Legislature(2009 - 2010)SENATE FINANCE 532
02/10/2009 09:00 AM Senate FINANCE
| Audio | Topic |
|---|---|
| Start | |
| Overview: Economic and Capital Market Outlook & Permanent Fund Performance Review |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
SENATE FINANCE COMMITTEE
February 10, 2009
9:01 a.m.
9:01:39 AM
CALL TO ORDER
Co-Chair Stedman called the Senate Finance Committee meeting
to order at 9:01 a.m.
MEMBERS PRESENT
Senator Lyman Hoffman, Co-Chair
Senator Bert Stedman, Co-Chair
Senator Charlie Huggins, Vice-Chair
Senator Johnny Ellis
Senator Kim Elton
Senator Donny Olson
Senator Joe Thomas
MEMBERS ABSENT
None
ALSO PRESENT
Mike Burns, Executive Director, Alaska Permanent Fund
Corporation, Department of Revenue; Michael O'Leary,
Executive Vice President, Callan Associates, Inc.
SUMMARY
^Overview: Economic and Capital Market Outlook & Permanent
Fund Performance Review
OVERVIEW: ECONOMIC AND CAPITAL MARKET OUTLOOK & PERMANENT
FUND PERFORMANCE REVIEW
9:05:00 AM
Co-Chair Stedman introduced Callan Associates as the state's
principal investment advisor for the permanent fund, the
Alaska retirement funds, and the Treasury Division. The firm
had been invited to help the committee understand the
interrelationship of the state's major savings accounts and
to offer advice.
9:06:21 AM
MIKE BURNS, EXECUTIVE DIRECTOR, ALASKA PERMANENT FUND
CORPORATION (APFC), DEPARTMENT OF REVENUE, gave a brief
history of the permanent fund. The state has deposited about
$13.4 billion into the fund from mineral royalties, from
general fund appropriations, and from legal settlements.
Over the life of the fund, the corporation has paid out
$16.7 billion in dividends. Today the fund has between $28
billion and $29 billion. He suggested holding the
perspective of the success of the fund. Callan Associates
has provided the board with asset allocation advice,
performance measurements, manager searches, and other duties
since 1990.
MICHAEL O'LEARY, EXECUTIVE VICE PRESIDENT, CALLAN
ASSOCIATES, INC., presented a PowerPoint "Alaska Senate
Finance Committee Market & Economic Review, 2009 Capital
Market Projections and APFC Performance, February 2009"
(Copy on File).
Mr. O'Leary provided a fourth quarter overview (Slide 1):
· Terrible market environment for all major asset
classes.
· Credit markets froze around the world.
· Extraordinary governmental policy actions initiated
quickly but not as rapidly as many had hoped.
· Flight to quality resulted in sharp declines in short-
term government rates and increases in "risk" premiums.
· Commodity fell sharply as expectations regarding the
length and depth of economic slowdown mounted.
· U.S. dollar strengthened significantly hurting profits
for multinationals, unhedged international investors
and returns on international investments for U.S. based
investors.
Mr. O'Leary described Slide 2, "Second Half of 2008:
Startling," as a list of the major financial news items that
impacted the market, including:
· Fannie Mae and Freddie Mac placed into conservatorship.
· Lehman Brothers declared bankruptcy.
· AIG rescued by government.
· Merrill Lynch sold to Bank of America.
· Morgan Stanley and Goldman Sachs convert to bank
holding companies.
· Washington Mutual seized by regulators and assets sold
to JP Morgan.
Mr. O'Leary highlighted December 16, 2008 on the timeline,
the date the Federal Reserve System (The Fed) target
interest rate was reduced to between zero and 0.25 percent.
9:12:31 AM
Mr. O'Leary turned to Slide 3, "U.S. Fixed Income," with a
graph depicting the U.S. Treasury yield curves. He explained
that the blue line represents the Treasury yield as of the
end of calendar year 2008, the green line represents the
September 20, 2008 yield, and the yellow line represents the
year end 2007 yield. The graph illustrates the remarkable
change in Treasury rates during the year. By the end of the
year, the 30-year bond was yielding less than 3 percent. The
graph on the right depicts the yield deferential for various
sectors of the bond market over Treasurys. Bar graphs at the
bottom of the page show the absolute returns for various
sections of the bond market relative to Treasurys. For
example, corporate high yield investments in the quarter
were down 17.9 percent in absolute return, down 24.9 percent
relative to like-duration Treasurys.
