HOUSE FINANCE COMMITTEE February 15, 2016 1:33 p.m. 1:33:19 PM CALL TO ORDER Co-Chair Thompson called the House Finance Committee meeting to order at 1:33 p.m. MEMBERS PRESENT Representative Mark Neuman, Co-Chair Representative Steve Thompson, Co-Chair Representative Dan Saddler, Vice-Chair Representative Bryce Edgmon Representative Les Gara Representative Lynn Gattis Representative David Guttenberg Representative Cathy Munoz Representative Lance Pruitt Representative Tammie Wilson MEMBERS ABSENT Representative Scott Kawasaki ALSO PRESENT Randall Hoffbeck, Commissioner, Department of Revenue; Craig Richards, Attorney General, Department of Law; Representative Cathy Munoz; Representative Mike Chenault. SUMMARY HB 245 PERM. FUND:DEPOSITS;DIVIDEND;EARNINGS HB 245 was HEARD and HELD in committee for further consideration. Co-Chair Thompson reviewed the meeting for the day. HOUSE BILL NO. 245 "An Act relating to the Alaska Permanent Fund; relating to appropriations to the dividend fund; relating to income of the Alaska Permanent Fund; relating to the earnings reserve account; relating to the Alaska Permanent Fund dividend; making conforming amendments; and providing for an effective date." 1:34:08 PM RANDALL HOFFBECK, COMMISSIONER, DEPARTMENT OF REVENUE, indicated he would spend just a few minutes recapping what was covered in the previous meeting up to Slide 11. He relayed that the Alaska Permanent Fund Protection Act (APFPA) was one of three major components of the New Sustainable Alaska Plan, the governor's plan to reach a sustainable long-term budget and revenue stream for the State of Alaska. The Alaska Permanent Fund Protection Act only dealt with one piece having to do with how the state used its Permanent Fund (PF) earnings. It also contained a portion which restructured the dividend. Vice-Chair Saddler asked if there was an old sustainable Alaska plan. Commissioner Hoffbeck responded in the negative. He continued that the plan sought to do three things: to close a budget gap, to solve the issues of spending down savings, and to have a long-term plan for sustaining government. 1:36:19 PM CRAIG RICHARDS, ATTORNEY GENERAL, DEPARTMENT OF LAW, relayed he would be presenting the plan in the bill: the Alaska Permanent Fund Protections Act. As he reviewed the elements of the bill package he would be discussing the reasoning behind certain decisions that were made relative to other options. He would conclude his presentation with a brief sectional review of HB 245. Attorney General Richards began with slide 12: "Overview." He suggested that the APFPA was fairly simple when viewed in relation to how the PF was currently structured. The plan changed three things. First, it took out $3.3 billion per year from the PF as an endowment fund and placed it into the general fund (GF). He explained that currently the only external money drawn from the PF was the dividend. The governor's plan added a spend rule to the existing rules- based framework around the PF. The second change reflected in the bill was that it placed 100 percent of royalties and 100 percent of production taxes directly into the PF fund each year. Currently under the constitution, 25 percent of all royalties went directly into the corpus. The plan did not propose changing that provision since it was constitutionally mandated. He added that there had been some statutory rules that had historically deposited slightly more than 25 percent, about 30 percent, of royalties into the corpus. The plan he was presenting placed 100 percent of royalty and production taxes percent into the PF in order to address volatility and to create some sustainable spending options. The third piece the bill changed was how the dividend was paid. The bill changed the dividend payout rule, the method by which the state calculated how it paid the dividend. Currently, the dividend was based on a five-year average of half of the earnings of the fund. Historically, the formula had worked fine. However, the governor was proposing an alternative formulation where the dividend was based on 50 percent of the year's royalties. Co-Chair Thompson acknowledged that Representative Lance Pruitt had joined the committee and recognized Representative Cathy Tilton in the audience. Representative Guttenberg referred to number 3 on Slide 12. He asked if Attorney General Richards had done a comparison of the dividend payout with the suggested 50 percent royalties paid from the Earnings Reserve Account (ERA). Attorney General Richards clarified whether the representative was asking if the Department of Law (DOL) had gone back historically to see what the divided would have been if the state had based the dividend payout on a 50 percent royalty. Representative Guttenberg responded in the affirmative. Attorney General Richards had seen such a comparison and would provide it to his office through the chairman. 1:40:17 PM Attorney General Richards reviewed slide 13: "Alaska Permanent Fund Protection Act": 1. Protect the corpus 2. Protect the dividend 3. Grow the fund 4. Stabilize the budget 5. Stabilize the economy Attorney General Richards indicated that the slide laid out the goals developed for the administration with the consideration of adopting an endowment model for the PF. The goals included protecting the corpus of the fund, the constitutionally protected principle of the fund that could not be spent. Another aim was to ensure and protect a dividend. He pointed out that without change in the status quo, funding for dividend payouts would run out by about FY 22. One focus of the legislation was on continuing to grow the fund to avoid a static value over time - the administration wanted to ensure the fund maintained its relative value for the next generation. The bill would also adopt a spending rule, tapping PF earnings in some capacity to help stabilize the budget shortfall, moving from an oil based economy to one that was based on both oil and financial assets for budgeting purposes. Lastly, the administration hoped that, throughout the use of all of the changes in the governor's plan including the PF, the plan would help to stabilize Alaska's economy. Attorney General Richards quoted Governor Jay Hammond in slide 15: "The Permanent Fund." "I wanted to transform oil wells pumping oil for a finite period into money wells pumping money for infinity." Attorney General Richards thought the quote captured what Governor Hammond was thinking when the PF was established. He realized that oil was fundamentally a depletable asset. Given a long enough period of time with conventional reservoirs, production levels would be lower than when the development of the basin first began. The following generation would not have access to the same level of natural resources that the prior generation enjoyed. Co-Chair Neuman referred back to item 5 on Slide 13 regarding stabilizing the economy. He commented that in the previous year the State of Alaska placed approximately $1.4 billion of cash into Alaska's economy through the PFD. He asked if there had been any analysis about the economic impact of less cash going into Alaska's economy. Attorney General Richards deferred to Commissioner Hoffbeck, as he had worked with Dr. Gunnar Knapp on the issue. Commissioner Hoffbeck reported that Dr. Knapp had completed an analysis in a report that was pending and was expected to be delivered in the current day. He had looked at the impacts of reducing the size of the dividend compared to the other options in the plan. Co-Chair Neuman wondered if Commissioner Hoffbeck had asked Mr. Knapp to do an analysis on the impact of Alaskans with different levels of income losing the dividend. It would impact Alaskans with and income of $20 thousand per year much differently than Alaskans with an income of $200 thousand per year. Commissioner Hoffbeck confirmed that a less detailed analysis had been requested. It would outline how it would affect people with different levels of income as well as how it would affect different regions of Alaska. Co-Chair Neuman looked forward to receiving the information as soon as possible. 1:44:39 PM Representative Wilson asked to return to page 15. She agreed that the reserves were established to potentially be used for spending. However, the current discussion was not only about using the reserves but also about using PFD monies. She was uncertain Governor Hammond ever intended to use the PFD monies for government spending. She wondered where in any of Governor Hammond's comments he thought the dividends should be changed or were not a high priority. She saw the money that went into the corpus as the peoples' money. The Permanent Fund Dividend (PFD) was the payoff for Alaskans annually. She did not believe the sentiment was being reflected in the quote. Attorney General Richards explained that the quote was from 1976 before the PF had been designed. The Earnings Reserve Account had not been set up at that time and the dividend payout formulation that was first adopted (Alaska Inc. and ultimately rejected by the U.S. Supreme Court) had not yet been adopted. He thought it had been a formational time in terms of people's thinking about the PF. His personal view aligned with something David Rose, one of the first executive directors, had told him a number of years prior: one of the successes of the PF was that not every piece was defined as to its purpose. Different people could interpret its utility in different ways. Mr. Rose thought how the dividend played relative to what amount it should be, how it should be calculated, and ultimately determining a fair share between supporting government versus direct payouts to the people were things different people could rationally differ on. Representative Wilson could agree somewhat with Attorney General Richards's rationale if the government had not already received its share. However, because Alaska did not own the subsurface rights on most of its properties and the dividend was there to help offset that circumstance, she thought the whole of the state would be able to receive a royalty payment. She wanted to make sure that when quoting Governor Hammond no one should try to make it appear that the governor had ever thought the dividend portion would go away. Attorney General Richards understood her point. He did not mean to suggest that Governor Hammond or any other governor had rigidly defined what share belonged to the people and what share was properly usable for governmental services. Representative Guttenberg returned to slide 13. He commented that he thought all of the money (the Permanent Fund monies) belonged to the people. He suggested that when stabilizing the budget and dealing with the operations of the state government it was simply about the delivery of services to the people of the state. He asked if there was an analysis about cutting the PFD, which he was deeply concerned about having represented a sizable portion of Rural Alaska. He wondered about the impacts of budget cuts and about how the deletion of services would affect the private economy. 