Legislature(2003 - 2004)
10/30/2003 07:07 PM Senate JUD
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ALASKA STATE LEGISLATURE
SENATE JUDICIARY STANDING COMMITTEE
ANCHORAGE LIO
October 30, 2003
7:07 p.m.
MEMBERS PRESENT
Senator Ralph Seekins, Chair
Senator Scott Ogan, Vice Chair
Senator Hollis French
MEMBERS ABSENT
Senator Gene Therriault
Senator Johnny Ellis
OTHER LEGISLATORS PRESENT
Senator John Cowdery
Representative Mike Hawker
COMMITTEE CALENDAR
SENATE JOINT RESOLUTION NO. 18
Proposing amendments to the Constitution of the State of Alaska
relating to limiting appropriations from and inflation-proofing
the Alaska permanent fund by establishing a percent of market
value spending limit.
HEARD AND HELD
SENATE JOINT RESOLUTION NO. 19
Proposing amendments to the Constitution of the State of Alaska
relating to the Alaska permanent fund.
HEARD AND HELD
PREVIOUS ACTION
SJR 18 - See State Affairs minutes dated 5/1/03 and 5/6/03 and
Judiciary minutes dated 5/15/03, 6/26/03, 10/28/03, and
10/29/03
SJR 19 - See State Affairs minutes dated 5/13/03 and Judiciary
minutes dated 5/17/03, 6/26/03, 10/28/03, and 10/29/03
WITNESS REGISTER
John Kiernan
No address provided
POSITION STATEMENT: Testified on SJR 18 and SJR 19
Sharman Haley
No address provided
POSITION STATEMENT: Posed questions on POMV
ACTION NARRATIVE
TAPE 03-59, SIDE A
SJR 18-CONST. AM: PF APPROPS/INFLATION-PROOFING
SJR 19-CONST. AM: PERMANENT FUND INCOME
CHAIR RALPH SEEKINS called the Senate Judiciary Standing
Committee meeting to order at 7:07 p.m. Judiciary members
present were Senators French, Ogan and Seekins. Senator Cowdery
and Representative Hawker were also present.
He recognized John Kiernan who was present to testify and
informed him that Mr. Bob Storer from the Alaska Permanent Fund
Corporation would give an overview of the POMV (Percent of
Market Value).
BOB STORER from the Alaska Corporation (APFC) Board of Trustees
explained that both SJR 18 and HJR 26 propose a constitutional
amendment, which they refer to as "the 5 percent solution."
Multiple boards have determined that this is a superior way of
insuring that all generations benefit equally from the permanent
fund.
He referred to the slides on page two of the PowerPoint
presentation to show the four year change in the realized income
account and the reserved account, which includes principal and
unrealized gains. He pointed out that the principal is protected
in the constitution and cannot be touched without a vote of the
people. In contrast, realized income, which is actualized profit
from the sale of an asset and interest from bonds and dividends
income, may be appropriated.
He explained POMV is a formula that limits the spending of the
fund and is based on the total market value of the fund. They
suggest setting a percentage that is based on the expected
difference between the total investment return and the rate of
inflation. The Legislature has always appropriated the impact of
inflation into the fund principal and the payout is the excess
return. The board maintains there is a superior method, which
would be to limit the amount that can be appropriated in any
given time to the real or excess earnings of the fund and the
affects of inflation would remain in the fund.
Historically, inflation has been three percent and over time
they believe they are able to earn about eight percent so a five
percent appropriation is reasonable and what they are suggesting
for appropriation. Justification for this change may be found in
looking at data from the last ten years because it shows returns
during the bull market as well as the recent results when the
market performed poorly. Over the previous wildly fluctuating
ten year period, the fund earned 7.8 percent and inflation was
just 2.5 percent, which made it possible to achieve a real
return of 5.3 percent. Looking forward, they believe they can
continue to do the same.
He then referred to the slide showing the asset allocation
shift. In the late 1970s and early 1980s, the fund was invested
exclusively in fixed income instruments and most income was
realized from cash flow. As the fund matured, emphasis shifted
from income producing assets to asset appreciation to produce
income. Recognizing contemporary investment standards, they
believe a superior methodology would be to limit the payout of
the total market value of the fund, which would also capture the
appreciation of equities.