Mr. O'Leary described Slide 4, "The Capital Markets: What a
Difference One Year Can make," as illustrating the calendar
year performance over the last several years for the U.S.
stock market and various other components. He highlighted
the 2008 inflation number of 0.09. During the year on a
year-over-year basis, it seemed as though inflation would be
up around 5 percent; this means all the decline in the
consumer price index (CPI) occurred in the later half of the
year. In the shaded years, the five-year compounded returns
for each of the market indexes are listed, the five years
ending at the end of 2007 and the five years ending at the
end of 2008. The same is repeated for the ten-year and
fifteen-year intervals. He emphasized that the numbers show
the notable change in the long-term return for various asset
categories because of one year. He cited the example of the
Russell 3000 Index, a broad measure of the stock market,
illustrating how one significant year can have a huge impact
on longer-term results.
9:16:32 AM
Mr. O'Leary explained that Slide 5 shows real estate
returns, including the National Council of Real Estate
Investment Fiduciaries (NCREIF) returns.
Co-Chair Stedman returned to Slide 4 and asked for more
information on fixed income and cash markets.
Mr. O'Leary explained that the Lehman [Brothers] Aggregate
Bond Index (LB Aggregate), now called the Barkley's Capital
Bond Aggregate, is a measure of investment-grade bonds. Over
the fifteen year period including 2008, the LB Aggregate
return is nearly as great as the return for the Russell
3000. Over shorter periods the return is far superior, and
driven by long-term Treasury returns. The index below the LB
Aggregate is the Citigroup Non-U.S. [Dollar World
Government] Bonds Index, a government index issued in
foreign currency terms. The return reflects both the return
in local currency and changes in the value of the dollar.
Cash Market is the 90-day Treasury (T-Bill).
9:18:14 AM
Mr. O'Leary continued with Slide 5. Many institutional funds
invest in direct real estate. The graph at the bottom of the
slide provides a sense of real estate returns. The blue line
represents the total return of the index and the red line
reflects the income component of the index. The graph shows
a sharp decline in the fourth quarter of 2008 for the values
assigned to direct real estate investments.
Co-Chair Stedman asked how real estate is priced in the
model. Mr. O'Leary answered that the index is based on
appraisals of unlevered real estate and comprised of
hundreds of properties held by institutional investors
throughout the country. There is detailed information
available on the income generated and other factors. The
properties in the index are appraised at least annually, but
if there is a transaction, the actual value of the
transaction is captured. During the periods when the asset
is not appraised, the appraisal methodology is applied to
the financials for the property. Recently, there was some
increase in vacancies; the required yield increased more
because risk interest rates are higher and the spread
difference is wider.
9:21:10 AM
Mr. O'Leary explained that Slide 8 shows a calendar year
performance for the Callan Public Fund [Sponsor] Database;
the red dot reflects the preliminary return numbers for the
Alaska permanent fund, negative 25.7 percent during 2008;
this is essentially at median. He pointed out that the
importance of the real estate chart is to demonstrate how
comparisons can be muddied; many public funds report their
real estate returns with a quarter lag. The end of December
report shows in effect the twelve months ending in
September. The permanent fund values its real estate on a
current quarter basis, with one investment as an exception.
Therefore, it has already incorporated the significant
decline in the valuation of real estate. Others in the
distribution may or may not have; Callan's sense is that
lagging is common. The graph shows:
· The permanent fund did better than the median public
fund in 2001 and 2002, both declining market
environments;
· The fund lagged in 2003;
· The fund was very competitive in 2004 and 2005;
· In 2006, the return was attractive, but essentially
median;
· In 2007, the return was attractive;
· In 2008 return was at median.
9:23:22 AM
Mr. O'Leary directed the committee to Slide 9, "Stock Market
Returns by Calendar Year," with a histogram graph putting
2008 performance in perspective within of the history of the
U.S. stock market. The 2008 return is highlighted; stocks
were down 37 percent. Most of the time, the stock market has
produced a positive return. The only years with returns as
bad as 2008 were in the 1930s.
Mr. O'Leary pointed out that whenever anyone talks about
stock market returns, they will point out things like the
market is down one in four years or more. People will talk
about the typical decline. The 2008 decline, while atypical,
is consistent with other bear markets; what is unusual is
that it was concentrated in so short a period.
Co-Chair Stedman asked if the bear market was over. Mr.
O'Leary replied that he did not make that statement. Co-
Chair Stedman asked if the measurement were then complete.
Mr. O'Leary responded that it was not complete through
January of 2009, which was also a negative month.
9:26:21 AM
Mr. O'Leary reported that Slide 10, "Rolling 5-Year
Geometric Returns" illustrates another way of viewing the
situation. A blue line on a graph depicts the actual five-
year return for periods ending December 1930 through
December 2008; for the most recent five years, the S & P
[Standard & Poor's] 500 had an annualized return over five
years of negative 2.91 percent. The average of all the
averages was 10.35 percent. The left side of the graph shows
how bad the five-year returns were during the 1930s; the
declines were between negative 10 and negative 16 or 17.