1:49:00 PM Commissioner Hoffbeck stated that the information Representative Guttenberg was inquiring about would be included in the forthcoming analysis. The analysis included looking at the impact of reducing the size of the dividend, using earnings, making cuts to services, and imposing taxes including an income tax. They were compared against each other as far as the relative impacts on the economy. Representative Guttenberg asked if the "do nothing" option would be included in the analysis. Commissioner Hoffbeck suggested that the impacts of the changes were compared to the status quo. Representative Gara referred back to slide 15. He wanted the administration to refrain from speaking for Governor Hammond. He had become very good friends with Governor Hammond in his later years. He suggested that the governor had said many things based on the context of the time. He relayed that one of the things the former governor had said to him frequently was that if the state was going to have a fiscal plan and there was a problem the state should address it by getting a fair share for the state's oil first, then impose an income tax, and if needed tapping into the PF. He did not feel that it was useful for people to co-op Governor Hammond. The governor had said things at various times. He discouraged others from invoking Governor Hammond as the supporter of anyone's plan. Co-Chair Thompson thanked Representative Gara for his statement. Attorney General Richards noted Representative Gara's feedback and would be removing the slide from the presentation. Attorney General Richards jumped to slide 17: "Defining "Sustainable"" indicating he would come back to slide 16 later in his presentation. He explained that the administration posed the question that if the state was going to create a spending rule that put some amount of the PF earnings into the GF the state would have to clearly define "sustainable." The state was aware it wanted to have a PF that was sustainable; loosely meaning it would have a like or greater value for the next generation of Alaskans in perpetuity. In financial modeling it was not enough to have a vague idea of the meaning of a sustainable PF. Ultimately, the administration broke it down into three parts. The first key piece was leaving the corpus of the PF untouched, consistent with the constitution. Attorney General Richards explained the second part. If the state was going to adopt an endowment model where the government relied on funds from the PF for its ongoing operations, there had to be a durable earnings reserve account (a consequence of the first part that the corpus could not be spent). In other words, if the state was going to rely on PF monies from year-to-year, then there needed to be assurances in place that the money would be available each year. In anticipation of a couple of bad market years or other unexpected events, the earnings reserve account initially needed to be large enough to ensure its durability to avoid falling below zero. Otherwise, the state would simply be exchanging one budget hole for a different kind of budget hole. Attorney General Richards relayed that the third part was the definition [of sustainable] the administration adopted. In order to be sustainable the PF value needed to maintain its real value. He explained that a nominal value did not take inflation into consideration. Whereas, a real value did. The fund's value would grow at an amount that at least equaled inflation. The state's sustainability rule was designed with a target of maintaining the real value of the fund or growing it over time. Attorney General Richards furthered that the administration had an inflation rule embedded in its economic modeling that accounted for inflation. He explained that the state went farther to provide a mechanism that not only protected the total value of the fund against inflation, but actually adopted a mechanism of inflation-proofing similar to the current system where inflation-like funds were put into the corpus so the corpus, itself, grew. He would be talking about how the formulation used in the plan of growing the corpus for inflation adjustments was different than what was currently in place. 1:54:42 PM Co-Chair Neuman mentioned the earnings reserve durability and expressed his concern about having members of the cabinet on the board of the Permanent Fund Corporation (PFC). He presented a hypothetical situation in which the corporation ended up in a deficit situation. He wondered if the PFC board would be inclined to sell assets to ensure that there was available funding for the state to pay its bills. He suggested that in the governor's plan the Permanent Fund's sole purpose was to fund government. The Permanent Fund Dividend check would be solely dependent on production taxes and royalty revenues. There was a big switch in how things would be done in the new plan. He asked Attorney General Richards if he had contemplated a way in which the administration and the legislature could work together in resolving the issue of how the PF was managed and by whom. Attorney General Richards stated that after having visited in Co-Chair Neuman's office he had had time to think about their conversation. He and Commissioner Hoffbeck were both members of the PF board. As a member of the board he had a legal fiduciary obligation to manage the fund as a trustee under fairly well-defined legal standards. The obligation superseded the obligation as a member of the governor's cabinet. It was the same obligation, in terms of management, that a person would have as a cabinet member or a non-cabinet member appointed by the governor. In his mind the trade-off of having commissioners sitting on the board aware of what the administration was doing was more beneficial than having increased political independence with non-cabinet members sitting on the board. Co-Chair Neuman reported that his point was to ensure that other members of the finance committee and the public were aware of the conversations he had had with Attorney General Richards. He reiterated his concerns with having cabinet members sitting on the PFC board. 1:58:04 PM Representative Munoz asked if the PFC board or its staff considered mandatory changes in the investment mix with the requirements of an annual cash draw. She was unclear whether there would be a change in management. Commissioner Hoffbeck stated that currently the trustees and the managers of the fund had not looked at changing the mix of investments. As part of the plan, the corporation and board of trustees would have to remain autonomous from government intervention. He asserted that it was the only way a rules-based system worked. The board's focus would have to be on generating returns rather than specific money generating components. The size of the cash portion would be larger than in the past because previously the dividend was the only item being paid from the draw. With the governor's plan in place it would pay something essentially 2 to 2.5 times the amount of the prior year's dividend. The corporation would have to manage for more cash annually but there would be a known draw in the future and the PF could be managed accordingly. Overall he did not believe the underlying investment portfolio would change to any extent. Co-Chair Thompson argued that it would be difficult to remain autonomous with a governor trying to draw additional money out with a number of his cabinet members on the board. 