CS FOR HOUSE BILL NO. 213(FIN)(efd fld) "An Act relating to the investment, appropriation, and administration of the public school trust fund." 3:12:54 PM REPRESENTATIVE JUSTIN PARISH, SPONSOR, introduced the legislation. He explained that the bill would help the public school trust fund to operate at the industry standard. He lamented that failure to modernize the trust had resulted in years of lost income. 3:13:45 PM AT EASE 3:14:25 PM RECONVENED 3:14:44 PM Representative Parish looked at a graph title, "CSHB 213(FIN), Public School Trust, Actual vs. POMV 6/30 Balances" (copy on file). The document contained a bar graph that provided the numbers in thousands. the POMV assumed a 70/30 equity/fixed income asset allocation from July 1, 1978 - with a 4.75 percent payout of trailing 5 year market average. He relayed that the bill would allow the use of equity growth as a form of income, which would have a higher yielded income. He remarked that the fund was dedicated to education. He thought that the bill would allow for more consistency and predictability by using the POMV draw on the fund and preserving the inflation adjusted value. 3:16:28 PM Co-Chair MacKinnon solicited questions from the committee. She believed that the fund management plan in the bill was unique. 3:16:54 PM ROBERT EDWARDSON, STAFF TO REPRESENTATIVE PARISH, discussed the Sectional Analysis (copy on file): Section 1. (page 1, line 4): Amends AS 37.10.071(d) to reflect the repeal of AS 37.14.110(c) in section 5 of the bill. Current AS 37.14.110(c) maintains the distinction between principal and income, and the purpose of this bill is to convert the public school trust fund to an endowment fund structure that does not require maintaining the distinction between principal and income. Section 2. (page, line 7): AS 37.14.160 is amended to add section 5 to the duties to direct the commissioner to determine the average monthly balance for the public school trust fund based on the monthly average market value of the fund for the five years preceding the previous fiscal year. 3:18:52 PM Mr. Edwardson continued to discuss the Sectional Analysis: Section 3. (page 2, line 21-26): Adds new section, AS 37.14.165 relating to the use of the public school trust fund allowing the legislature to appropriate 4.75 percent of the amount determined by the commissioner under new AS 37.14.160 (enacted by section 2 of the bill). Appropriations must be for the purpose of funding support for state public schools or for reimbursing the costs of administration of the fund. Section 4. (page 2, line 27 page 3, line 8): AS 37.14.170 is amended to focus the investment of the trust fund on increasing returns from capital appreciation as opposed to increasing net income from the generation of cash dividends and interest. This permits the commissioner to invest for long term capital appreciation by adjusting the asset allocation of the trust fund to weight it more heavily to equities as opposed to cash-generating fixed income securities. Section 5. (page 3, line 9): AS 37.14.110(c) and AS 37.14.140 are repealed. AS 37.14.110(c) is discussed above at section 1. Current AS 37.14.140 provides for expenditure of net income only. This is replaced by AS 37.14.165 (section 3 of the bill), which permits expenditure of 4.75 percent of the average market value of the fund. 3:20:13 PM Senator Micciche asked whether the actual rate of return had been assumed in the data set on the previously discussed document. Representative Parish deferred the question to Mr. Barnhill. 3:21:19 PM MIKE BARNHILL, DEPUTY COMMISSIONER, DEPARTMENT OF REVENUE, said that the key element of the fund management could be found in existing state law, AS 37.14.110(c), which required retention of the deposits to principal and the capital gains and losses. He provided a brief history of the fund and its comparison to the Permanent Fund. He said that the education fund had grown slowly because it had not been fully exposed to equity markets. He shared that the chart showed what would have happened if the fund had been invested from the beginning like an endowment. He said that the department supported the bill and believed that it was time to treat the fund more like an endowment so that it could take on a larger exposure to equities and grow at a faster rate over long periods of time. 3:24:04 PM Co-Chair MacKinnon understood that the fund was a dedicated fund, which was rare. She asked whether there were any problems with this approach to the fund, based on its historical use. Mr. Barnhill believed that there were no legal issues. e provided He shared that the fund was a pre-statehood dedicated fund formed in 1915 by the federal government as a land grant fund for public education. He relayed that in the mid-1970s, with the anticipation of substantial oil and gas revenues, the legislature made the decision that the fund would be more robust if the land were removed and replaced with a dedication of one-half percent receipts from the management of state lands. 