Mr. O'Leary turned to Slide 11, "Credit Spreads Exceed
Historic Highs," showing investment grade credit spreads
from 1979 through 2008. He explained that credit spreads
were the difference in returns and yields between debt
instruments that are highly rated over comparable maturity
treasury securities. By the end of 2000, there were
unprecedented levels for the 1979 through 2008 period.
Subsequent to year end, credit spreads have narrowed.
9:28:30 AM
Mr. O'Leary listed the potential implications of the
financial crisis (Slide 12):
· Structure of the U.S. financial system is changed
permanently.
o End of traditional investment banks.
o Consolidation of financial institutions into
large, highly regulated commercial banks.
o More government oversight and regulation.
o Lower leverage and ultimately lower risk in
financial system.
o Tighter credit conditions for foreseeable future.
· U.S. deficit and overall federal debt will expand
dramatically.
o Trillion dollar plus deficits likely in near term.
o Risk of devaluation of U.S. dollar elevated.
o Long-term risk of higher real interest rates and
crowding out of private borrowing.
· U.S. consumer is being forced to delever.
o Loss of wealth in housing and equities will change
behavior.
o Less spending and consumption.
o Postponed retirements, second jobs, will expand
labor force.
· Financial markets become smaller and less efficient.
9:30:42 AM
Mr. O'Leary directed attention to Slide 13, "U.S. Economic
Growth by Sector." A graph illustrates the importance of the
consumer to economic growth, especially the composition of
real gross domestic product (GDP) and how much growth is the
result of consumption, residential investment, and so on.
Mr. O'Leary pointed to a graph on Slide 14, "Hard Landing
for the U.S. Economy," showing real GDP. There have been
modifications of the reported numbers for 2008; the decline
in the second half of the year is shown, plus the projection
for negative growth in 2009.
Mr. O'Leary highlighted a few points on Slide 16, "The
Current Economic Environment: Slow going until 2010":
· Optimistic outlook: government intervention stabilizes
credit markets, fiscal stimulus kick-starts rapid
upswing. Beware of inflation lurking in the wings.
· Pessimistic scenario: vicious downward spiral between
the economy and credit markets worsens. Specter of
deflation looms.
· Most likely scenario: severest declines in GDP will be
recorded in fourth quarter of 2008 and first quarter of
2009. GDP resumes modest growth in the second half of
2009, as credit markets slowly unthaw and confidence
returns.
Mr. O'Leary reported that there will be a lag before the
impact of government intervention arrives. The situation
deteriorated during the fourth quarter; however, by the end
of December there were signs of stabilization. There have
been signs of improvement in financial conditions, primarily
credit risk spreads. New bonds have been issued over the
last several weeks by investment grade issuers and were
received well by the market, which did not happen in the
fourth quarter. There is no question that the economy is
continuing to decline, although there are indications in
some areas of emerging stability. The bulls would say that
the market begins to recover before the economy. The average
recession has been ten months in duration. The current
recession began in the middle of 2008. Major economists say
there will not be improvements until July or the first
quarter of 2010.
9:34:43 AM
Mr. O'Leary said the pessimist's view is that the damage to
the financial system is extreme enough to create concern
about deflation.
Mr. O'Leary turned to Slide 17, "The Current Economic
Environment: Slow going until 2010." He explained that every
year Callan Associates goes through a long-term planning
exercise for expected returns. Callan is always going to
project the central estimate of stock returns to be above
bond returns and bond returns to be above cash, and tries to
capture variability by the range of expected returns as
measured statistically. Callan thinks inflation will be a
non-issue in 2009, and not a significant issue in 2010, but
that during the forecast period, inflation will become more
of an issue. Callan thinks that stocks will anticipate and
lead the recovery, not cause it. The firm has studied every
stock market recovery subsequent to a major bear market;
early on, the returns are attractive. The key issue is
figuring out when is too early.
9:36:54 AM
Co-Chair Hoffman asked what the federal stimulus package
would do. Mr. O'Leary responded that they did not know yet,
since the package is not detailed. The composition of the
final package will most importantly affect confidence. He
understood the bill that is likely to be enacted is
primarily spending as opposed to tax cuts and that the
composition of the spending is less stimulative than the
critics wanted. Part of the assessment reflects Callan's
view toward longer-term inflation. He opined that the
package would help the economy shorter term, but there were
still questions.
9:39:18 AM
Mr. O'Leary stated that the expectation is that there will
be meaningful stimulus, but stressed that affecting consumer
attitude is critically important.
