Legislature(2005 - 2006)SENATE FINANCE 532
02/17/2005 10:00 AM Senate FINANCE
| Audio | Topic |
|---|---|
| Start | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
| + | TELECONFERENCED | ||
MINUTES
JOINT
SENATE FINANCE COMMITTEE
HOUSE FINANCE COMMITTEE
February 17, 2005
10:06 a.m.
CALL TO ORDER
Co-Chair Green convened the meeting at approximately 10:06:27 AM.
PRESENT
Senate Finance Members:
Senator Lyda Green, Co-Chair
Senator Gary Wilken, Co-Chair
Senator Con Bunde, Vice Chair
Senator Fred Dyson
Senator Bert Stedman
Senator Lyman Hoffman
House Finance Members:
Representative Kevin Meyers, Co-Chair
Representative Mike Chenault, Co-Chair
Representative Bill Stoltze, Vice-Chair
Representative Mike Hawker
Representative Jim Holm
Representative Eric Croft
Representative Bruce Weyhrauch
Also Attending: SENATOR TOM WAGNOR; REPRESENTATIVE HARRY CRAWFORD;
REPRESENTATIVE KURT OLSON; REPRESENTATIVE JAY RAMRAS; MIKE BURNS,
Chief Executive Officer, Alaska Permanent Fund Corporation,
Department of Revenue; MICHAEL O'LEARY, CFA, Executive Vice
President, Callan Associates; DR. JERRY MITCHELL, Member, Permanent
Fund's investment advisory council and former, Chief Investment
Officer, The Massachusetts Pension Fund;
Attending via Teleconference: There were no teleconference
participants.
SUMMARY INFORMATION
Presentation by the Alaska Permanent Fund Board and Advisors
10:07:55 AM
MIKE BURNS, Chief Executive Officer, Alaska Permanent Fund
Corporation, Department of Revenue, introduced the members of the
Alaska Permanent Fund Board of Trustees and consultants present at
this meeting and gave detailed backgrounds of the consultants'
accomplishments.
10:10:22 AM
MICHAEL O'LEARY, CFA, Executive Vice President, Callan Associates,
gave a presentation titled, "Alaska Permanent Fund Corporation,
2005 Capital Market Outlook" [copy on file] and reviewed events in
the financial market of the past few years.
Page 2
After a Slow Start, Capital Markets Enjoy Second Straight Year
in the Black
[Chart showing rates of returns for the years 1999 through
2004 and the five-year average annual rate of return for the
years 2000 through 2004 for the following several funds.]
Mr. O'Leary outlined the types of stocks included in the funds.
Mr. O'Leary called attention to the five-year annual rates of
return pointing out that this no longer includes the bull market
that concluded in 1999. The five-year average includes the bear
market years of 2001 and 2002, although fortunately good returns
were realized in 2003 and 2004. He stressed the strong performance
of bonds and small cap stocks. The inflation rate over this five-
year period was approximately 7.7 percent.
10:13:24 AM
Page 3
The Current Economic Environment
Steady Growth But Unsteady Sentiment
· U.S. economy all of a sudden looked hot in 2004, but the
expansion has been underway for several years, and growth
has actually continued at an orderly, if unspectacular
pace.
· Jobs data finally turned around, and unemployment finally
fell below 6%.
· Business spending was weak until recently, as many
industries are still plagued with overcapacity.
· Inflation remains a low level threat, despite what we
read in the headlines. Absent oil price pressures, core
rate is around 2%.
· Interest rates are still extraordinarily low:
o Treasury bonds yields are not that far from their
40-year lows.
o Fed policy still seems to work, at least on
consumers…
· Consumers have been tireless, and the federal government
has been spending to boost the economy and for the war in
Iraq. However…
Mr. O'Leary stressed that the advisors at Callan and Associates are
not economists and this information reflects the organization's
perspective of the economy and the future economy. This information
is utilized to demonstrate how the organization develops
perspectives and determines the range of risks and how those risks
change.
