't think there  has been a significant                                                             
change on the  likely affect on realized  income due to the  shifts.                                                            
He  explained   that,  in  absolute   return,  the  turnover   rates                                                            
associated  with the strategies  tend to be  high, which results  in                                                            
quicker   realization   of  gains   over  losses.   The  Board   has                                                            
incorporated  high yield fixed  investments  as part of an  expanded                                                            
opportunity  set  for the  bond  area that  is  also a  high  income                                                            
generator.  Real estate is  the major liquid  asset category,  which                                                            
has been a  fixture of the Fund for  some time.  The primary  driver                                                            
has  been income  return  for direct  investments,  but  there is  a                                                            
meaningful  portion of the real estate  allocation that is  invested                                                            
in  REIT's  (real estate  investment  trusts),  which  are  actively                                                            
managed,  so there  is  both income  and  realized gains  or  losses                                                            
affecting  realized income.  Private  equity is the  one place  that                                                            
would not be invested in  if there were an income orientation, since                                                            
it  is  an  inherently  long  term  and  capital  gains   investment                                                            
strategy.  A typical private  equity  fund has a  six to eight  year                                                            
holding period  before the gains are distributed.  The actual amount                                                            
invested  is  significantly   less  than  that  targeted   at  a  4%                                                            
allocation.  The  Board has  not suggested  increasing  the  overall                                                            
equity allocation, which would have a greater impact.                                                                           
                                                                                                                                
10:16:47 AM                                                                                                                   
                                                                                                                                
Mr. Burns  added that the  statutes do not  direct the Board  toward                                                            
investing  with an  eye on  realized  income. Statutes  address  the                                                            
"maximum  prudent return".  The maximum  return  must be  considered                                                            
even  if  unrealized  income  provides   the  best  maximum  return.                                                            
Managers are not responsible for the distribution formula.                                                                      
                                                                                                                                
10:17:47 AM                                                                                                                   
                                                                                                                                
Senator  Stedman referred  to page  23 of the  handout. He  observed                                                            
that  for mix  5, a  targeted  rate  of return  of 8.5  percent,  if                                                            
private  equity,  emerging  market  equity,  international   equity,                                                            
small/mid  cap, and large  cap equities are  included there  is a 74                                                            
percent allocation to equities.  The Permanent Fund's target is 7.77                                                            
percent return  at 57 percent  equity exposure.   He questioned  how                                                            
the  asset  mix  plays  into  the  projections  published  on  their                                                            
website.                                                                                                                        
                                                                                                                                
10:19:37 AM                                                                                                                   
                                                                                                                                
BOB BARTHOLOMEW,  Chief  Operating  Officer, Alaska  Permanent  Fund                                                            
Corporation,  Department of  Revenue, explained  that the five  year                                                            
range  was  used   for  the  whole  fifteen  year  projection.   The                                                            
projections are not changed after five years.                                                                                   
                                                                                                                                
10:20:02 AM                                                                                                                   
                                                                                                                                
In response  to comments by Senator  Stedman, Mr. O'Leary  explained                                                            
that the  expected growth  in liabilities  for pension programs  are                                                            
affected by projected  inflation. Actuaries typically  use estimates                                                            
of inflation that are reasonable  for a "very" long-term perspective                                                            
(3.5  -  3.75   percent).  Financial   markets  deal  with   current                                                            
inflation;  inflation today  is lower,  which is  reflected in  cash                                                            
markets  and  fixed income  investments.  The  projections  used  an                                                            
inflation  rate of  2.75 percent.  A 40  year forecast  would use  a                                                            
higher inflation  number,  which would result  in a higher  expected                                                            
return for  stocks and bonds.  The actuarial  rate is 8.25  percent.                                                            
The expected  return from  their existing  portfolio using  the same                                                            
assumptions  in their  policy  mix is just  under  7.9 percent.  The                                                            
difference is due to a  heavier commitment to private equity more in                                                            
the absolute  return area than the  Permanent Fund had been  able to                                                            
do.                                                                                                                             
                                                                                                                                
10:22:48 AM                                                                                                                   
                                                                                                                                
Senator Stedman  referred to actively traded stocks,  where the rate                                                            
of return is public and  known. He observed that the rates of return                                                            
for private  equity assets are based  on estimates. He asked  if the                                                            
variability of potential outcome would be spread.                                                                               
                                                                                                                                
10:23:40 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary  noted that a high risk  number is used for investments                                                             
where volatility is not  observed. He used real estate as an example                                                            
and explained  that the  standard deviation  for volatility  is 16.5                                                            
percent, but when  real estate volatility is observed  it looks like                                                            
it is less than that for  bonds because of the appraisal process. In                                                            
the  private equity  arena,  the  industry  convention  is to  carry                                                            
investments  on a cost basis until  there is a financing  event that                                                            
would provide  a basis for  increasing the  value. This creates  a J                                                            
curve, where  because fees are paid,  the returns are negative,  but                                                            
to the extent the investments  are productive the return is achieved                                                            
with liquidation.  Just as with real estate, gains  are not realized                                                            
until  the property  is disposed  or refinanced.  He concluded  that                                                            
private  equity  is inherently  risky  but  it also  has  attractive                                                            
return  opportunities.   A comparatively   small  portfolio  in  the                                                            
Permanent  Fund of 4 percent  is the target  and is appropriate.  As                                                            
other endowments  and foundations  are observed, it is not  uncommon                                                            
to see upwards  of 50 percent of the  investment pool invested  in a                                                            
combination   of  private  equity   (up  to  15%)  and  alternative                                                             
strategies,  including hedge funds,  of another 30 or more  percent.                                                            
                                                                                                                                