POMV would provide for a permissible legislative payout from the
permanent fund in each year of five percent of market value,
averaged over a five year period. Under the current scenario,
actual earned income from the fund is available for legislative
appropriation. The Board of Trustees supports a solution that is
up to five percent of market value. They believe that will
conserve the fund for future generations and maintain the
ability to pay out monies for current generations.
POMV protects the fund by eliminating the distinction between
principal and earnings. With regard to the concern that there
could be an invasion of principal, he pointed out that four
years ago about 25 percent of the fund was earnings that could
have been appropriated. If that amount had been appropriated,
there would have been nothing available for payout. This limit
imposes discipline so there wouldn't be overspending in a bull
market, which he believes to be critically important in
protecting principal.
He explained the chart on current formula payouts for 1998, 2000
and 2003 takes the total realized income for the last five years
multiplies it by .21 percent and divides by two. Applying the
current formula out to 2005 and using a mid-case scenario, there
would be less available for the dividend and not enough to meet
inflation proofing.
In comparison, the POMV simply takes the market value of the
fund at the end of five years, average the five years and take
five percent. He referred to the chart to show that there is
less volatility using this formula.
He then explained the chart showing realized income versus
market value. In 1996, realized income increased by 80 percent,
but it dropped by that same amount in 2001 and 2002 showing the
volatility in the current formula. Predictability and stability
of payout is important and the current formula shows higher
volatility. He emphasized this by reminding members that the
board repeatedly warned of the possibility of no payout earlier
in the year.
People sometimes ask which method would have the greater payout
over time and they say that ultimately, it's the same, but POMV
smoothes the payouts to higher lows and lower highs. In
addition, POMV eliminates any question that the asset
allocations are based on anything other than investment
management decisions. Under the current method, actions will
affect the dividend.
JOHN KIERNAN testified as a private citizen and noted that
several years ago 83 percent of the Alaskans that voted
indicated they did not want the dividend touched and now the
Legislature is going after the permanent fund itself. He said:
When we have BP taking 65 percent of the profits of
oil, the federal government gets 35 percent
corporation tax, Alaska gets about 3 percent and with
what the federal government gets it makes up 35
percent and then the other 65 percent of the profits
go to BP - of oil. And oil is the big money in this
state. We fought the war of 1776.... to get the
British out of America, but they're taking our money
in oil money out of here, to London. So okay, I can
invest in BP and share some of that profit, that's
great, but I understand from a letter I've gotten hold
of... that says 'At statehood a major portion of our
private property mineral rights were negotiated away.
We property owners were told that the state would
manage our mineral rights for the benefit of all. We
would receive a dividend, much like a stock dividend
to compensate us for the loss of this significant
right.' She then says, 'Hands off my dividend!' among
other things. She says, 'Now unrestrained state
spending threatens the dividend and the proposed,
highly promoted, POMV is not the answer. Alaska spends
more than twice as much as any other state per
person." If that be the case, you guys know more about
that than I do and I can only take from what she has
written here and this was in the Alaska Digest Email
News on 10/23/03, which was just a few days ago. If
that is the case, then the state has committed itself
to taking care of those mineral rights and paying a
dividend to the public. Okay, we have a permanent fund
that does that, but what the public are concerned
about is that they said no, don't touch the dividend,
but now they're looking at going after the fund
itself. Five percent of the fund sounds okay, but if
the fund is not earning money at all. If we hit a real
depression, and do we still continue to pay out five
percent of the fund even in a really depressing
situation? That would cause the fund to disappear if
the depression lasted a long time. I agree five
percent, five into 100 is 20 years, but okay, in rough
calculations it would take a long time for it to
disappear.
Okay, then I read another problem. Why is Alaska being
ripped off? Most oil exporting countries go to great
lengths to keep their tax policies secret. However, a
great deal of information about OPEC member Nigeria's
oil tax policy can be found at a certain email address
which I've got written down here. Doing business in
Nigeria, when you reach the page, do a word search and
find petroleum profits tax is payable at the tax rate
of 85 percent for all companies. And 85 percent rate
is the norm for all OPEC countries.... [They] all pay
those taxes. A complete list of companies that pay
those taxes can be found at another email address. If
85 percent does not stop major oil company involvement
in Nigeria, what is our Governor or our Legislature
doing about our pitiful, miniscule tax rates here in
Alaska? Why are we giving away our resource wealth,
but are attempting to raid the permanent fund
dividend.