Mr. O'Leary relayed that the advisors at Callan and Associates are
in consensus that the economy had recovered by 2004, and would have
solid growth in 2005. There is no reason this would not continue
into 2006.
Mr. O'Leary informed that recovery to date has been led by the
consumer and that a large "driver" has been the decline in interest
rates, which has supported the housing sector and allowed consumers
to refinance and augment income to maintain spending. This has been
beneficial in sustaining the economy through the recession and into
recovery.
Page 4
Leadership Passes from Consumers to Businesses
· With interest rates rising and tax cuts finished, the
consumer spending boom is over. Moderate gains in
employment and income will drive consumer spending.
· Housing markets have peaked by remain strong.
· Business equipment investment is surging in response to
strong profits, growing markets, and technological
advances.
· Nonresidential construction is beginning to slow
recovery, restrained by excess capacity.
· Budget pressures on state and local government are easing
as tax revenues rise, but federal stimulus is ending.
· Exports are rebounding in response to the dollar's
depreciation and renewed growth in foreign markets.
· Outlook for 2005 is "good by not great".
Mr. O'Leary commented that the "baton" must now be passed to
business investment to continue to grow the economy.
10:15:56 AM
Page 5
The U.S. Expansion is Strengthening
2004 Saw Best Growth Since the Late 1990s
[Bar graph showing Real GDP, annual percent change for the
years 1990 through 2004.
Mr. O'Leary stated that economic expansion was over four percent in
"real terms", which "by any standard is a good year". Growth is
expected to continue at a slower rate this year, but still above
the economy's long-term trend.
10:16:32 AM
Page 6
U.S. Economic Growth by Sector
[Spreadsheet listing annual percent changes, and "direction of
change" of several sectors for the years 2002, 2003 and 2004.]
Mr. O'Leary detailed that consumption would be moderate,
residential investment would remain positive and grow, although the
rate of growth would slow. Business fixed investment had "only last
year really picked up" and would continue to grow.
Mr. O'Leary continued that the federal government activity would be
"less of a stimulative factor" than in the past due to the need for
"decremental fiscal stimulus". State and local governments "don't
feel flush", however, revenue is "improving" and is expected to
continue to improve. Some assistance is expected from an increase
in the rate of spending by state and local governments.
Mr. O'Leary next stated that the export sector activities are
"attractive" in that the percent increase in exports the previous
year was "meaningful". Hopefully, continued export growth would
occur, particularly with the dollar "weakness" making the dollar
more "competitive." This would assist in diminishing, but not
closing, the trade deficit. Simultaneously, import growth is
expected to decelerate. Much of the spike in import growth is
attributable to higher energy prices.
10:19:25 AM
Page 7
Employment Slowly Recovers
December 2004 employment remains 240,000 below its March 2001
peak.
[Bar graph showing annual percent change in payroll employment
for the years 1998 through 2004.]
Mr. O'Leary explained this graph supports the projections made on
the previous page. Employment growth has been "disappointing coming
out of the recession" but has begun to "get on track" in 2004.
Expectation is for continued growth.
10:19:56 AM
Page 8
Industrial Production is Rebounding
Capital Spending Follows GDP
[Graph showing quarter percent changes of Real GDP, Equipment
spending, and High Tech, for the years 1990 through 2004.]
Mr. O'Leary stated this graph demonstrates a sharp decline in
spending for high tech and equipment. This was core of the
recession. An increase occurred in 2004 for these areas and is
expected to continue.
10:20:34 AM
Page 9
A Third Good Year for Corporate Profits
[Bar graph showing percent changes for Profits with IVA & CCA
for the years 1990 through 2004.]
Mr. O'Leary expressed that profit growth has been "tremendous", and
that remarkable changes in the economy are the result of
improvement in corporate financial conditions. Corporations have
"plenty of cash" or "liquidity" and subsequently have the ability
to fund capital expenditures, increase dividends, and buy back
stock if advantageous.