2:00:18 PM Attorney General Richards commented that the amount drawn from the fund was a legislative prerogative. The two potential outflows were monies to the GF and the dividend amounts. Both amounts were determined by the legislature. Attorney General Richards continued to slide 18: "APFPA Cash Flows." He pointed out that the slide showed a visual depiction of the governor's plan. It showed how cash flowed in and out of the system. He drew attention to the corpus of the PF on the left and the earnings reserve account (ERA) in the middle of the slide. In the governor's plan 25 percent of mineral royalties automatically went into the corpus of the fund, a constitutional requirement. The remaining 75 percent of royalties and 100 percent of production taxes would be placed into the ERA. Two different cash flows would come out of the ERA. A fixed amount of $3.3 billion would be placed into the GF. The payment of dividends would also come out of the ERA. Currently, what came out of the corpus was the state's statutory net income (the earnings of the principle of the fund) and an allowance for inflation-proofing (taken from the ERA and returned to the corpus). Attorney General Richards explained how the governor's plan changed how the ERA functioned. In the plan the ERA would hold statutory net income, royalty monies, and production tax funds. These monies would remain in the ERA until the account reached four times the size of the payout (4 x $3.3 billion). It was a mechanism that would allow the state to have 4 years of anticipated draws in the ERA providing for a high level of durability even if the state had poor stock market years or the price of oil went down further. The state would have a very robust smaller tank of savings to be able to make the dividend payments in a $3.3 billion draw each year. Once the target was reached, anything over the target would be placed back into the corpus of the fund as a form of inflation-proofing. He concluded that the governor's plan changed the plumbing of the system. Attorney General Richards addressed why the governor was proposing the change. The proposal put the state's three largest sources of income (income on financial assets from the PF, production taxes, and royalties) into a common pot. The plan included monitoring the three cash flow sources to determine the amount to draw as an annuity year-to-year at a level such that it could be done in perpetuity. Rather than trying to live on the summation of three different volatilities from year-to-year, the administration was suggesting drawing down a fixed amount. He compared the idea to a person might have two options to draw from financial assets in retirement. A person could draw an amount that equaled a percentage of financial assets every year. It would mean that a person would be living on a variable income based upon asset size. A person could also draw a fixed amount based on a person's total amount of assets, taking only an amount that would perpetuate a stable fixed income. He viewed the governor's plan similar to the later providing stability to the budget year-to- year. 2:05:43 PM Attorney General Richards moved to slide 19: "How to handle the draw." He reported that the administration had not known what it would view as the more optimal approach until modeling was applied trying many different things. Prior to addressing volatility, the administration posed a question about the definition of sustainability. The answer it came up with was that under a Percentage of Market Value (POMW) about $2.4 could be taken out of the PF in the current year. Out of the $2.4 billion historically about $1.4 had been allocated for dividends. Currently about $1 billion could be placed into the GF. The administration opted to do it a little differently by placing production and royalty taxes into the Permanent Fund to stabilize the amount and help close the gap. If the state were to adopt an endowment model for the PF, the issue of how to handle the draw had to be addressed: should it be done as a percentage value of the fund or as a fixed amount. He encouraged the legislature to review the consequences of both options. Attorney General Richards stated that it was not obvious which option was better. He relayed that there were pros and cons to both a percentage system and a fixed system. The advantage to the POMV system, the percentage system, was that there would be less certainty to the budget but more certainty to the fund. In other words, if the fund went down the amount drawn to the budget would go down as well. Conversely, if the value of the PF went up, the amount drawn into the budget would go up. It created a self-adjusting mechanism for the PF. The mechanism would help to protect the fund against the risk of being run down as quickly if there was a string of bad luck. However, variability would be housed in the state's year-to-year budget rather than in the fund itself. Attorney General Richards moved on to discuss a fixed system, reflected in the governor's plan and lacking an automatic adjusting mechanism. If there was a period of bad years, then $3.3 billion might be too big of an annuity to draw. Under such circumstances, the state would need a method to adjust the draw down. He reported that the periodic review was included as part of the governor's plan as a means to adjust the draw down. The periodic review, conducted every 4 years, was a way to look at whether the amount the state would be drawing was sustainable. Attorney General Richards maintained that the main question was whether the state wanted stock market volatility residing in the payment to the budget or whether the state wanted the payment to the budget to be fixed and the stock market volatility to reside more in the PF. The governor's plan chose to have more stability in the GF and more volatility in the PF. He concluded that both plans were reasonable. 2:09:31 PM Co-Chair Neuman relayed that the one thing the state had was historical numbers on the investments for the Permanent Fund. He asked if Attorney General Richards had taken both the fixed system and the percentage system methods and applied them to historical data for comparison. If so, he requested to see those numbers. Attorney General Richards relayed that the administration had done the modeling a number of ways and would provide the information to the committee. Co-Chair Neuman asked for the information. Co-Chair Thompson reiterated that the information be provided to the committee. Attorney General Richards continued to address slide 19. He relayed that there were two decisions that would have to be made by the legislature if it adopted an endowment model. The first was whether to choose a fixed draw system or a percentage value system. He stated that petroleum revenues were not static due to production levels changing. He recommended that, in looking at the POMV system option, the legislature should take into account that the percentage that could be withdrawn currently was less than the percentage that could be drawn in the future if petroleum production declined. Conversely, if petroleum production increased, then in the future the sustainable percentage draw would be slightly higher. He recommended using a periodic review as a mechanism for measuring sustainability with the POMV system. He also noted that the PF, itself, held debt. It was not just cash or equity, the PF had a large real estate portfolio using debt: the corporation borrowed money to invest in real estate. The consequence of that was when a percentage draw was defined the state would have to make sure to draw on a percentage of the net value of assets and not on the value of assets with debt. Co-Chair Neuman asked Attorney General Richards to give a more coherent explanation. Attorney General Richards explained that about 6 months ago the PF had a debt of roughly $7 billion in its portfolio. The debt resided in the PFC's real estate, hedge funds, and some of its private equity portfolio. The state would not want to borrow money, then calculate the total draw based on the value with the debt included. The state would end up borrowing money then immediately paying it out. The state would need to make sure that it was paying either dividends or the payment to the government using a method that did not payout on the borrowed monies. Co-Chair Neuman did not believe the PFD [calculation] accounted for unrealized assets or debt at present. He wondered why the corporation would want to start such a process. Attorney General Richards explained that if the state did not change the dividend formula, it would not be an issue. However, if the legislature adopted a POMV approach to the fund draw down then the definition would need to be clear. The debt would need to be taken out of the total calculation of a POMV draw of 4.5 percent, for example. Co-Chair Neuman did not believe it could be done legally anyway. 2:14:11 PM Representative Gara had not seen the math on paper but understood that the governor's plan promised a $1000 dividend for the first 2 years. There was significant concern that the 50 percent of Alaskans whom earn the least amount of money received about 20 percent of their income from the dividend. He reported hearing about $400 dividends following the first 2 years of $1000 dividends, based on some oil price scenarios. He asked about potential scenarios after the first 2 years that would decrease the dividend to $400. Co-Chair Thompson asked him to also comment on production scenarios accounting for increased production. Commissioner Hoffbeck made a correction that the governor only guaranteed $1000 for the first year rather than for the first 2 years. He added that if the revenue forecast in the Revenue Sources Book was used for price and production the dividend would decrease to between $700 and $800 in year 2. If the calculation was based on current oil prices at about $30 per barrel then the dividend would decline to between $400 and $500 in the second year. Much would depend on oil price recovery over the following year. The dividend would track with the state's overall economic health under the governor's plan. Attorney General Richards reported that slide 20: "How to handle the draw: A simple endowment draw adds revenue, but does not address volatility": reflected a hypothetical scenario. He explained that the blue bars demonstrated historically what the unrestricted petroleum revenues were to the state. Like other oil based economies, it was very difficult for Alaska to budget year-to-year with volatile fluctuations in the unrestricted petroleum revenues (70 to 90 percent of the total state budget). The slide demonstrated a problem with the classical POMV system as Alaska had currently contemplated. The yellow bars reflected what the POMV would have added into the GF after the dividend payment had the state adopted a 4.5 percent POMV in 2002. It was an exercise going back in time. He furthered that the slide demonstrated that in years of low oil prices the classical POMV endowment model was useful because the state would be getting revenues from financial assets when needed because of oil prices being low in the classical system. In poor years it helped close the gap. However, without a rule-based system that accounted for high oil price years the POMV model compounded the problem. In the years when the state was getting more petroleum revenues than needed the state had the tendency for pro- cyclical spending resulting in large capital budgets and growing operating budgets that would have to be clawed back in later years. He suggested that the state might not want a POMV that paid from its financial assets when oil revenues were high because more aggressive spending would likely take place. He advised that if the legislature opted for the POMV system, members should be cognizant of making sure a rule was in place preventing money from being pumped in from the state's financial assets into the budget which would otherwise compound the pro-cyclical spending pattern. 