Senator Elton asked how the stimulus package would affect
consumer attitude. Mr. O'Leary replied that the housing
market is particularly important for many people. If the
package holds promise of stabilizing housing or reducing the
risk of foreclosure, it could have a very positive affect on
attitude. An immediate increase in income through payroll
tax reductions would also help.
Senator Elton asked if consumer attitudes would be affected
through the Trouble Assets Relief Program (TARP) funds. Mr.
O'Leary responded that he was speaking of the stimulus
package in Congress.
9:42:04 AM
Mr. O'Leary continued with Slide 18, "Equity Is More
Reasonably Priced: Trailing P/E [Price to Earnings Ratio]
Dips Below Its Long Run Average". He maintained that
financial assets look very attractively valued if the stance
is taken that in the next two years there will be the
beginning of a financial recovery. The case is easier to
make for investment-grade bonds then for equities, although
the case is just as strong. This is because earnings will be
dismal in the short term. The leveraged operating
flexibility of major corporations is tremendous. Valuation
levels for equities are often seen as normal earnings power
and not 2009 expected earnings, which means asking where
corporate earnings will be five years from now. Taking a
look at the equity markets in light of the 37 percent
decline in the past year, stocks appear very attractively
valued. There is risk; broad diversification is essential.
9:44:51 AM
Mr. O'Leary explained that the data on Slide 19, "Past
Recessions and Subsequent Market Performance," is taken from
the JP Morgan Guide to the Markets, December 31, 2008. The
average economic expansion since 1900 has lasted 45 months
and the average recession has lasted 14 months. The table
shows the post World War II recessions at an average of ten
months. During the recession in the post World War II era,
stocks went up 1.4 percent on average, indicating that
recovery began before the recession ended. This was not true
in the 1970s and in 2001.
9:46:28 AM
Mr. O'Leary pointed to graphs on Slide 20 depicting the
yield to worst on the Lehman Aggregate Bond Index from
January 1, 2001 to January 16, 2009. Yield to worst presumes
that a bond gets called if it is advantageous for the issuer
of the bond to call it. At the end of 2008, the yield to
worst on the Lehman Aggregate was just under 4 percent;
subsequently, yields declined even further. The index can be
used for future five-year bond returns. Over the next five
years, bonds could be expected to return to near 4 percent.
Co-Chair Stedman referenced the 5.7 percent yield on
10/31/08. He asked for clarification about the inverse
relationship with value. Mr. O'Leary gave the example of a
concept called durations. If interest rates go up, the value
of existing bonds declines, because the rational investor
will not buy at 4 percent when a new bond will come out with
a 5 percent yield.
9:48:48 AM
Co-Chair Stedman added that when yields go up to 5.5 percent
from 3.75 percent, the value of the bonds will decline
because of downward pressure. Mr. O'Leary pointed out that
Treasurys were great last year but have been terrible in
2009 because long-term Treasurys have gone up as panic in
the markets lessened.
Mr. O'Leary told the committee that the graphs on Slide 21
give some sense of the composition of bond market total
return. The upper left graph shows the total return, the sum
of the market value change plus income. The upper right
graph shows the income return. The lower left graph shows
the price change. The income return component tends to be
fairly stable, but the price change tends to be volatile,
reflecting the changes in the general level of interest
rates.
9:50:17 AM
Mr. O'Leary turned to Slide 23, "Bond Market Opportunities":
· We don't know when markets will react positively to the
extraordinary governmental policy actions taken to
restore liquidity to credit markets, but we are
confident that they will.
· We believe that risk spreads (both credit and equity)
have reached very attractive levels and patient
investors will be handsomely rewarded from recent price
levels.
· We do not expect credit spreads to return to the slim
premiums of 2004 to early 2007.
· The extraordinarily low yield and duration on the
Aggregate mask the extreme divergence between the
component sectors of the index, and therefore the
potential opportunities.
· Very large increase in specialized "distress" oriented
fixed investing.
Mr. O'Leary explained that one of the reasons for the
downturn was too much liquidity. Investors did not require
enough of a premium for the risk they were taking. One
manifestation of that was the sub-prime confusion; people
were given loans, and the risk was not reflected in the
price they were paying for the loans. The confusion was not
limited to sub-prime; it occurred across the financial
spectrum.
9:51:14 AM
Mr. O'Leary directed attention to Slide 25, "2009 Capital
Market Expectations," a narrative explaining expectations
for the major asset categories.
· Bond returns held at 5.25%. Current measures of the
broad market are very unusual. We expect Treasury rates
to rise, but spreads will narrow and opportunities
abound in the non-Treasury portion of the market.