10:21:30 AM
Page 10
Productivity Growth Has Boosted Corporate Profits, But Not
Wages
[Graph showing percent of GDP of Wages and Salaries, and
Economic Profits for the years 1999 through 2004.]
Mr. O'Leary noted this graph shows the growing discrepancy between
profits and wages and salaries. Wages and salaries "have not
participated" in the recovery. As unemployment rates have been
reduced and are expected to decline further, wages and salaries
should "begin to pick up". Also, corporate profit margins would
continue to improve. This is a normal cyclical pattern.
Page 11
The Consumer Is Stretched
· Household net worth has recovered from its 200-02 drop,
thanks to rising home prices and the last two years'
stock market rally. However, a low saving rate is
limiting asset accumulation.
· Federal tax cuts have boosted disposable income growth
for three years. Now tax burdens are likely to rise.
· Debt service burdens and the household financial
obligations ratio peaked in late 2001. But rising
interest rates will forestall further improvement.
· Net result will be a slowdown, but not a retreat.
· Rising employment and income will drive the next phase of
the expansion in consumer spending.
· Credit card delinquencies will decrease slightly as the
job market improves.
Mr. O'Leary reiterated that it is expected that consumer activities
would be less of a factor in "taking the economy forward". This is
because the consumer is "pretty leveraged," primarily through home
ownership. Given the sharp increases in the price of homes across
the country there is concern regarding a "housing bubble."
10:23:25 AM
Page 12
Home Prices Have Risen Sharply…Although Low Interest Rates
Mean That Homes Are Still "Affordable"
A higher index means homes are more affordable.
[Graph showing the Affordability Index for Existing Single-
Family Homes for the years 1972 through 2004.]
Mr. O'Leary noted that although home prices have "absolutely
increased at a very significant rate," the impact has been
moderated by the decline in interest rates, so that homes are
"essentially as affordable today as they were four years ago-five
years ago." He acknowledged that individual markets have home
values "out of sync" and could experience a decline, but this is
not a generalized condition.
Page 13
Inflation's (Temporary) Resurgence
· Soaring energy costs, dollar depreciation, a synchronized
(if modest) global expansion, and lean inventories have
revived inflation.
· Global commodity prices also reached peaks at times in
2004.
· Consumer prices surged at a 4.1% annual rate in the first
seven months of 2004, while core inflation reached 2.4%.
For the full year, inflation was closer to 3%.
· Despite the headlines, this recent burst of inflation is
temporary.
· Slack labor markets and rising productivity will keep
unit labor cost increases in the 2% range.
· Oil prices in the $40s (or the $50s) don't mean the same
now as in the early 1980s.
· Supply responses will eventually bring down energy
prices.
· Bottom line: core inflation will settle in the 2.0-2.5%
range after 2004.
Mr. O'Leary stated the inflation outlook is important.
10:24:16 AM
Page 14
Inflation Has Ticked Up…
Year-Over-Year Change in Consumer Prices
[Graph showing the percent change of CPI All Urban Cons, and
CPI-Core for the years 2001 through 2004.]
Mr. O'Leary informed that inflation accelerated significantly and
has increased substantially from the prior year. This is primarily
the result of commodity spikes, especially energy. Core inflation
increased at a rate of 2.2 percent.
10:24:58 AM
Page 15
…But Headline Fears Are Overblown
Year-Over-Year Change in Consumer Prices
[Graph showing aforementioned detail for the years 1980
through 2004.]
Mr. O'Leary demonstrated that in a historic context, inflation is
currently at a low level. The expectation for the next five years
predicts the CPI would increase at an approximate 2.6 percent rate
annually. That is unchanged from the consultant's estimates for the
past three to four years.