2:19:09 PM Representative Wilson asked what the dividend would have been in 2012 under the governor's plans. Attorney General Richards did not know the exact number but estimated it to be roughly $1300. He elaborated that royalties in 2012 were about $2 billion. Representative Wilson asked what the dividend would have been in 2008. There would be a difference in the POMV addition. She wondered if it would be greater than $1300 due to the unrestricted petroleum revenue. Attorney General Richards responded that the dividend would have been large in 2008. Representative Wilson commented that in 2008 and 2009 the dividend amount was not very exciting due to the stock market. She wondered if the plan would change how the dividend was handled. Although the state did not receive extra in the big years such as 2008 and 2012, she wondered what the justification would be to change when looking at low numbers in the following couple of years. Attorney General Richards remarked that the governor's plan proposed changing the way the dividend was paid so that individual Alaskans were rewarded when the economy was doing well as opposed to a dividend system that rewarded Alaskans for financial market success. Either system was rational but the governor felt that Alaska was better aligned if its people were successful when the economy was doing well. Representative Wilson commented that she would otherwise agree with the governor's position if the state was looking at an increase going forward. However, the state was facing a decrease. She felt that the people of Alaska had already taken a hit because of the stock market. She felt that the administration was asking Alaskans to take a second hit because of the change in oil revenue. Commissioner Hoffbeck replied that the state had to start somewhere. He asserted that the state was in a situation driven by economics where the state had to make some decisions that would otherwise not be required under different circumstances. Attorney General Richards added that there was a fairly conservative 20 year production forecast from the Department of Revenue (DOR). It assumed steady decline because it anticipated that the state would not have much success in the form of new fields, a gas line, or in the Arctic National Wildlife Refuge (ANWR). He thought it made sense from a budgetary perspective to have a conservative- based assumption. He thought that a really pessimistic assumption about the future would carry over to the royalty dividend. Conversely, if there was a positive outlook at higher oil prices or more success in Alaska's petroleum or mining sectors in the future, then the royalty dividend would look higher. 2:22:59 PM Co-Chair Neuman asked how the dividend would be calculated in the POMV example. Attorney General Richards responded that it was a historical actual payout. The numbers were historical numbers and the actual payout was already known. Co-Chair Neuman confirmed that the payout was calculated under the current dividend calculation method. Attorney General Richards responded in the affirmative. Vice-Chair Saddler asked why nominal dollars would be used over a 40-year period rather than using real dollars to account for inflation. Attorney General Richards suggested that originally the chart used real dollars but he later decided to stick with one convention in the presentation choosing to use nominal figures to avoid confusion. The real dollar chart communicated similar information. Vice-Chair Saddler noted that the Attorney General had stated earlier that he wanted to make the PFD more connected to the people based on the health of the economy (oil royalties). He asserted that Attorney General Richards wanted to make the PFD work well when oil wells were pumping oil rather than when money wells were pumping more money, which they were currently. Representative Gara mentioned talking about the dividend amount. Two of the largest parts of the governor's plan were the dividend change and the income tax. He indicated that everyone was looking for a plan that would be comprehensive and fair to everyone. He wondered how he would explain the current plan to his constituents in the low income parts of his district who would be affected the most. Commissioner Hoffbeck responded that there was some balance between the income tax and the dividend in that the income tax impacted people earning higher wages more than those earning lower wages. Conversely, reducing the size of the dividend impacted lower wage earners more than it did for those earning higher wages. However, he argued that the income tax impacted the higher wage earners at a higher percentage. One of the things the administration tried to recognize was that the dividend had been volatile over the years. The dividend would go up and down under any scenario. The bill changed the dynamics. The bill provided for a smaller dividend than did the current system, but doing nothing created the possibility of losing the dividend altogether within 4 years. He added that part of the intent of the bill was to be able to sustain the dividend long-term. 2:27:38 PM Representative Gara thought the state should have a balanced plan but he took issue with the definition of balanced. Vice-Chair Saddler asked about the threshold for a person to have a net payment of federal taxes notwithstanding the earned income tax. He was looking for a perspective on how much income a person who was heavily dependent on a PFD would actually pay in taxes. Commissioner Hoffbeck put into perspective that someone with a family of 4 that made $50 thousand per year would pay about $47 in state tax, close to the tax threshold. 2:28:42 PM Representative Gara spoke to the reduction of the dividend to $500 or $800 in the out years. The revenue the state would be generating by reducing the dividend was about 4 times as much as the $200 million towards a $4 billion deficit that the state would raise from the income tax. He asked if the income tax would generate about $200 million. Commissioner Hoffbeck replied in the affirmative. In looking at the federal tax liability, since the state was tied to it, between 40 and 50 percent of people did not pay federal tax. The same dynamic would apply to a state income tax. About half of the reduction in the dividend was out of the higher wage earner. In looking at the impact of the lower wage earner about $350 million would be taken from the dividend system. A state income tax would generate about $200 million. Co-Chair Thompson reminded members that the committee would be addressing a separate bill on income tax. Committee members would be supplied with more explanations on the numbers in the future. Attorney General Richards mentioned that in the following 2 slides he would be reviewing the assumptions of the governor's plan used in the model. He addressed slide 21: "Calculating the Draw: The Financial Model." He explained that the governor's plan relied on probabilistic modeling for many of its inputs. It meant that rather than picking a discrete oil price or return assumption, the economic modelers built a range of potential prices and assigned probabilities of being at certain prices over time. It created a more sophisticated way of doing the modeling rather than choosing static variables. He relayed that Mackenzie [Wood Mackenzie] would provide a much more detailed presentation to the committee at a later time outlining how they vetted all of the assumptions in great detail, why certain assumptions were reasonable, and why other assumptions were changed to reflect better thinking. Attorney General Richards continued. He explained that the PF modeling assumed that the starting assets equaled $55 billion. The $55 billion included the PF projected value as of the end of the fiscal year (FY 16). A point in time needed to be chosen in order to build the models. He reported that the PF had lost a value of about $3 billion in the previous 3 to 4 months. He thought the number was higher than in the current day. If there was an assumption of $2 billion less than the starting assets in the governor's plan, then there was about $100 million less than the state could have in its sustainable draw. It was possible in the decision that the state would use $53 billion rather than using $55 billion, for instance, which would result in a draw of $3.2 billion versus a $3.3 billion draw. He believed that getting the exact beginning principle accurate was not as important as it was to make reasonable assumptions about long term returns for the state. It was important to make good assumptions about what would likely occur over time. He noted that of the $55 billion, $3 billion was an assumed transfer from the CBR into the ERA. The $3 billion was to provide a level of confidence to ensure that the ERA was going to be large enough to compensate