· Project an upward sloping yield curve, with a risk
premium for bonds over cash (2.25%).
· Building equity returns from long-term fundamentals
gets us to about 9%: 3-4% real GDP growth, which means
5.75%-6.75% nominal earnings growth, 2% dividend yield,
0.5%-1% "buyback yield." Shorter term, these
fundamentals may look weak, but equity looks cheap
relative to longer-term valuations. Equity markets tend
to perform well after substantial declines, and
typically lead the economy out of recession. Broad U.S.
equity expectations are increased 50 bps [basis
points], from 9.0% to 9.5%. Non-U.S. equity returns are
increased by a similar amount.
· Real estate return held at 7.6%; returns may not
recover as quickly as liquid equity markets.
· Private equity return held at 12%, narrowing its
premium over public equity markets.
Co-Chair Stedman asked for a breakdown relative to time. Mr.
O'Leary responded that in the shorter term, over the next
year or two, Treasurys are not likely to produce a very
attractive return, because the starting interest rate levels
are so low, and the issuance needs for the Treasury are so
great. He stated that a high-quality credit bond would
return more than Treasurys.
Mr. O'Leary speculated that a five- or six-year return for
highly-rated investment credit bonds could easily be in the
over 6 percent range and near 3 percent for Treasurys.
Callan's longer-term expectation for total returns from
Treasury Inflation-Protected Securities (TIPS) is around 4.9
percent. This is much higher than for Treasurys because the
market is not pricing in future inflation.
9:54:42 AM
Mr. O'Leary turned to the subject of the permanent fund. He
directed the committee to Slide 26, which addresses findings
of the National Association of College and University
Business Officers (NACUBO), a group with a mission similar
to that of the permanent fund.
Mr. O'Leary explained that the permanent fund is permanent
and so has an advantage very few other pools of capital
have. The fund has a long-term investment horizon; its
objectives are to preserve the purchasing power of the fund
over the long term and to make distributions that are
consistent with that. The legislature has historically
determined the pace of distributions.
Mr. O'Leary compared the permanent fund with major
university endowments. Distribution policies may be
expressed differently but the objective of both is to
preserve the purchasing power of the principal and to make
distributions that support the objectives of the institution
or fund.
Mr. O'Leary observed that NACUBO commissions a comprehensive
survey of college and university endowments. Slide 26
contains the most recent data taken from a survey of 774
institutions. The table shows how the institutions have
invested their money. He encouraged focus on endowments
greater than $1 billion, calling them a "peer group" for the
permanent fund. He listed the various asset investment
categories of the major endowments:
· 40 percent invested in equities of all kinds;
· Only 11 percent invested in fixed income
· 6 percent invested in real estate;
· More than 22 percent invested in hedge funds;
· 10 percent invested in private equity;
· 3.6 percent invested in venture capital; and
· 5.3 percent invested in natural resources.
9:57:53 AM
Co-Chair Hoffman noted the large spread between investment
pools of $25 million and $1 billion. Alaska's fund is
substantially higher than that. He asked how many
institutions had pools above $1 billion. Mr. O'Leary guessed
there were around 20. Co-Chair Hoffman asked if the larger
endowments had a large spread in the allocation of their
investments.
Mr. O'Leary pointed out the difference between the dollar-
weighted average and equal-weighted average. The dollar-
weighted average is dominated by the 20 large institutions.
Within those, there is a wide spread, but not as wide as the
spread in the $500 million to $1 billion group. He offered
to get more detailed information.
Co-Chair Stedman solicited an explanation on hedge funds,
private equity, venture capital, and natural resources. He
wondered if the categories were all forms of equity
ownership versus debt ownership. Mr. O'Leary responded that
the private equity and venture capital were predominantly
illiquid equity investment. Both the permanent fund and the
state pension pools invest in private equity; there is not a
distinction between private equity and venture capital. The
targets are about 7 percent for both entities.
10:00:33 AM
Co-Chair Stedman asked for a brief overview of hedge funds.
Mr. O'Leary explained that hedge funds are not an asset
class but an amalgamation of investment strategies and
characteristics, private partnerships that typically invest
predominantly in public securities using a variety of
strategies. He emphasized that there are over 8,000 hedge
funds, which makes them difficult to generalize. They often
have niches by types and try to achieve a return that is
like a publicly traded equity return without the volatility.
On average hedge funds are looking to achieve a return
greater than that available from a bond market. Others try
to have less short-term volatility than traditional equity-
only portfolios. Hedge funds are very expensive; the general
partner in the limited partnership is paid a fee and a
percent of profits. Hedge funds can sometimes pursue very
aggressive investment strategies which can cause other
investors to cash out.