10:25:35 AM
Page 16
The Fed is Moving Toward Neutral
Interest Rate Increases Should Stay Gradual
[Graph showing the percents for Federal Funds Rate and 10-Year
Treasury Bond Yield for the years 1994 through 2004.]
Mr. O'Leary stated this graph demonstrates how the federal fund
rate has changed. Short term interest rates have been "incredibly
low" The "fed and others were very concerned about the possibility
of deflation a couple years ago and pumped in massive liquidity and
took us to a position where short term interest rates in that one-
percent range were actually negative real interest rates." He
explained that if it were possible to buy the CPI, money could be
borrowed at an interest rate of one-percent and the purchaser would
receive a two percent return. He ascertained that the "fed" is
"mindful of the long term concern about inflation, but over time
short term interest rates have tended to be pretty close to the
rate of inflation, maybe plus a little."
10:27:22 AM
Mr. O'Leary remarked that ten year treasury yields have actually
"not moved at all." The expectation is that interest rates would
rise as expansion continues, but would not reach the eight to nine
percent annual rate of a decade prior.
10:28:03 AM
Page 20
2005 Capital Market Preview:
Keeping Those Expectations Low
· The economic recovery will continue, but growth will
remain modest. Capital spending will ultimately follow
GDP.
· Fed has already shifted to tightening monetary policy.
· The stock market recovery will be slow. Profits cannot
outpace GDP, share prices cannot outpace earnings.
· Callan's outlook in a nutshell: expect a low inflation,
low interest rate, low return environment.
· Low return expectations mean 8% nominal return
assumptions may be difficult to achieve. Callan's 2005
assumptions won't likely generate an expected return for
a 60% stock/40% bond allocation greater than 7.4 % over
the next five years. To the extent possible, investors
may need to shift their focus to real return
expectations.
Mr. O'Leary reminded that after the presentation to the Committee
the prior year, the Members knew the projections would not change
this year. The consultant has not changed projections in any
significant for several years. He added that low equity is also
expected over the long term.
10:30:57 AM
Page 21
Domestic Equity vs. Bond Yields
[Graph showing percentages of S&P 500 Earnings Yield vs. 10-
Year Treasury Yield for the years 1981 through 2004 and graph
showing Ratio of S&P 500 Earnings Yield and 10-Year Treasury
Yield for the same time period.]
Mr. O'Leary referenced the "fed model for valuation". This graph is
an attempt to demonstrate the same information. The earnings yield
is the "reciprocal of the PE ratio". Since the year 1981, those
instances when the earnings yield of the S&P 500 was close to the
ten-year treasury suggested that the stocks reasonably valued. In
the last five years, the combination of declining stock prices and
declining interest rates resulted in the earnings yield above the
income yield of the ten-year treasury. He cautioned of the
situation of the 1950s in which dividend yield on stocks exceeded
the income yield on treasury obligations. The valuation of the
stock market despite the two-year recovery, is not excessive
provided the anticipated "decent earnings growth going forward."
Page 22
Bond Market Faces a Challenging Environment
· With inflation in check, investors poured money into
bonds following the bursting of the stock market bubble,
driving prices up and yields to 40-year lows.
· Corporate (and particularly high yield) spreads widened
through 2002, then staged a remarkable comeback in 2003
and 2004.
· Long-term secular decline in inflation since early 80s
fueled bond market returns that may not be seen again for
a long time.
· Looking forward, current yields and expectations for
inflation and interest rates drive expected future
returns. With low current yields and the potential for
rising interest rates as the economy expands, prospects
for future bond market gains may have faded. The best
case for bonds is a faltering economy.
10:33:12 AM
Page 23
Domestic Fixed Income
Lehman Aggregate Index - Daily Yield to Worst from 1/1/01 to
12/31/04
[Graph showing Yield to Maturity percentages of every month
from January 2001 through December 2004]
Mr. O'Leary outlined highlighted dates of the end of each year on
the graph. This demonstrates that the overall rate has not
fundamentally changed, despite significant volatility. The current
yield on the bond market is a "very good naive" predictor of future
returns.