for a couple of years of bad stock market returns. It would provide a cushion enabling the state to make a $3.3 billion draw each year. 2:33:28 PM Co-Chair Neuman asked about the sustainable budget baseline. He wondered if it was the governor's current $5.4 billion budget. Attorney General Richards replied that the current legislation did not assume any particular budget. Instead it determined what could be pulled out of the PF every year that met the definition of sustainability. The number, under the way the governor's plan was calculated for the PF, was $3.3 billion regardless of the budget every year. For instance, if the budget was $6 billion only $3.3 billion could be withdrawn. If the budget was $4 billion only $3.3 billion could be taken out. The sustainable draw amount of $3.3 billion was independent of the budget. Co-Chair Neuman assumed a starting budget of $5.4 billion like the governor's proposed budget. He asked if it would prove to be more beneficial for the budget if the legislature could reduce it to $4.5 billion or $4.7 billion. Attorney General Richards deferred to Commissioner Hoffbeck. Commissioner Hoffbeck answered that if the budget was reduced by only $700 million of about $2.1 billion to $2.3 billion needed to balance the budget, it would reduce the state's future draw by about $100 million to $120 million. The state would have to draw down on saving to make up the remaining funding. The amount the budget fell short reduced the amount that the state would have going into the future. He had received a matrix immediately before the meeting and had not had a chance to vet it. It would be part of the packet the DOR would be providing to members. Co-Chair Neuman asked if the commissioner had just stated that if legislators did not take any action in the current year the required draw down would be reduced by $100 million. Commissioner Hoffbeck replied that if the state did not do anything in the current year except to pass the budget it would reduce the sustainable portion of the draw by about $150 million annually. The state's draw would be $3.15 billion rather than the current year's figure of $3.3 billion. He added that the state would never recover the difference. Attorney General Richards added that it was accurate based on his understanding of the modeling from the DOR. However, there were also consequences to delaying in addition to the reduced sustained draw. He would be discussing the consequences of delay at Representative Edgmon's request. 2:37:03 PM Representative Munoz asked if he had looked at the financial model without the $3 billion CBR draw. She asked for the specific number of a sustainable draw without the investment. Attorney General Richards stated that he had looked at the model and claimed that the draw would be reduced by approximately $150 million. The negative impact would be that the amount in the ERA might be less robust rather than impacting the amount of the sustainable draw. The risk of running the ERA down to zero would intensify if the stock market did poorly in the following 2 years. The $3 billion was not added to increase the total amount of sustainable draw. It was inserted to ensure a robust ERA balance of approximately $10 billion. Representative Munoz asked if the plan required an annual draw from the CBR. Attorney General Richards responded that it was a one-time draw from the CBR to make the earnings reserve sustainable. He reported that there were aspects of the plan not related to the APFPA that had some different assumptions. Commissioner Hoffbeck replied that there was an ongoing draw from the PF because the administration anticipated needing about $100 million to $150 million per year in investment returns out of the CBR. If money did not get drawn from the CBR and placed into the ERA the state could still make the draw from the CBR annually. The draw would be smaller from the ERA and make the difference with a draw from the CBR. Once the plan was in place the CBR would be invested similarly to the PF. The instability of having the money in the CBR was having to access it with a required three-quarter vote of the legislature. Attorney General Richards added that the true advantage was having the $3 billion in the PF rather than the money residing in the CBR. The Permanent Fund would become self- sustaining generating the dividends and about $3.3 billion on its own without having to pull from another piece. He mentioned the importance of having a rules-based framework. The success of this part of the plan, dependent on a political element such as a successful CBR vote, made the plan a little less robust from a rules-based perspective. 2:40:52 PM Representative Edgmon wanted to make clear that the total return in the statutory net income was part and parcel of one portfolio, the corpus of the PF and the earnings reserve being managed as one entity. He saw nods at the table. He asked whether the modeling demonstrated the corpus continuing to grow proportionately, looking 4 years down the road and after drawing down each year, so to avoid having a larger amount of investments in more liquid assets such as the Earnings Reserve. He wanted a quick comment about what the modeling showed. He was thinking about the portfolio and the make-up of the asset allocation. He suggested that a more aggressive investment might be necessary to meet the targets of the Earnings Reserve if the corpus was not keeping pace. Attorney General Richards responded that the earnings reserve and the corpus of the fund were managed the same and, he did not see any change. The way the PF accounted for the two was an accounting exercise on paper. It was not as if they were managed as separate funds managed in different ways. In terms of how money was accounted for in the corpus versus the earnings reserve, it was not very impactful from a management standpoint. It came down to whether the money was available to draw when needed. He addressed Representative Edgmon's second question. The growth of the corpus, under the governor's plan, went back into the corpus after the making payments to the government's GF, paying out the PFD's, and reaching the 4:1 target level. It was not the same as an inflation-proofing type of growth that the corpus had currently, it would be less in the early years until the target of $13 billion was reached. Once the target was reached the inflationary growth would go into the corpus. Representative Edgmon thought there would plenty of room for comments because the permutations were endless at the current stage of discussion. Representative Gara asked if $13 billion (4 years x the draw) was the amount recommended to keep in the ERA. He commented that every time he looked at the constitution and at Legislative Research's analysis of the issue they stated that GF available for appropriations at the end of the year should be swept into the CBR. Currently, there was about $6 billion in the CBR. Under the proposed legislation the state would have $13 billion at the end of every year. If the Legislative Finance Division (LFD) was correct the $13 billion would get swept into the CBR. If Attorney General Richards was correct the money would not get swept into the CBR. He thought that LFD's interpretation was closer to the constitution. The legislature would be left with needing a three-quarter vote every year to make the governor's plan work. He thought the requirement made it less stable with changing legislators at different times and wondered if Attorney General Richards agreed. Attorney General Richards responded that if one looked at the history of the CBR sweep and the reverse sweep in particular, the legislature had always exercised the reverse sweep. He suggested that the question would not come up about the provision applied to the ERA, unless there was a change in how the legislature conducted its business. If the state did not do a reverse sweep it would not only impact the ERA, it would also affect a wide number of accounts. He listed a number of examples including pension assets and some of the mental health trust funds. He surmised that it would be a big change in the system to arrive at the question. The administration viewed the option of the legislature not doing a reverse sweep as a low-probability event. If the legislature did not, the state would be in a situation in which someone could challenge whether the ERA was subject to a sweep. The state already had a Supreme Court decision that stated that the earnings reserve was not subject to a sweep. The question about the ERA changing the nature of the Supreme Court's decision could come up if the state did something differently than it did traditionally; either monies were coming out of the ERA into the GF, or monies from production taxes and royalties were going into the ERA. The Department of Law did not believe the Supreme Court would change its mind. If two low-probably events occurred, the state did not do a reverse sweep, and the Supreme Court changed its mind then potentially the earnings reserve could go to the CBR and the Supreme Court held. The administration went forward with the plan as designed because the probability of the two events occurring was low. Even if the very low probability event occurred the state would have a Supreme Court ruling that stated how the system worked and the state would redesign the system to accommodate it in a way that made sense. 