10:03:01 AM
Senator Elton asked how the 2008 numbers compared to the
2007 numbers for the larger funds. He specifically wondered
if they started moving towards hedge funds and private
equity. Mr. O'Leary answered that five or more years ago the
equity allocation was higher, the hedge fund and private
equity allocations lower, and the bond allocations higher.
Reduction in the bond allocation has been the primary source
of funding. In some cases, they've also reduced equity to
get a different form of equity management from a segment of
the hedge fund world.
Senator Thomas asked which university endowments were
largest. Mr. Burns thought that Harvard's endowment was
about the size of the permanent fund. Mr. O'Leary answered
that Harvard, Yale, and Stanford were the three largest.
10:05:14 AM
Mr. O'Leary pointed out that private foundations have
investment policies similar to the permanent fund. He stated
that half of the assets of a major private foundation he
works with are illiquid, invested in real estate, absolute
return, hedge funds, and private equity.
Senator Elton asked if managers' options for the permanent
fund were negatively restrained because of the prescribed
asset allocation. He wondered if the state had the
flexibility of other large funds.
Mr. Burns replied that the law was changed three years prior
to allow the corporation to invest as a prudent investor. He
added that the state does not have the risk tolerance of the
private endowments like Harvard or Yale. The corporation is
not constrained. One of the differences is that a university
foundation graduates a new group of donors each year, while
oil is a finite resource.
Mr. O'Leary referred to the time of the statutory list when
the permanent fund was at a disadvantage. The legislature
has been responsive to requests for liberalization,
including giving the permanent fund board the authority to
modify things. The pension system has had greater
flexibility. For example, the army has more money invested
in private equity than the permanent fund, because the army
was able to start earlier.
10:08:28 AM
Mr. O'Leary presented Slide 27, "2009 Capital Market
Expectations, Return and Risk." Callan has always focused on
five-year return estimates, but financial markets are very
volatile. If one invested dollar loses 50 percent, it has to
gain 100 percent in order to break even. The table considers
an arithmetic mean return, or the average expectations in a
single year, and then geometric mean returns for five and
ten years. The five-year number is lower than the arithmetic
mean number, but the arithmetic mean is used to calculate
the five-year number, which reflects the effect of
volatility. The further the time horizon is extended, the
less meaningful the volatility is. The numbers, with the
notable exception of fixed income, reflect an increase in
five-year return from previous numbers. The reason is the
significant decline that has occurred. None of the numbers
get that back in the short run. If there was a 9 percent
broad domestic equity return number last year as a five-year
projection, that same number would now be 9.63.
Co-Chair Stedman asked if the state would be unable to get
back to expectations of a year ago at the end of the five-
or six-year cycle.
10:11:18 AM
Mr. O'Leary returned to Slide 10 and explained that
projections now are consistent just as they were a year ago
with the type of volatility and range of five-year returns
depicted on the graph. Over the last five years, the return
was negative 2.19 percent. There could be a five year period
with a return of over 20 percent, and that would be
consistent with the projects being built in to the modeling.
The five-year number is the average of thousands of
simulations of returns calculated using the arithmetic mean
return assumption and the annual standard deviation looking
at the history. Two standard deviations capture 95 percent
of the range of expectation. There could be a wide range of
returns.
Mr. O'Leary reported that Callan thinks that given the
magnitude of the decline and the presumption that the
economy will eventually recover there will be a period of
above-average returns over the next five years.
Co-Chair Stedman asked when the change in assumptions
occurred.
10:14:22 AM
Mr. O'Leary responded that there was no expectation of a
recession one year ago and the downturn in July affected
thinking about reasonable rates of return.
Co-Chair Stedman asked when Callan became concerned about a
recession. Mr. O'Leary replied in 2007.
Co-Chair Hoffman asked what projections were in September of
2008. Mr. O'Leary replied that Callan had not modified their
projects from the year previous; they had extensive
conversations with concerned clients. Lehman Brothers had
gone bankrupt September 15 and the markets were not
functioning. He described normal transactions that could not
be completed.
Co-Chair Hoffman asked if a hypothetical $1 billion should
have been invested high-risk or low-risk in September of
2008. Co-Chair Stedman restated the question with various
timelines.
10:17:27 AM
Mr. O'Leary responded that if the timeline were one year,
the investment should be in something safe such as a bond
portfolio. For a twenty year timeline, assuming minimal
possibility of significant cash outflow, the answer would be
that that is a very long investment horizon and there would
be a heavy equity commitment. The shorter the time, the
lower the equity commitment, with a norm being a balanced
portfolio in the 60 or 70 percent range. The key variability
is the probability of the money disappearing. The more
certainty, the easier it is to be aggressive. If a person
will retire in five years, the advice would be in the
direction of meaningful equity participation. If the subject
is a child's college savings fund, a portion of which will
be needed in five years to pay tuition, then the investment
should be balanced but more conservative.