10:34:49 AM
Representative Croft commented that the graphs indicate an
optimistic future and asked if this is because stocks are
undervalued.
Mr. O'Leary replied that the relative valuation difference could
change by increased interest rates, by increased stock prices with
interest rates the same, or earnings collapsing, in which case the
earnings yield would decline.
Representative Croft asked if this occurred in the 1960s or 1970s.
Mr. O'Leary replied that the world has changed since the 1950s.
During that time the dividend yield on stocks was higher than the
income yield on treasuries. Some analysts say the 1980s were an
aberration. A relationship has always existed between interest
rates and price-to-earnings ratios. If interest rates are high,
price earnings ratios would be low.
Representative Croft surmised that the portfolio balance between
fixed income and stock should have more investment in stock.
Mr. O'Leary agreed that according to the information presented this
would be a reasonable conclusion.
10:37:39 AM
Senator Bunde noted that a nominal return rate of eight percent has
been conventional wisdom. He asked if the information on Page 20
indicates that expectation has changed.
Mr. O'Leary responded that the Permanent Fund expected return the
prior year was 7.6 percent. The eight-percent figure is derived
from an assumption of five percent real return and three percent
inflation. The real return expectation has not changed, although
the inflation rate has changed.
10:38:42 AM
Page 25
2005 Capital Market Projections
[Spreadsheet listing Summary of 5-Year Capital Market
Projections (2005-2009) by asset class.]
Mr. O'Leary stated this graph indicates the projected annual return
for each asset category, and also provides the projection of the
previous year. He reminded that the consultant never makes a
specific point projection, rather projects a range of returns. He
detailed line items on the spreadsheet to demonstrate this. Stocks,
over the long term, have tended to return 5.5 to seven percent in
real returns. Last year stocks actually returned approximately 11
percent, which reflects the projections. Bonds and real estate have
remained relatively unchanged. However, because bond returns are so
low, investors are "looking to other things" to attempt to improve
their overall fund return without "ratcheting up" the equity
exposure further, due to concern about volatility.
Mr. O'Leary informed that equity exposure of 60 plus percent range
for major public funds, such as pension funds, is typical. Fixed
income exposure is comprised at approximately 25 percent and
pension funds are making use of nontraditional investment
approaches, including absolute return strategies, farmland, timber,
and other resource exposure.
DR. JERRY MITCHELL, Member, Permanent Fund's investment advisory
council and former, Chief Investment Officer, The Massachusetts
Pension Fund, referenced a handout titled, ""Asset allocation of
the Massachusetts Pension Reserves Investment Trust Fund" [copy on
file.] He compared the Massachusetts Pension Fund to the Alaska
Permanent Fund. Both funds have the same challenges to determine
what asset classes to make investments to achieve the best possible
return at the most acceptable level of risk. The Alaska Permanent
Fund has a balance of approximately $30 billion and the
Massachusetts Pension Reserves Investment Trust (PRIT) Fund has a
balance of approximately $36 billion.
Dr. Mitchell joined the PRIT in the year 2001 with the mandate from
"a very supportive" board and "active" investment advisory
committee was to increase the number of asset classes the fund was
invested in. This mandate was given because the board intended to
reduce the volatility of the fund and ensure that those asset
classes that could provide a higher return than the ordinary stock
market or bond market, had participation. In 1990, the PRIT had
five asset classes, which did not change significantly until a
sixth asset class was added in the year 2000. At the end of 2004,
the PRIT was invested in ten asset classes.
10:45:46 AM
What has the PRIT Fund done?