2:47:19 PM Co-Chair Thompson relayed that the committee would be addressing the question at a later meeting. Representative Gara understood that the subject would be addressed later and commented that the court would not reverse its opinion. The court's previous opinion on the earnings reserve was based on it being used solely for the PFD and inflation-proofing. Under the plan currently being proposed the earnings reserve would be used to fund general government. He added that the Supreme Court would not change its opinion, but rather change the purpose of the ERA which was the Legislative Finance Division's analysis. Attorney General Richards commented that he looked forward to a future opportunity to debate the issue with Representative Gara. Vice-Chair Saddler suggested that the SBR and CBR had been the state's emergency "go-to" money for deficit situations. The legislation would get rid of the CBR by placing it into the ERA. He wondered about the emergency capacity for spending if the state experienced an earthquake, a flood, or oil prices went down to $8 or $4 per barrel. He wondered if the money would be in the ERA. Attorney General Richards responded that the governor's plan only placed about half of the CBR into the ERA. The most recent balance in the CBR was about $7 billion. The plan would place $3 billion in the ERA leaving $4 billion in the CBR which would either be appropriated in the current year or remain in a stabilization account: a short term account used to meet emergency needs or to close current year budget gaps. The plan did not eliminate all of the funds by placing the funds into the PF, only $3 billion of the $7 billion. Vice-Chair Saddler clarified that Attorney General Richards was talking about $3 billion of the $7 billion in the CBR. He noted he was only seeing $3 billion in the CBR, not $7 billion. He saw $7 billion in the ERA. Attorney General Richards relayed that one represented an amount and one represented a cash flow. He reported that there would still be about $2 billion in the CBR to fill a need. Attorney General Richards advanced to slide 22: "Calculating the Draw: The Petroleum Model." He informed the committee that the administration used a probabilistic method in its petroleum modeling. There had been a question about why the petroleum revenue projections in the APFPA modeling were slightly different than in some of the budgetary projections. He explained that rather than basing all of the projections on one price, a range of oil prices was used and each price was assigned a probability of occurrence. The consequence of applying a range was that the revenue collected differed from when an average was applied. The state had a progressive tax system. Less revenues would be collected at $50 per barrel of oil than if $50 per barrel was the mean with the chance of the price of oil reaching $100 per barrel. At progressive rates it was a much larger number than the mean $50. In other words, by capturing a range of oil prices (rather than one price) future projections were more accurately captured. Attorney General Richards continued that for production forecasting a range was not used, but rather the model took the DOR's production forecast out to 2040 adopting it as a static. He believed it created a conservative bias to the model. The Department of Revenue projected development from known fields and deposits currently in production, and a small amount of non-currently producing oil in the form of future development in field. It did not assume any development from some of the future potential additional new fields: ANWAR, offshore, and the Outer Continental Shelf (OCS). It was a conservative view of Alaska's future. Co-Chair Thompson acknowledged Speaker Mike Chenault in the audience. Attorney General Richards summarized the calculation from the governor's bill and explained how the $3.3 billion was determined. It started with the balance of the PF as of the projected end of the period plus the $3 billion assumed in the model to be transferred to the ERA. It then calculated how much the state projected in PF investment earnings over time, how much would be deposited into the PF from production taxes in the future, and how much would be deposited into the PF from royalties in the future. It also accounted for the fact that the PF had expenses, the dividend payout, and a draw from the PF that went into the GF under and endowment model. Using the 50 percent royalty dividend formulation the state would be able to take out $3.3 billion per year from the PF to the GF. The 2 draws, (the dividend and the fixed draw) allowed the PF to grow at the rate of inflation over time. 2:53:42 PM Representative Munoz asked about other projected GF revenues outside of the $3.3 billion sustainable draw. Attorney General Richards responded that there were two parts to his answer. First, there were revenues already on the books such as state income taxes and petroleum property taxes. Second, the governor's total plan placed other new revenue measures on the table which would not go into the PF. Commissioner Hoffbeck confirmed that the corporate income taxes and the petroleum property taxes were the largest revenues. There were other revenues that would equal about $800 million to $850 million in fees and taxes that were currently on the books. The Department of Revenue projected an additional $100 million to $150 million in investment earnings outside of the PF. He concluded that there was about $1 billion in other revenues that flowed into the GF. Representative Munoz noted that Commissioner Hoffbeck's figures brought the total up to about $4 billion. She wondered how the plan balanced the budget. Commissioner Hoffbeck mentioned new revenues of about $450 million in new taxes proposed by the governor and additional cuts. The governor's plan had about $500 million in reductions. Co-Chair Thompson referred back to the barrel chart on slide 18. He noted that the PFD would be based on royalties. Statements had been made that 50 percent of the royalties would go towards the PFD payments. In the scenario on the barrel chart it appeared that 25 percent of royalties were placed into the corpus and 75 percent into the ERA. He wondered if 50 percent of the total royalties would go towards dividends or 50 percent of the 75 percent that were going into the ERA. Attorney General Richards responded that it was 50 percent of total royalties. He added that the 50 percent did not have to run through the PF. It made sense to do so from an asset management perspective as well as keeping the dividend tied to the PF. The administration thought it was part of Alaska's psyche which made sense to maintain. 2:56:39 PM Attorney General Richards scrolled to slide 24: "Earnings Reserve Durability." He indicated that the slide addressed the sustainability of the earnings reserve. He emphasized that whatever endowment model was adopted (POMV, the governor's plan, or another plan) needed to be accompanied by a high level of confidence that enough money would be available in the earnings reserve to pay the dividend and the payout to the GF each year because the constitution stated that the corpus of the fund could not be touched. If the state were to run its savings down to zero the state would be faced with a fiscal hole that could be plugged by sending less to the GF then planned or by not paying the dividend as planned. In the administration's plan it created a high level of certainty by maintaining a target balance in the ERA of four times the annual payout. Such a target provided the state 4 years of cash-on-hand to pay the total draw down each year. He asserted that it was a fairly robust target figure. He had heard that the Alaska Mental Health Trust used a similar system, the ratio of which was smaller. They had been successful in having less than four times in their payout account. Vice-Chair Saddler asked if the same conservative, short- term, cash-based investment standards would be applied to the funds available to pay dividends. He wondered if it would decrease the overall take on the corpus and the earnings reserve. Attorney General Richards relayed that the earnings reserve was typically managed the same as the corpus of the PF. However, if money needed to be withdrawn every year in addition to the dividends the funds would need to be managed for more liquidity. Some amount of money would possibly be managed shorter term, but most likely only a small percentage. He had discussed the issue with the Permanent Fund Corporation. Vice-Chair Saddler commented that he would have accepted accounting for more volatility at an amount of four times the expected draw. 2:59:37 PM Co-Chair Thompson wondered why any excess funds above the targeted reserve amount would be placed in the corpus rather than in the SBR or the CBR for emergency purposes. Attorney General Richards stated that Representative Thompson's suggestion was feasible and was a policy decision. However, it would impact the model by no longer reaching the sustainability goals. If the money was removed from the PF above the target reserve amount (used for inflation-proofing the corpus) the corpus would not be growing the size of the PF equal to inflation. He furthered that the definition of sustainability would have to change to exclude inflation-proofing or draw less to account for the growth in the system. Attorney General Richards advanced to slide 25: "Earnings Reserve Durability." He noted that regarding durability the 4:1 target amount was conservative and provided a high level of confidence and coincided with the state's periodic review. In the following year and in every 4 years after there would be an analysis of the sustainability of the plan, whether the draw amount needed adjusting, and whether the ERA was sufficiently durable. Having the 4:1 target ratio in place meant that the state would have about enough money to provide for the period of time between the 4 year review cycles. Representative Guttenberg was unsure whether the 4:1 ratio was the proper proportion. He assumed that the investment board conducted the modeling and the reviews. He asked whether the sufficient time to react had to do with the investing or the legislature's ability to provide solutions. Attorney General Richards reported that the legislation called for the DOR to conduct periodic reviews with input from the PF Board of Trustees. The Permanent Fund Corporation was not doing the modeling but providing the return assumptions and the statutory return assumptions to be used in the modeling. It was expected that the PF would not manage to the model. If an adjustment was needed it would be at the direction of the legislature. The Permanent Fund Corporation did not dictate how much money should be in the fund or how it was spent. It took direction from the legislature. 