3:26:51 PM BRIAN BJORQUIST, ATTORNEY GENERALS OFFICE, ANCHORAGE (via teleconference), relayed that the department did not believe that there was a dedicated fund problem with the legislation. 3:28:07 PM Co-Chair MacKinnon asked what would happen if the fund lost money and had to pay out part of its principal. Mr. Bjorquist replied that the dedicated fund component meant that the trust and the monies in it were dedicated to supporting public schools, regardless of the amounts paid out or what happened with increases or decreases of the fund. He added that there was no requirement that there be no invasion of principal, restrictions applied to one section of land, only 30 percent of the value of the trust. He said that the bill would modernize the trust management of the fund. He did not believe that there were any legal problems with the bill and that it did not violate the dedicated fund clause. 3:29:55 PM Co-Chair MacKinnon referred to a letter from the department from February 6, 2018. She asked whether the department maintained the position taken in the letter. Mr. Bjorquist replied in the affirmative. 3:30:11 PM Senator von Imhof asked whether the model on the graph assumed a certain return or used historical returns based on a theoretical mix of assets. Mr. Barnhill replied that the graph was modeled on a 70 percent equity, 30 percent fixed income asset allocation represented by the Russel 3000 Index when it began, prior to the Russel 3000, the S&P 500 Index had been used. He said the Lehman Aggregate Index, now called the Bloomberg Barclays Index, had been used for the 30 percent fixed income asset allocation. 3:31:06 PM Senator von Imhof asked who would manage the fund in its new format. Mr. Barnhill replied that the department would continue to manage the fund. 3:31:29 PM Senator von Imhof asked whether there would be any cooperation with the Alaska Permanent Fund Corporation (APFC). Mr. Barnhill responded that the fund would be kept separate from APFC. 3:31:48 PM Co-Chair MacKinnon noted that the department was outpacing APFC in some areas. Mr. Barnhill stated that the relative performance between APFC and the Treasury Division vacillated over time. 3:32:23 PM Senator von Imhof queried the future proforma return expectation. Mr. Barnhill relayed that under current practices a 6.6 percent return was expected. 3:33:46 PM AT EASE 3:35:31 PM RECONVENED 3:35:34 PM Co-Chair MacKinnon explained that a chart containing forward looking assumptions was being distributed to the committee. [This document is posted under the "documents" tab for HFIN meeting 2/28/18] 3:35:51 PM Mr. Barnhill related that the chart had been developed in the other body in an effort to understand what the different trailing averages looked like under a 4.75 percent POMV. He noted that the impact on the balance on the fund in terms of its ability to keep up with inflation using the current Callan Capital market assumptions. He said that the modeling was done on the current balance, as opposed to the principal balance or the inflation adjusted balance. He said that because the Callan assumptions were pessimistic over the next 10 years at 6.5 percent, if the objective was to maintain the inflation adjusted value of the current balance, that would be difficult under any of the methodologies. He said that at some point the 10 year plus bull market would come to an end and the 8 percent that was hoped for would not be a reality. He lamented that it would be difficult to maintain the inflation adjusted value of the current balance under a POMV methodology, a variety of percentages, over the next 10 years. He believed that things would improve over a longer horizon of 20 to 30 years. He stated that as an endowment the objective was to maintain the inflation adjusted value of deposits to principal. He said that the total balance of the fund is north of $650 million. The notional value of those is $310 million and had been tracked since 1978. He said that taking the deposits to principal and adjusting them for inflation using the consumer price index, the current approximate inflation adjusted value of the fund was closer to $513 million. He furthered that if the objective for managing the endowment was to maintain over all periods of time the inflation adjusted value of the principal deposit it did not matter which trailing average was used. At a 4.75 percent distribution, under the current Callan Capital market assumptions, inflation adjusted value of the deposits to principal would be successful over the 10-year horizon and into the future. 3:40:14 PM Co-Chair MacKinnon said that she had been measuring the fund by the Power Cost Equalization Fund. She stated that with that fund, the state had lowered the expected rate of return and decreased the risk. She understood that under the bill the asset allocation would be changed, possibly increasing the risk factor. Mr. Barnhill felt that the distribution point for the PCE fund had been fairly aggressive. He said that the bill contained a modest 4.75 percent distribution point. He added that the 4.75 to 5 percent distribution range was standard in managing endowments around the country. He believed that the department would be successful in managing the fund going forward while protecting the inflation adjusted value. 