1. Increased asset classes from 5 to 10.
2. Increased sub-asset classes to 15.
3. Increased less liquid investments.
4. Increased non-correlation of asset classes.
5. Est. return 8.3 %, est. risk 11.5 %
Dr. Mitchell outlined the first two items on this list. The sub-
asset class includes large capitalization equities and small
capitalization equities; distressed debt, regular and below
investment grade US bonds and emerging country bonds for high yield
bonds. The PRIT also emphasized less liquid investments because the
theory and practitioners results suggested that willingness to
accept a less liquid investment should receive a higher rate of
return. An institution or individual who required access to money
immediately would not invest in this manner; however, large funds
similar to the Alaska Permanent Fund and the Massachusetts pension
fund could afford to make these less liquid investments.
Dr. Mitchell stated that when the PRIT increased asset and sub-
asset classes, it also increased the non-correlation of asset
classes. Different aspects of the economy affected the earnings of
different investments. The intention was that as one type of
investment was rising, another would rise more slowly and avoid the
shocks experienced if all investments were made in US stocks or
bonds.
10:48:04 AM
Dr. Mitchell spoke to the estimated return and estimated risk. That
is utilizing estimates similar to those described by Mr. O'Leary.
The 8.3 percent return was established due to the actuarial
assumption of 8.25 percent.
Dr. Mitchell stated that diversification is beneficial because the
asset class that would be the best performer is unknown. Therefore
multiple asset classes provide greater protection against
volatility.
Dr. Mitchell exampled less liquid investments as timber, venture
capital and leveraged buyout partnerships. Less liquid assets
provide a bonus because they could not be sold for a period of
time.
Goals
1. Meet 8 1/4 percent actuarial return target.
2. Reduce risk by increasing non-correlation.
3. Continue to diversify.
4. Benefit from less liquid, higher return asset classes.
5. Use indexing in public markets where appropriate.
Dr. Mitchell in certain asset classes, such as large capitalization
of US stocks, it is difficult for active managers to "beat the
index" It could be done, but those managers are difficult to locate
and employ. For these asset classes, the PRIT determined that
instead of focusing on securing such a manager, it would index 80
percent of that allocation with two active managers "running 20
percent."
Dr. Mitchell compared this to the finding that with small
capitalization and emerging market international stocks, active
managers could regularly outperform the index. As a result, the
PRIT is 100 percent active in its emerging markets investments and
80 percent active in small capitalization US stocks.
Dr. Mitchell characterized the use of an index to that of a club to
provide incentive to managers to work harder. Active managers would
be threatened with the possibility that the funds could be removed
from their oversight.
10:51:50 AM
Senator Stedman asked if the Massachusetts pension plan has an
"asset liability mismatch".
Dr. Mitchell replied that the Massachusetts plan is a defined
benefit plan that is approximately 70 percent funded.
Senator Stedman asked if the plan has a target of 100 percent.
Dr. Mitchell answered it does, although it is uncertain whether it
could be achieved.
Senator Stedman asked if efforts are made to protect the PRIT from
this mismatch or if a total rate of return is anticipated to solve
the total liability issue.
Dr. Mitchell qualified that the Massachusetts fund is unusual in
that the management of the asset is overseen by a separate
governmental entity that the entity that oversees payout of
benefits. He was involved with the entity to manage the funds, with
the directive to manage the funds in the best manner possible.
Senator Stedman asked which entity establishes the 8.25 percent
target.
Dr. Mitchell responded that the benefit payout agency establishes
this with the assistance of an actuarial consultant.
Senator Stedman clarified that the PRIT does not submit its
projections to the benefit payout agency for review.
Dr. Mitchell answered, "no", an independent board controls asset
allocation. The actuary report is consulted and the funding status
of the plan is considered.
Senator Stedman asked if the asset liability mismatch has always
existed.
Dr. Mitchell replied it has and informed that when the PRIT was
founded, the funding level was approximately 20 percent. The
Massachusetts Legislature separated the investment and benefit
payout entities to insulate the investment management from the
pressures of previous administrations.