It's not a bad solution to our financial dilemma, but
it's not going to help the people, this taking away
the permanent fund from the people. The oil companies
should be paying more in taxes than just three percent
to Alaska and five percent to the federal government
and then walking away with 65 percent. That's my
thinking.
I hear you in that you say that the five percent would
be a steady form of income. And then how expensive
would be another matter, but it would be a steady form
of income and even in bad times it would take it over
20 years for the fund to be wiped out completely.
Usually bad times only last about a year and then
we're back to the good times again. So I see your
point, it's possibly a good thing to do. But you have
to sell it to the people and yes, that 83 percent said
no, don't touch the dividend so you've got to sell it
to the people.
I would say that if the people saw that their
dividends were going to continue and if all the oil
revenue was put into the fund for investment, not just
put into state coffers for spending, but all of the
oil revenue and all of the revenue from everywhere was
put into the fund for investment and then only payout
five percent, you might convince some people then. But
[not] to just take five percent of the fund and add it
to the general fund.
SENATOR COWDERY noted that when he homesteaded in 1954 it was
clear that he didn't have any subsurface rights and he had no
problem with that.
He recalled that the first lease sale was about $900 million and
royalty rates were set at about 12.5 percent. He asked Mr.
Kiernan how he would change the formula.
MR. KIERNAN asked about the length of the leases.
CHAIR SEEKINS said, "In perpetuity."
MR. KIERNAN expressed surprise.
CHAIR SEEKINS explained that if a company leases a piece of
property for oil extraction, they pay a royalty and harvest the
resource until it is not longer there. Their profit comes after
they have paid royalties. He pointed out the company isn't
paying just three percent; they've already paid at least 12.5
percent in royalties.
SENATOR COWDERY added that the royalty on some fields has been
as high as 50 percent.
CHAIR SEEKINS stated there was no agreement at statehood
regarding sacrificing subsurface mineral rights for a dividend.
MR. KIERNAN acknowledged that his source might be incorrect then
asked about mineral rights on leasehold property.
CHAIR SEEKINS said the agreement has already been made and it
can't be altered.
REPRESENTATIVE HAWKER noted that Section 6 of the Statehood Act
gave all of the fundamental resource wealth to Alaska. The first
line clearly delineates the purpose for which that wealth was
given, which was to develop Alaska's community infrastructure.
CHAIR SEEKINS added that the federal government held that wealth
in trust for the people of the future state.
SENATOR OGAN suggested returning the discussion to the POMV.
CHIAR SEEKINS agreed.
SENATOR COWDERY said an agreement is an agreement and the state
signed the agreement. People were very pleased when the oil
companies arrived.
SENATOR FRENCH referred to the third bullet point on the POMV
solution and noted that protecting the fund by constitutional
inflation proofing is there by implication only.
MR. STORER agreed it was there by implication.
SENATOR FRENCH said that if there were a year where the return
on the fund was five percent and the Legislature decided to
spend the five percent then there wouldn't be any inflation
proofing that year.
MR. STORER said they use the term "over time" to say that you
will succeed in earning a five year return over inflation. He
said, "You're correct, it is implied; the residual remains with
the fund."
They did a study on rolling tenures and found there was never a
ten year period in which less than five percent was earned. This
includes the recent three year bear market. Looking at shorter
time horizons there is no question there have been periods when
that goal wasn't achieved, but with the long-term discipline you
will achieve the goal he said.
SENATOR FRENCH asked what it is about the current structure of
the fund that jeopardizes future generations receiving a
dividend.
MR. STORER replied that's a good question because to date the
Legislature has appropriated for inflation proofing and at times
they have appropriated additional revenue into principal.
However, there is no way to predict whether or not that would be
the case with future Legislatures. Currently statute requires
the dividend come first followed by inflation proofing. By
memorializing this in the constitution, it has a more powerful
effect on inflation proofing and if they are correct, the
purchasing power will be maintained and all generations would
benefit equally.