3:03:45 PM Representative Guttenberg conveyed that discussions had been going on about the management of the PF to meet the state's budget level. Commissioner Hoffbeck mentioned hearing two complaints most frequently about the governor's plan relating to the dividend. First, it changed the value of the dividend. Second, the volatility was transferred to the dividend even though it created a sustainable draw for government. He believed that the concerns were addressed in slide 26: "How to Handle the Dividend: Historic Dividends." He noted that the dividend had always been volatile never having had a fixed price. Over a period of the previous 12 years the dividend reached over $1500 on 4 occasions, between $1000 to $1500 on 4 occasions, and below $1000 4 times. He furthered that the dividend would continue to be volatile in the future, no matter the formula. He pointed out that the dividend had been high for the previous 2 years: $1800 dividend 2 years previously and the highest dividend ever in the prior year. The median payout over the 34-year life of the dividend was about $1000. The average payout was $1140. He also noted that the dividend payout had only reached above $2000 twice in 34 years. Secondly, the fiscal plan included a balance of the earnings from the state's wealth, its spending, new taxes, and the dividend. Increasing the size of the dividend would decrease the amount of earnings that could be used for government services which would require more new taxes or additional reductions. He reiterated that a $2000 assumption of the dividend payout was not consistent with historic data. 3:06:41 PM Commissioner Hoffbeck advanced to slide 27: "How to Handle the Dividend: The current formula distributes 50% of realized gains." He relayed that the dividend was generated by a formula. The constitution stated that all of the PF earnings were to be deposited into the general fund unless otherwise provided by law. The earnings have always flowed out of the dividend and made accessible. The current law provided that the earnings were to be used for 4 things: dividend payments, inflation-proofing the corpus, earnings reserves, or savings. The funds in the earnings reserve had always been available for appropriation. The legislature created a stable and durable circumstance by following the rules established by a legislature 35 years previously. Vice-Chair Saddler had heard criticism from some Alaskans that the legislature had "Spent like drunken sailors, spent every dollar available to them." He thought the information that Commissioner Hoffbeck had presented made it clearly evident that the legislature had been prudent with the large influx of revenue, spending only half of it and saving the other half. Commissioner Hoffbeck responded, "Absolutely." Representative Edgmon commented that with the downturn in oil revenues there would be a shrinkage in the overall gross domestic product of Alaska. He wondered if any of the modeling pointed to a decrease in Alaska's population resulting in an increase in dividend payouts in the future. Commissioner Hoffbeck commented that in doing the modeling the DOR considered that there would likely be a decline in population in future years. Representative Gara referred to the previous page where the commissioner talked about the historical average of the dividend being about $1100. He relayed that for most of the life of the dividend the PF balance had not been at $50 billion. He did not feel it was fair to factor in years when the PF did not have a high balance. Attorney General Richards made the point that no one expected investment returns such as in the '80s and '90s. The historic growth of the fund was over 9 percent during that time. Currently the projection was 6.9 percent. 3:10:08 PM Commissioner Hoffbeck explained the current dividend formula. The state took a 5-year average of the statutory net income (using a 21 percent figure) that flowed into the ERA. Half of the 5-year average was taken to pay the dividend. In using the previous year's numbers the balance of the PF was $13 billion times 21 percent equaled $2.7 billion. Half of $2.7 billion or $1.4 billion was transferred from the ERA into the dividend fund. After adjustments the dividend fund was divided by the number of eligible applicants, more than 644,000. Individuals received a check for $2072 [in 2015]. It was a legislatively derived formula from 35 years previously. Commissioner Hoffbeck turned to slide 28: "APFC Board Resolution 03-05." "The Board recognizes that … a POMV spending limit methodology … may necessitate changes to … the Permanent Fund Dividends" Commissioner Hoffbeck concluded that people began to recognize that once earnings were used in any fashion the dividend payout would change. The formula, inputs, or both would change along with the payout. The earnings reserve would have to be used in some portion to fund government services. If a person allowed for the fact that some of the earnings would be used going forward, then the dividend formula would change no matter what. Commissioner Hoffbeck pointed to slide 29: "How to Handle the Dividend." He relayed that the governor's proposal tied the dividend to royalties, 50 percent of Alaska's ownership share in oil revenues. It connected the dividend to the success of the state and tied Alaskans to the economy. As a resource state the better it was doing with resource development the better for the state. The dividend would increase or decrease according to what the state could afford to pay by tying it to the royalty. The state could also payout a flat dividend of $1000 or $1200 dividend going forward. It would just change the amounts of the other components. He reported that $1000 dividend would equal about $650 million per year based on Alaska's current population. Compared to the 50 percent royalty dividend, it would drop the state's sustainable draw by about $200 million per year. Co-Chair Thompson asked for a report on what had been the royalty value over the previous 10 years. Commissioner Hoffbeck would provide the information. 3:14:18 PM Representative Wilson asked about the connection of the dividend to the state's success. She wondered why the state's success was not related to its spending. Commissioner Hoffbeck replied that was his third option not listed on the slide. The state could tie the size of the dividend to the fixed draw linking it to state spending. Representative Wilson interjected that her question had to do with why the success of the state was not connected to its spending. Commissioner Hoffbeck suggested that to some extent he felt that as part of the plan state spending had to drop. The budget could not be balanced by only taking one element of the plan, but rather all three: cuts, revenues, and the use of the earnings reserve. Representative Wilson agreed that the state could not rely solely on oil revenues. She thought there were sustainable numbers with the right size of government down to $4 billion or $4.5 billion. She was hearing more about generating new revenue rather than controlling state spending. She opined that a balance between revenue and spending was lacking. She did not believe the reduction of $100 million was enough. She wondered if there were any formulas being discussed having to do with the state's spending levels. Co-Chair Thompson reported that the subcommittees would be coming back to the finance committee with suggested sustainable spending levels. Additional revenues were the current focus. Commissioner Hoffbeck opined that the APFPA started with determining the sustainable draw. The other targets would be decided once establishing the draw amount. The administration had $1 billion dollars to account for to balance the budget. He suggested that the discussion would become about reducing the size of government or a combination of that and generating new revenues. Attorney General Richards invited members to consider the options on slide 30: "Periodic Review." He thought he had already covered the key points and would move to the next slide. He added that a periodic review was a good idea regardless of what plan was decided upon. 3:18:02 PM Attorney General Richards scrolled to slide 32: "Government Spending & the Economy." He suggested that the state's current situation was due to the volatility of commodity prices and perhaps long-term declines in oil production. He relayed that there were other oil-based economies such as Africa, the Middle East, Wyoming, and Alberta that were experiencing similar types of issues that Alaska was encountering. He wondered how to have a sustainable, predictable, rational budget when 70 percent to 90 percent of revenue was based upon a commodity that could jump 50 percent in price from year-to-year. Attorney General Richards noted that recently there had been a significant amount of academic and other literature available on how to address the problem. He reported that in October the International Monetary Fund finalized a report that compared 85 economies over 3 decades. It was determined that the devil was pro-cyclical spending. The state needed to address its pro-cyclical spending; the way in which commodity-based economies tended to spend more on government at times when commodity prices were high and the economy was doing well. There were typically large capital budgets, growth in operating budgets, and growth in other service budgets. At times when commodity prices fell without a designed fiscal system to handle the fall capital budgets were reduced and operating budget growth was clawed back. The report stated that for economies that were able to design rules-based systems or diversified their revenue bases through other forms of taxation to address the commodity rollercoaster, the net result was an increase in .3 percent year-to-year GDP growth - a huge number. If there were booms and busts in an economy accompanied by contraction in investor confidence, consumer confidence, and governmental spending, an economy's long-term growth would be hampered significantly. 