10:26:11 AM                                                                                                                   
                                                                                                                                
Senator Stedman stressed  that there are a lot of interrelationships                                                            
between the  pension portfolio's management  and the Permanent  Fund                                                            
and both are  critical to the citizens  of the state.  He  concluded                                                            
that  the more  volatility in  the estimate  of  the portfolio,  the                                                            
harder it is to understand  the potential exposure in the retirement                                                            
system and observed that the liability side is hard enough.                                                                     
                                                                                                                                
10:27:11 AM                                                                                                                   
                                                                                                                                
Senator  Hoffman noted constituent  questions  after the  Governor's                                                            
announcement  of a  potential  20 percent  state  investment in  the                                                            
natural  gas pipeline  ($20 - $25  billion).  The Governor's  budget                                                            
includes a down payment  of $400 million. He recalled discussions of                                                            
a possible  investment  by  the Permanent  Fund and  questioned  the                                                            
likelihood of such an investment.                                                                                               
                                                                                                                                
10:28:20 AM                                                                                                                   
                                                                                                                                
Mr.  Burns  clarified that  they  have  not been  presented  with  a                                                            
specific  proposal.   The  Board  has  been  advised   that  various                                                            
scenarios are  being discussed. The  Board plans to discuss  the RFP                                                            
that  would allow  them to  hire a financial  adviser  to look  into                                                            
three broad areas: Board  education regarding capital infrastructure                                                            
products, how  they are being utilized  and how they might  fit into                                                            
the Permanent  Fund's portfolio;  a determination  of the  potential                                                            
investment merits;  and if it is a good investment,  how does it fit                                                            
into  and  complement  the  portfolio.  The  process  of  hiring  an                                                            
independent expert is occurring.                                                                                                
                                                                                                                                
10:29:49 AM                                                                                                                   
                                                                                                                                
Senator  Hoffman  questioned  if  the  Board  believes  it  has  the                                                            
authority  to make  an [investment]  decision, or  would it  require                                                            
legislative approval.                                                                                                           
                                                                                                                                
10:30:14 AM                                                                                                                   
                                                                                                                                
Mr. Burns thought  that initial review  would address the  question:                                                            
"Is this  prudent?"  The Board  would not  go forward  if it is  not                                                            
prudent. They  must consider: "Is  it a good investment and  is it a                                                            
good investment for this portfolio."                                                                                            
                                                                                                                                
10:31:05 AM                                                                                                                   
                                                                                                                                
Mr. Burns emphasized  that there would  be significant input  by the                                                            
legislature  and noted that the legislature  controls their  budget.                                                            
                                                                                                                                
10:31:31 AM                                                                                                                   
                                                                                                                                
Senator  Olson asked  if  there is  a misconception   that high  oil                                                            
prices  result in  larger dividend  payments, and  noted that  high-                                                            
energy  costs affect  the market.  He asked which  has the  greatest                                                            
impact: high oil prices or low energy costs.                                                                                    
                                                                                                                                
10:32:25 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary responded  that the health of financial  markets has the                                                            
greatest affect,  which he clarified to mean: not  disruptive energy                                                            
prices.                                                                                                                         
                                                                                                                                
10:32:54 AM                                                                                                                   
                                                                                                                                
Mr. Burns  spoke to  inflation,  estimates and  potential damage  of                                                            
different  levels of  inflation.  He pointed  out that  the Fund  is                                                            
protected   against  all  but  a   "really  extraordinary   jump  in                                                            
inflation." He  acknowledged that current yield could  be sacrificed                                                            
for the  future protection  from inflation,  but concluded  that the                                                            
trade offs were not compelling.                                                                                                 
                                                                                                                                
10:34:33 AM                                                                                                                   
                                                                                                                                
Senator Stedman  asked about  expectation of  state dividend  in the                                                            
near future.                                                                                                                    
                                                                                                                                
10:35:05 AM                                                                                                                   
                                                                                                                                
Mr. Burns explained that  the realized income for the first 6 months                                                            
[FY 06] of $1.3  billion was more than the number  that falls out of                                                            
the formula.  The Fund receives, at  a minimum, $60 - $70  million a                                                            
month in  interest and dividend  income. The  number going  into the                                                            
formula  should be  significantly higher.  He pointed  out that  the                                                            
formula contains  low numbers  ($280 - $300  million) over  the next                                                            
two years.  He concluded that the  dividend would go up in  2006 and                                                            
be even  higher in the next  two years, if  the markets hold.  There                                                            
are extraordinarily low numbers for 2007 and 2008.                                                                              
                                                                                                                                
10:36:19 AM                                                                                                                   
                                                                                                                                
Mr. O'Leary emphasized that a percent of market approach toward                                                                 
distributions results in greater consistency and predictability.                                                                
                                                                                                                                
10:37:03 AM                                                                                                                   
                                                                                                                                
Co-Chair Wilken thanked the trustees for their leadership and                                                                   
service.                                                                                                                        
ADJOURNMENT                                                                                                                 
                                                                                                                                
Co-Chair Gary Wilken adjourned the meeting at 10:37:59 AM.                                                                    

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