SENATOR FRENCH said that since the fund moved away from a bond
strategy into equities it seems less likely that the dividend
payout would be too much under the current structure. He used
Microsoft stock as an example. It pays no dividends, but the
value of the stock has risen considerably. If the permanent fund
were to have a lot of this stock, the size of the fund would
increase, but there wouldn't be any realized earnings until the
stock was sold. Under current methodology, none of the
appreciation would be available for distribution as a dividend
or inflation proofing or any other use unless the stock was
sold.
MR. STORER said,
"You brought up an excellent point and it goes back to
another point I touched on briefly....
TAPE 03-59, SIDE B
7:52 p.m.
...is almost given away, it's one half of a percent is
what we pay for the management of that. And there is
virtually no turn over unless a stock enters or is
removed from the dividend. So what happens is, on that
portfolio, you get a dividend, but there is virtually
no change and so what would happen in that portfolio
absent activity, would be it would appreciate
theoretically. Your Microsoft keeps appreciating and
there are only paper profits, yet the value of the
fund is increasing rather dramatically. The other half
of the portfolio - we use active managers. We use
active managers to diversify the risk and you expect
them to add some incremental value above the index.
Otherwise why would you do that? Those managers are
active all the time and in fact when they buy
Microsoft their discipline actually is different....
Many of them own it, but they tend to own a limited
amount in the portfolio. When that Microsoft stock
goes up, and you've got five percent of the portfolio,
they sell. So now you've got only three percent of the
portfolio. So they're selling the profits.
The other decision that they make is they may like
Intel better than Microsoft for whatever reason so
they may sell all the Microsoft because they think
they can earn more in Intel. The problem becomes that
we have a balance. What if - I know one state whose
domestic portfolio is exclusively passive. If we did,
there would be virtually no dividend whatsoever unless
you made non-investment arbitrary decisions to harvest
the profits. Which brings the second question. What do
you do with the money? So, there are potentially
arbitrary and non-investment decisions that can come
out of these kinds of things. That's the beauty of
limiting to the value of the market value of the fund.
That way you're capturing some of that appreciation,
but no more than would be in excess of inflation. So
it eliminates the ambiguity other than it's a pure
investment decision.
CHAIR SEEKINS referred to the chart showing realized income
versus market value and asked if the change in value in 1996
resulted from a management decision or a Board of Trustees
decision because they wanted to increase the dividend payout.
MR. STORER advised he didn't participate in those discussions,
but he believes the debate stemmed from fact that assets were
increasing dramatically in the raging bull market and there was
concern that future generations would benefit from the bull
market more than the current generation. At that time the board
made the decision to take profits in the passive portfolio,
which had the effect of increasing the dividend.
CHAIR SEEKINS stated this decision was made without legislative
consultation for the purpose of increasing the dividend.
MR. STORER replied the payout would be the same ultimately, but
there was an arbitrary decision with regard to when.
SENATOR FRENCH asked if this was the permanent fund.
MR. STORER said it was. He pointed to the spike in 1996 and
advised that was during the bull market so there was profit
taking, but there was also a specific decision made by the Board
of Trustees to take profits in the passive portfolio.
SENATOR COWDERY questioned how close we came to having no
dividend.
MR. STORER said that according to their studies, there was a ten
percent chance there would be no dividend in 2003. Things
changed in the last quarter of the fiscal year and they earned
about ten percent. "But if that was the first quarter there
would have been about a ten percent probability of no dividend
under the existing formula."
SENATOR COWDERY questioned, "On the existing formulas, if it had
stayed that way for two or three more quarters before it
turned?"
MR. STORER quipped, "Another executive director would be making
this presentation."
SENATOR COWDERY asked if the fund plummeted $4 or 5 billion
during the slump.
MR. STORER said it wasn't that much, but it was dramatic. At
fiscal year end, the earnings reserve was $1.6 billion and
around mid July [2002] that money was gone. By July 24 it was
back up, but the volatility lasted for about a six month period.
That year, [2002] the fund had the worst quarter in the history
of the fund. That quarter was -7.5 percent, but for the fiscal
year the fund earned about 5.5 percent. During the latter part
of that calendar year, the value of the fund was less than the
principal about three times. That includes the unrealized
losses.
SENATOR COWDERY asked if it was correct that the dividend would
have been about the same if the POMV had been in place during
that time.