10:20:05 AM
Co-Chair Hoffman described aggressive and non-aggressive
investments related to the permanent fund and asked whether
Mr. O'Leary would have recommended in September 2008 that
the investment be in more aggressive funds, given what is
now known about the market. Mr. O'Leary stated that he would
not have invested if he had known the market would decline
20 percent. He would have been willing to invest any
reserves in more aggressive investments as that market
environment was unfolding. Callan does not attempt to time
markets, but advises clients to have a long-range policy and
to try and maintain it through good and bad times. For
example, almost every institutional fund in the country had
less equity than their target equity by the end of calendar
year 2008 because equities went down more than bonds went
down. Every investor had to make decisions about whether to
change the target to being more conservative or moving
allocations to get back on target.
Co-Chair Hoffman asked what the recommendation would have
been in September 2008. Mr. O'Leary responded that [equities
and bonds] were not out of balance in September; the
recommendation would have been to maintain the long-run
policy. In December the recommendation would have been to
begin rebalancing the portfolio.
10:23:06 AM
Senator Elton asked if Callan would shift back towards
equities if given $1 billion to invest now. Mr. O'Leary
answered that if he would if he were under his long-term
target in light of the new projections. He would invest in
other risk assets besides equities, such as high-yield bonds
or real estate. He cited an example related to another major
corporation for whom he is doing an asset allocation and
liability analysis. The corporation has never owned direct
real estate, but is seriously considering establishing it as
a category for investment in their pension plan.
Mr. O'Leary turned to Slide 29, "Illustrative Efficient
Mixes Using 2009 Projections." He said the table takes the
permanent fund's existing allocation asset policy and uses
Callan's long-term capital market projections and the five-
year simulated return given the new inputs as 9 percent,
compared with the previous year's 8 percent. The table looks
forward.
Co-Chair Stedman asked if last year's market point could be
projected forward with the previous year's 8 percent and
other considerations. Mr. O'Leary said he could provide the
information.
10:26:20 AM
Mr. O'Leary returned to the table on Slide 30 and said his
consulting advice was not to pick a particular point on the
efficient frontier but to pick an area that is consistent
with risk and return expectations. The 9 percent line
provides positive real return above inflation. Volatility
for the total portfolio is estimated at 12.82 percent.
Mr. O'Leary directed attention to Slide 42, "Tax Exempt
Yields vs. Treasury." The graph depicts a yield spread with
a ratio of municipal bond index yield to the ten year
Treasury. The graph helps demonstrate how significant the
disruptions in the credit markets have been.
Mr. O'Leary turned to Slide 44. Grantham, Mayo, Van Otterloo
& Company (GMO) is a major investment management firm that
does monthly seven-year projected real returns. The company
has a history of being very conservative. He said that J.P.
Morgan has a similar projection process; their most recent
projections as of the end of November show a longer term
compound number. He assured the committee that the numbers
used by Callan are consistent with the numbers used by many
in the financial industry as long-term projections.
10:30:27 AM
Mr. O'Leary described "Year-end Strategists Projections" on
Slide 46. At the end of the calendar year a service asks
noted authorities in the financial industry to make their
single price target projection for the equity market. He
noted that some of the projections are from the year end and
helps illustrate that market timing has not been mastered.
Co-Chair Stedman asked for tables depicting December 31,
2007 and December 31, 2008 allocations for the permanent
fund, retirement funds, and the constitutional budget
reserve.
Senator Olson queried Callan's recommendations regarding
inflation in the permanent fund.
10:33:50 AM
Mr. O'Leary recommended using real assets such as real
estate, infrastructure investment, timber, TIPS, and so on
as a defense against inflation. The defense can take many
different forms, such as. Equities do a better job of
preserving purchasing power than fixed assets over the long
run. The more one is concerned with future inflation, the
greater the emphasis should be on those types of asset
categories. He thought this was particularly true of the
permanent fund. The permanent fund has greater flexibility
because of limited liquidity needs. Ideally there should be
nothing left in the retirement fund when the last
beneficiary dies. The system is designed to meet the
requirements of the participants.
Mr. Burns added that regarding inflation, the corporation
has tried to come up with the present value of future cash
flows from oil revenues.
10:36:26 AM
Co-Chair Stedman asked how the corporation deals with less
liquid investments if forced to re-balance. Mr. Burns
replied that the target for domestic fixed income is 19
percent plus or minus 6 percent, or 25 percent; the fund is
at 26.67 percent, or slightly high in domestic fixed income.