3:40:44 PM Co-Chair MacKinnon asked whether the 4.75 percent suggested in the legislation was the effective draw. Mr. Barnhill said that taking 4.75 percent of the trailing 5-year average would almost always produce a percentage draw of that year balance of less than 4.75 percent. He reiterated that the objective was to maintain the inflation adjusted value over long periods of time. He shared that the department had requested in the bill that rather than have a static 4.75 percent, that the words, "not more than 4.75 percent" be included in the language. He explained that this would correct annually if for whatever reason it was prudent to spend less than 4.75 percent in a particular year. 3:41:26 PM Co-Chair MacKinnon agreed that the department was attempting to maintain the value. She felt that it had been hard to determine a calculation on this particular fund over the past few years working with the department. She wondered why the legislature would give the department more flexibility. She wondered how the Office of Management and Budget Director arrived at the calculation of money available for education out of the fund over the past decade. She said that a solid mathematical formula had not been determined. Mr. Barnhill did not think that the cash flow should be volatile. He said that going to a static 4.75 percent of market value should make the cash flow more predictable and stable. He offered reasons for why the department would suggest going below 4.75 percent. 3:46:56 PM ALEXEI PAINTER, ANALYST, LEGISLATIVE FINANCE DIVISION, discussed the fiscal notes. The first note was from the Department of Education and Early Development (DEED), K-12 Aid to School Districts. He stated that the true impact of the bill would be the increase of the amount of trust funds used. He asserted that the fiscal notes could be confusing due to the way that the Governor's FY 19 budget was written. The fiscal note reflected an increase of general funds of $1 million, and a decrease of Public School Trust Funds of $1 million, the actual affect of which would be to make an additional $17 million realizable. He said that if the bill passed, the fund change that would be built in would be an increase of $17 million of trust funds and a decrease of the same amount of undesignated general fund. The second note was for DEED, Mount Edgecumbe Boarding School and showed that the school was no affected by the legislation. Co-Chair MacKinnon asked if the first note reflected $1.2 billion in total operating cost. Mr. Painter replied in the affirmative. He explained that the bill would impact the source of the funding for the K- 12 formula and the easiest way to show that was to show all of the funding in the Governor's request and then show the change in the funding. He clarified that not all the funding would be affected by the bill. 3:49:39 PM Co-Chair MacKinnon asked whether the fiscal note would be incorporated in to the budget. Mr. Painter replied that the fund source would change and the numbers appropriation of Public School Trust Funds would increase, thereby decreasing the fund capitalization of unrestricted general funds by the same amount. It would not change the amount that would go to the foundation formula. He reiterated that the note lacked clarity. 3:50:24 PM Co-Chair MacKinnon thought that there was a chance that education was being double funded. Mr. Painter said that the $1.2 billion was included in the Governor's request. The appropriation requested in the left column of the note showed the change in the fund source. He revealed that the fiscal note could not be adopted into the budget because the budget adopted by the body did not match the Governor's request on the fund source. 3:51:15 PM Senator von Imhof asked why a fiscal note that showed the difference going from the current statutory income from the fund to a potential new POMV. Mr. Painter replied that the Governor's budget had built in a fiscal note similar to the one before the committee into the base budget that did not reflect current statute or the legislation before the committee. He shared that the note reflected a version of a different bill, that used a different calculation; and unorthodox move by the Governor, that created an unusual fiscal note. 3:52:07 PM Co-Chair MacKinnon offered assurances that an appropriate bill would be crafted by the committee, and would travel with the bill, should the legislation pass out of committee. 3:52:30 PM Co-Chair MacKinnon OPENED public testimony. Co-Chair MacKinnon CLOSED public testimony. 3:53:14 PM Co-Chair MacKinnon announced that amendments were due by 5pm the following day. She discussed additional housekeeping. CSHB 213(FIN)(efd fld) was HEARD and HELD in committee for further consideration.