MR. STORER said that was probably accurate. The irony is that
for the next two years the dividend will probably continue to go
down under POMV.
CHAIR SEEKINS asked about inflation proofing in POMV. He said he
understands it's inherent to the strategy, but it's not
constitutionally guaranteed.
MR. STORER agreed and added there is no constitutional guarantee
inflation proofing would be exercised in any given year.
CHAIR SEEKINS said, "When it came to cutting funds for education
or cutting inflation proofing, the Legislature can decide which
of those they are going to do."
MR. STORER replied the same fundamental debates regarding
inflation proofing could exist in the future.
CHAIR SEEKINS asked about the invasion of principal question. He
remarked that he understands very well how influential the Board
of Trustees can be in determining whether or not there is a
dividend and how large it might be because they are able to
instruct management to sell or not sell. If it was politically
expedient to make sure that there was money for a dividend, the
trustees could conceivably cherry pick the fund to produce
realized income so funds could be available for distribution
even though the principal of the fund was decreased.
MR. STORER replied that fact exists every year.
CHAIR SEEKINS said, "Even today there is no real constitutional
provision that protects the principal from invasion based on
different creative strategies."
MR. STORER agreed. In investment management there are an
increasing number of ways to get from A to B.
CHAIR SEEKINS asked whether the POMV strategy would provide
better, worse or neutral protection of fund principal.
MR. STORER opined it would unequivocally make every investment
decision a pure investment management decision.
SHARMAN HALEY, an economist, asked why the projections to the
end of the decade comparing the current formula with the POMV
under the 50 50 scenario shows that in the short run the POMV
dividend is higher, but by the end of the decade, the current
formula shows a higher dividend. She questioned why they aren't
more comparable.
CHAIR SEEKINS advised the 50 50 formula is not under
consideration under the bill.
MR. STORER said the 50 50 formula is an example they have used
and the answer goes to the stability of payout issue.
"Whereas there's less volatility in market value, you
get this constant that's going to go up like that....
So over the next few years, the moving average, the
amount that's available will, under the existing
formula, will continue to drop. What happens and what
you see are extrapolations of the median case only.
What happens is that as the normalized payout goes up
then you will see more profits generated in the
realized income that compensates. We overshot in the
bull market and we're undershooting rather
significantly so we go back out. In the out years
you'll see it go above a bit and what I think is that
ultimately they smooth out and compress a bit.
There is an arbitrary issue in our projections that
you can appreciate. We have to predict realized
income. Which means we're predicting two things. We're
predicting markets and we're predicting manager
behavior to those markets. So we take historical
turnover rates in our realized assumptions, but they
are arbitrary decisions.
CHAIR SEEKINS emphasized that in considering POMV, they aren't
considering any change in the way distributions are allocated.
It is just a proposal for determining how much is available from
the fund for distribution on an annual basis.
MR. STORER added that people do care a lot about the amount of
the dividend and there is a fiscal issue. They are parallel
issues, but they exist even without the POMV. He said their
point isn't the spending issue; it's the management of the fund.
CHAIR SEEKINS said his point is to insulate from market and, in
particular, political volatility. He pointed out that board
members serve at the pleasure of the governor and legislators do
not confirm the board. When he was removed from the board, he
received a letter from the governor stating he was being removed
because it was doubtful that he would invest according to the
governor's political philosophy. He opined it is a dangerous
situation to invest according to a governor's political
philosophy and it shouldn't be a possibility. In considering
POMV, that is a valuable consideration.
Considering POMV by itself, it is an upgrade. The chart showing
how asset allocation has changed makes it clear that an
allocation and distribution upgrade is in order. The proposed
formula is used by 85 percent of the major funds so it's not new
or untried. He stated his personal position is that, "I would
trust that the decision being made on how much to take out on an
annual basis, in case of a major depression would better be made
by the 60 members of the Legislature than the six political
appointees on the Board of Trustees - having been one and now
being on the other."
CHAIR SEEKINS announced he would hold a committee meeting on
this subject during the first week of the upcoming session. If
additional meetings are needed in different areas of the state
he will hold them.
There being no further business to come before the committee,
Chair Seekins adjourned the meeting at 8:20 p.m.
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