Some of that is a holding place for some underfunded asset
classes. The target for domestic equities is 26 percent plus
or minus 5 percent; the fund is at 23.11 percent. The target
for international equity is 13 percent plus or minus 3; the
fund is at 10.53 percent. The target for global equities is
14 plus or minus 4 percent; the fund is at 11.57 percent.
The target for international fixed income is 3 percent plus
or minus 3 percent; the fund is at 3.99 percent.
Mr. Burns reported that for illiquid assets, the target for
real estate is 10 percent plus or minus 3 percent; the fund
is at 13.09 percent. He thought there were valuations that
would bring the percentage down. The permanent fund is
approximately a quarter ahead of most funds, but there are
still changes in values that will adjust that. The target
for private equity is 6 percent plus or minus 5; the fund is
only at 2.13 percent. The corporation does not control the
outflow; funds have been committed funds to partnerships,
but the issue is how fast the corporation can find targets
to invest in. The corporation does not like to accelerate
the investment process. The target for absolute return is 6
percent plus or minus 3 percent; the fund is at 7.58
percent. The target for infrastructure, the newest asset
class, is 3 percent plus or minus 3 percent; the fund is at
1.3 percent.
Mr. Burns summarized that overall the corporation is still
heavy in fixed income and light in equities, but are within
margin.
10:39:53 AM
Co-Chair Stedman asked for the information in a data page.
He did not want the fund to be forced to rebalance by
selling premium real estate. Mr. Burns replied that there
was no pressure to sell privately owned real estate,
although the public real estate trust has been sold down.
The market is slow.
Senator Huggins asked about deflation. Mr. O'Leary responded
that the deflation cycle was a consequence of the credit
markets locking up; it would have occurred in the second
half of 2008. Before that time, inflation was the larger
concern. The price of oil reflects that. He did not think
the economy was currently in a deflationary period, although
he acknowledged that there was a risk.
10:42:40 AM
Senator Huggins pointed to Slide 17, which states that
deflation is a problem. He referred to another bullet point
on Slide 17 stating that inflation would be contained and
low interest rates persist.
Mr. O'Leary placed the statement about deflation in context.
The Federal Reserve System (the Fed) is focused on
stabilizing the financial system and kick-starting the
economy. He agreed with the Fed that deflation will be a
problem if they don't get credit moving. Callan's
expectation is that the Fed will get credit moving. There is
enough slack in the economy that demand-pull inflation could
be an issue in 2009 and most of 2010.
Senator Huggins asked if inflation could be a problem. Mr.
O'Leary answered in the affirmative.
Co-Chair Stedman asked for a summary of realized and
unrealized losses in the permanent fund and the fund's
ability to pay a dividend.
10:45:11 AM
Mr. Burns responded that the fund had been in a similar
situation in 2002, and the markets righted. The board asked
the attorney general and the Department of Law to come up
with an opinion regarding correct accounting if the notional
value of the principal was less than the market value of the
fund. The 2003 opinion was that unrealized gains and losses
should be allocated to principal and the earnings reserve
stood by itself. This is still the operative opinion.
Multiple audits done by Klynveld Peat Marwick Goerdeler
(KPMG) agree. The board asked for the current administration
to give an opinion, which has not yet been issued. Testimony
has been that the opinion agrees with previous opinion, but
it has not been published.
Mr. Burns added that as of the end of the year (12/31/08),
there is approximately $3.9 billion in the earnings reserve.
The dividend is difficult to estimate; the rough estimate is
around $1 billion, exclusive of the energy rebate. There is
currently enough money to pay a dividend.
Co-Chair Stedman noted the question was of concern to many
citizens.
Senator Olson asked if he could assure constituents that
they would receive a dividend.
Mr. Burns did not know if there was assurance in today's
market. He stated that the opinion of the Department of Law
[that unrealized gains and losses should be allocated to
principal and the earnings reserve stood by itself] was the
operative opinion but could be challenged.
ADJOURNMENT
The meeting was adjourned at 10:48 AM.
| Document Name | Date/Time | Subjects |
|---|---|---|
| APFC 2008 History Proj.pdf |
SFIN 2/10/2009 9:00:00 AM |
|
| APFC Asset Targets & Value Feb 03 2009.doc |
SFIN 2/10/2009 9:00:00 AM |
|
| Callan Economic and Capital Outlook.PPT |
SFIN 2/10/2009 9:00:00 AM |
|
| APFC Prelim Perf 2-9-09.PPT |
SFIN 2/10/2009 9:00:00 AM |