3:20:54 PM Attorney General Richards turned back to slide 16: "Rule- Based Fiscal Policy" referring to it as his capstone. He explained that the slide talked about some of the factors the administration believed the legislature should consider if the state was going to adopt an endowment model that spent PF earnings in a way other than paying dividends. He framed the policy in terms of rules. In looking at Alaska's history and hearing from Mr. Rietveld who testified about sovereign wealth funds, the administration found that the critical components that made the legislature so disciplined with the PF were rules-based systems and customs that were in place defining when the PF money could be spent. Following the rules-based systems the Alaska Legislature had done an amazing job by always inflation- proofing the fund (even though it was not constitutionally mandated), methodically following a dividend payout formula (also not constitutionally mandated), and never tapping the earnings reserve in an ad-hoc manner to pay for a capital project or to make up some short-term budget shortfall (even in the '90s when it needed to). It showed incredible discipline for a body to follow a rules-based system if the rules were well defined. Even though inflation-proofing, a dividend payout, and no ad-hoc spending were a result of a majority vote. The legislature had followed the rules-based system for the previous 30 plus years. The governor's plan hoped to take the current-rules based system and modify it to a slightly different rules-based system that maintained the equal level of respect and custom by the legislature even though it was subject to an appropriation of a majority vote going forward, much like the old PF system. Attorney General Richards continued that when thinking about the proposed plan he encouraged members to consider the rules for addressing each problem. The first problem had to do with whether the proposal had a way to remove the roller coaster consequences to the budget and to the economy associated with oil price volatility. The governor's plan accomplished this by placing production taxes and royalties into the PF and by having a fixed amount withdrawn as an annuity. There were other ways such as a spending rule or some other mechanism that might be used to similarly or differently address volatility. He thought the question should be about how the plan addressed volatility. The second rule was a new spending rule. If the state was going to draw funds out of the PF to go to the GF then a rule was needed such as a POMV or a fix-based system. He reasoned that many different rules were defensible, but having a rule was critical. Attorney General Richards reviewed the third rule. The savings rule would be different depending on the plan. The baseline would always be 25 percent of royalties because it was constitutionally mandated. There were also other ways of having savings included. He provided an example from the governor's plan which would include additional taxes and royalty revenues into the PF. The fourth rule, the growth rule, required sustainability. In looking at different proposals to use the PF, sustainability needed to be an important factor. In other words, the long-term growth of the PF needed consideration for each of the potential plans under evaluation. Under the governor's plan growth had to be at least at a level equal to inflation-proofing. The final rule he encouraged members to look at were protection rules. He asked what rules-based system would be in place to prevent ad-hoc rates. The current system and the governor's system were similar because in both plans there was a constitutional protection of the corpus, a statutory rules-based protection, and a custom built around the earnings reserve. He thought that the 5 rules in the slide provided a good framework to assist legislators in thinking about and comparing different proposals to tap the PF earnings. 3:25:58 PM Attorney General Richards referred to slide 36: "Delay will . . ." Delay will . . . · Risk the sustainability of an endowment plan · Reduce the sustainable draw · Risk a downgrade of Alaska's credit rating · Damage Alaska's economy Attorney General Richards told the committee that the slide was included at Representative Edgmon's request. He reported that particular question posed to the administration was whether there was a cost of delay. He defined delay to be "kicking the can down the road" or not making any decisions in the current year. He responded that it would be difficult to quantify or capture everything that could be affected. The administration identified 4 costs to delaying making decisions. The first he identified as the sustainability of the endowment plan. He explained that currently DOR projected that without making any changes (status quo) the state would completely spend down the CBR and the earnings reserve by FY 22. However, there was a 20 percent chance that it could happen by FY 21 depending on the stock market performance and the price of oil. The state would not have enough money by FY 21 or FY 22 if changes were not made to meet the state's budget holes with the CBR and the earnings reserve. There was a 5 percent chance that the state would run out of money by FY 20. Another cost of delaying the implementation of the governor's plan or another plan in place was that the state would spend down more savings reducing the state's sustainable draw. If the state waited 1 year the draw would decrease by $100 million to $150 million. If the state waited 3 years the sustainable draw would decrease by $400 million to $500 million. Attorney General Richards reported that the last two costs included the downgrade of Alaska's credit rating and the overall damage to Alaska's economy. Both risks were more qualitative than the first 2 items. The Department of Law had asked the DOR to quantify the actual costs to Alaska in terms of an increased interest as a result of any credit downgrades. He reported that Standard and Poor's stated that the state's credit rating would decrease if nothing changed. Lastly, the more qualitative problem of delay was that if investors and individual Alaskans did not see a path forward that gleaned confidence they would likely be less willing to invest. There could be a potential rippling effect of higher unemployment and a drop in home values: consequences of the economy not moving forward. A sustainable budget was such a large part of the state's economy. He would be providing some of the actual financial costs in borrowing if the state was downgraded. 3:30:07 PM Representative Edgmon appreciated the slide. He thought it captured the macro factors involved with kicking the can down the road. He was most concerned with the fourth item, damaging Alaska's economy. He wanted to hear more about item four and suggested also hearing from people from the private sector about damaging Alaska's economy. It was new for the legislature to have to entertain such a drastic level of new revenues, budget reductions, taxes, and all of the pejorative things imaginable in an election year. He thought it to be a watershed proposition if the legislature were to endow an endowment plan. He wanted to hear additional comments on how delay would damage Alaska's economy. Co-Chair Thompson remarked that there would be more detailed vetting of the bill along with others in the future. Vice-Chair Saddler referred to the governor's comment about how the plan was written in pencil rather than in ink. He asked how much of the bill (HB 245, version A) was in ink and in pencil. He wondered how committed the governor was to each element of the plan or to the general concept. He noted that there were competing concepts. Attorney General Richards responded that the administration and the governor were committed to the plan and thought it was the best plan in terms of addressing the issues listed on his capstone slide (growth, volatility, protection, and spending rules). He suggested that at the end of the day it was the legislature's prerogative to adopt a bill they thought was best. He added that the administration would work with the legislature to come to a compromise that addressed all the items on the capstone slide. Both the governor's plan and a POMV plan worked under any PFD formulation. The dividend could be set at any level. Future dividends could be based on a number of calculations which would be part of the dialogue. At the end of the day the consequence would be how much could be taken from the system for GF spending. Vice-Chair Saddler asked if there were any elements of the bill that, if not passed into law, the Attorney General Richards would advise the governor to veto. Attorney General Richards had not had such a dialogue with the governor. HB 245 was HEARD and HELD in committee for further consideration. Co-Chair Thompson indicated there would be additional hearings on HB 245 and a sectional analysis would be provided for review. He conveyed the agenda for the following day. ADJOURNMENT 3:34:32 PM The meeting was adjourned at 3:34 p.m.