Senator Stedman asked if a risk tolerance change, or risk premium
adjustment, has occurred since the 1999 market "crash".
Mr. O'Leary replied that investors did not obtain the equity
premium anticipated. Callan expectations of premium return for
equities have remained at 5.5 to seven percent real return, which
has been the long-term record.
Senator Stedman restated his question, asking if in 1999 investors
were "more on the top end of the range and today they're more at
the low end of the range."
Mr. O'Leary answered, "Undoubtedly yes" because the public
expectation of future returns for the equity market was "double
digit" of 15 to 17 percent. Four percent inflation added to 6.5
percent real return provides 10.5 percent return. Callan has
consistently anticipated the "lower end". At this time last year,
"we were a roaring bull compared to what others were saying, when
in fact, the assumption was essentially were it had been." The
style of Callan forecasts have been to change little from year to
year; others may change their forecasts more, possibly by reviewing
a different timeframe.
Mr. O'Leary furthered on the question Senator Stedman posed to Dr.
Mitchell regarding public entities. The experience of Callan has
been that the discount rate used on the pension "side" in the
public sector has been eight percent on average and has not changed
significantly. The funded status of public pension funds changed
from essentially fully funded status to becoming significantly
underfunded for three primary reasons. The first being some
combination of benefit enhancements and or contribution reductions
because the funds had been well funded. The second reason was the
unrealized decline that the expected earnings return for three
years during the bear market provided negative returns rather than
positive returns of eight or more percent. Over three years, this
results in a 24 percent difference in earnings. The third factor is
the decline in interest rates. When the value of future benefits is
discounted utilizing a lower interest rate, the liabilities are
larger. Higher interest rates would improve the funding status. The
only method to achieve higher liability matching is high quality
fixed investments; however, these provide significantly lower
returns and result in higher costs.
Senator Stedman commented that it is difficult therefore to match
unfunded liabilities. He surmised the current historic low yields
would further hamper this effort. He posed a question of whether
the overall policy for risk control should be reviewed
periodically.
Mr. O'Leary affirmed the policy should be reviewed. The findings
would vary for different systems dependant upon the inflation
sensitivity of each system. A system containing health care
benefits as a significant portion of liabilities would be more
sensitive to inflation.
Senator Stedman then spoke to the present historical years and
lower expectations for equities of approximately 7.4 percent over
the next five years. He noted that the Permanent Fund has no
unfunded liability, but rather a requirement to pay dividends in
the event of realized gains.
Mr. O'Leary stated the Permanent Fund has a real return target of
five percent. He explained that a actuarial advisement of an eight
percent return for a pension fund includes an inflation expectation
of 3.5 to four percent over 40 years. Therefore a typical public
pension fund has a goal of a greater than 4.5 percent real rate of
return. The Permanent Fund consistency of year-to-year return is
important given the constitutional provisions stipulating that in
the event of significant volatility, the ability to provide
distribution is eliminated.
Senator Stedman asked if the real return expectations have changed
significantly since 1999.
Mr. O'Leary answered they have not. He noted that the current
policy governing the Permanent Fund target allocation produces an
expected real return of five percent. This amount has varied by
tenths of percents from one year to another.
Senator Stedman expressed concern with the unfunded pension
liability of the Public Employees Retirement System (PERS) and the
Teachers Retirement System (TRS) and the target rate of 8.25
percent established in 1998 or 1999. Since that time, changes have
occurred in the economy and the market rate. If that rate were
reduced the liability would increase. He questioned whether this
rate should be reviewed.
Mr. O'Leary remarked that the discount rate would be utilized as a
portion of the actuarial set of assumptions through discussions
with the actuary and the PERS and TRS boards of directors. He
stressed the importance that the set of assumptions be balanced.
Senator Stedman learned from discussions with Mercer Consulting,
the actuary for the PERS and TRS plans, that the 8.25 percent rate
was not achieved from review of historical market projections, but
rather from asset allocation information provided by the Alaska
State Pension Investment Board (ASPIB). Mercer Consulting did not
independently set the discount rate.
Mr. O'Leary noted that ASPIB determines an expected rate of return
target when setting investment policy with a shorter time rise.
That shorter time rise target is significantly based on the
information provided by Callan and Associates. The ASPIB asset
allocation is somewhat more aggressive than that of the Permanent
Fund in terms of equity commitment.
11:07:36 AM
Co-Chair Wilken commented this is the seventh presentation he has
attended from Callan and Associates.
Page 18
Surplus Reverts to a Massive Federal Budget Deficit
[Bar graph showing Federal and State & Local surplus and
deficits for the years 1990 through 2010.]
Page 19
The U.S. Current Account Deficit: Over $600 Billion as Far as
the Eye Can See
[Bar graph showing Current Account Deficit and line graph
showing Deficit as % of GDP for the years 1980 through 2008.]
Co-Chair Wilken asked about the notations reading "*2005+ forecast
- Global Insight" on these graphs, specifically the meaning of
global insight.
Mr. O'Leary replied that Global Insight is a business entity that
provided the projections used to demonstrate future years on the
graphs.
Co-Chair Wilken announced a proposal for a long-term fiscal plan.
He asked the Permanent Fund trustees and legislators to review a
handout titled, "Senate Bill 88, A Bridge to Development, A Policy
on General Fund Revenue Shortfall, February 15, 2005" [copy on
file]. He requested critique of this proposal and offered to give a
presentation to the trustees. He expressed, "This is the start of a
long road" and added, "This group here is the group that would set
the course for a long term fiscal plan, whatever that happens to
be."
Representative Stoltze appreciated the presentation. He asked the
expectation from the trustees of the legislature now that the
committees had received this knowledge.
Mr. Burns responded that the Corporation would give a presentation
specifically related to the statutory investment list is "doing"
either to help or impede the Funds progress in providing the
expected returns. The Corporation intended to propose legislation
to amend the statutory investment list. The same returns could be
achieved at less risk, or higher returns could be realized with the
same level of risk if the Corporation were not encumbered by the
current statutory investment list.
11:12:17 AM
Co-Chair Wilken remarked that the Senate Finance Committee has
never denied a request of trustees for legislation to amend Fund
management procedures. He attributed this to the expertise of the
trustees. He asked if removal of allocation restrictions could be
implemented over a period of time of possibly five years.
11:12:53 AM
Representative Hawker clarified that Mr. Burns testified that the
same level of return could be achieved with less risk.
Mr. Burns replied that statistics indicate this is possible.
11:13:33 AM
Senator Stedman used an assumption that the allocation the defined
benefit plan is operating has greater stock exposure and subsequent
wider dispersion than the Permanent Fund. However, he held a "lower
risk tolerance" for the benefit plan fund than he held for the
Permanent Fund. The Permanent Fund would grow in perpetuity and
provide dividends in amounts possible, but the pension plan is
required to provide payments.
Mr. O'Leary opined that in "a comparative sense" the ASPIB risk
tolerance has been more conservative than the typical public
pension fund. However, the Permanent Fund has been "much more
conservative". He noted that 30 percent of assets of other major
endowments of over $1 billion are allocated to investments the
Permanent Fund is prohibited from participating in, with the
exception of the basket provision. The Permanent Fund may actually
be "sub-optimizing" return that could be produced over the long
term. If the current rate of return is desired, the volatility
could be reduced if the statutory investment list were changed.
Also, it could be determined that the current level of risk were
acceptable, the portfolio altered and the Fund could achieve a
higher expected rate of return. The ability to maintain a higher
return policy in the event of a year or two in which the earnings
reserve fund was insufficient to provide any distribution. This
nearly occurred a couple years prior.
ADJOURNMENT
Co-Chair Green adjourned the meeting at 11:17 AM
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