Legislature(2005 - 2006)
05/05/2005 04:55 PM Senate FIN
| Audio | Topic |
|---|---|
| Start | |
| HB61 | |
| HB149 | |
| HB169 | |
| HB211 | |
| HB225 | |
| HB123 | |
| HB215 | |
| SB46 | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
CS FOR HOUSE BILL NO. 215(FIN)
"An Act relating to the investment responsibilities of the
Alaska Permanent Fund Corporation; relating to regulations
proposed and adopted by the Board of Trustees of the Alaska
Permanent Fund Corporation and providing procedures for the
adoption of regulations by the board; and providing for an
effective date."
This was the first hearing for this bill in the Senate Finance
Committee.
MIKE BURNS, Chief Executive Officer, Alaska Permanent Fund
Corporation, Department of Revenue, stated that the issue at hand
is the question as to "why the Prudent Investor Rule even be
considered as the primary overarching policy governing the
investment of the Alaska Permanent Fund." The initial step in
addressing this question would be to review the Alaska Permanent
Fund Corporation (APFC)'s "mission, which is to maximize the value
of the Permanent Fund through prudent long-term investment and
protection of principal to produce income to benefit all
generations of Alaskans".
Mr. Burns read portions of his written testimony [copy on file] as
follows.
It is not difficult to see the many challenges inherent in the
Permanent Fund's mission and equally easy to see that they
often are in conflict. Maximizing returns in a manner that is
prudent, doing so over the long-run (indeed perpetuity) and
still protecting Fund principle while at the same time
producing and distributing substantial levels of income
annually in perpetuity (across future generations) is a major
challenge for those charged with investing the Fund's assets.
For several hundred years, most trustees facing similar
challenges have operated under a "prudent" policy implemented
by a simple constraint: permit the investment of fund assets
in only those instruments which, when viewed individually,
were likely to produce income and protect the nominal value of
the fund. These instruments were few and primarily focused on
fixed income. This particular foundation for a prudent
investment policy succeeded in some respects, but has
generally failed to meet the full spectrum of requirements
such as those expressed in the Permanent Fun's Mission. IN
particular:
· The predominate, and in some cases, exclusive use of
fixed income and related securities left the real corpus
extremely vulnerable to inflation.
Over the last three decades, trustees facing challenges highly
similar, and in some cases identical, to those facing the
Alaska Permanent Fund, have been abandoning the "restrictive
list" foundation for implementing a prudent investment policy
and instead have adopted the Prudent Investor Rule as the
guiding policy for investment fund assets.
Mr. Burns noted that 44 of the 50 states in the United States have
moved away from the restrictive or statutory lists.
The Prudent Investor Rule's underlying premise is that the
primary responsibility of the fiduciaries is to ensure that
the estimated risk and return of the total portfolio is
appropriate in light of risk tolerances and the particular
objectives of the assets. This focus on the least estimates of
the total portfolio's long-term behavior along with the
development of modern portfolio theory has fundamentally
changed the foundation for "prudent" fiduciary behavior…
In current law, this emphasis on the whole portfolio rather
than individual investment categories the fiduciary is said to
have " a duty to evaluate investments in the context of the
portfolio as a whole while the duty to select reasonable
levels of risk are targeted to the fund and diversification
itself becomes as a fiduciary obligation…
The relevant point for the Alaska Permanent Fund is that it is
quite possible that either now or at some time in the future,
the inability to access a broader range of asset classes may
result in the creation of a Fund that contains either excess
risk or unnecessarily lower long-term returns.
Mr. Burns referred Committee Members to the "'Efficient Frontier'
of Investments" graph on page four of the Alaska Permanent Fund
Corporation handout titled "Reducing Risk, Increasing Return" [copy
on file]. The graph's horizontal axis measures risks and the
vertical axis measures expected returns. The lower graph-line in
the chart depicts the "Efficient Frontier" for the Alaska Permanent
Fund "as constrained by the current statutory list". Each of the
dots on that line reflects the "risk and return characteristics of
different asset allocations". The square mark on that line,
referred to as "#8 March 2004 Target" is indicative of the risk and
return level of the Fund today, which is a 7.83 percent return with
10.29 percent standard deviation.
Mr. Burns continued that the upper graph line would reflect the
Permanent Fund's portfolio were it instead constrained by the
Prudent Investor Rule. The points on that line also reflect
differing asset allocation categories. The "green square" on the
upper graph line would reflect the 7.83 percent return being
currently experienced. Under the Prudent Investor Rule that level
would be obtained with lesser risk. The level of risk currently
being experienced is reflected on the upper line by mark "6";
however, under the proposed Prudent Investor rule, that level of
risk would be accompanied by a one percent increase in returns.
Mr. Burns stressed that, "the constraints of the statutory list
today are pushing us in the direction of higher risks for lower
returns and that is not what any of us are seeking".
[NOTE: Co-Chair Wilken assumed chair of the Meeting.]
6:31:32 PM
Senator Stedman, referencing the differences between the
aforementioned marks "6" and "8", asked "how accurate is the
measurement of that when you have static investments that aren't
actively traded". He noted that the Alaska State Pension Investment
Board (ASPIB) had provided testimony to the effect that standard
deviations were difficult to estimate and therefore not included in
their reports.
Mr. Burns asked whether Senator Stedman was referring to real
estate or private equities.
Senator Stedman clarified that his remarks pertained to private
equities.
Mr. Burns explained that the APFC includes "those in our financial
projections with their expected internal rate of return." The
determination is that that is the most accurate manner in which to
reflect it. Private equities, at a level of $2,900,000, are a small
asset, and at this time, do not have much affect. He pointed out
that the graph depicts "expected return and expected risk" based on
"historical factors for these asset categories".
6:33:03 PM
Senator Stedman recalled that the APFC asset allocation had been
increased by five-percent the previous year in order to allow the
Fund "to have more liquid assets classes" to help it "increase its
return and, in theory, decrease its volatility at the same time".
He asked whether that level had been obtained to date.
6:33:42 PM
Mr. Burns replied that that level has not been reached. He exampled
that the University of Alaska Foundation has specified that 18-
percent of its assets would go into what is referred to as
"alternative investments", which "are basically basket clause type
of investments" to which Senator Stedman has referred. Even though
the University is having difficulty reaching the 18-percent, there
are now commitments to increase that level to 24-percent. "You
don't control when the money goes out the door and you don't
control when it comes back on some of these private type of
investments, so you need to over-commit if you are going to get to
your target." APFC Trustees, through "the powers granted to us
through the additional basket clause made a commitment of
$600,000,000 to private equity". $240,000,000 of that $600,000,000,
allocation has been committed, and of that $240,000,000,
"$2,900,000 is out the door. It is a very lengthy process." It is
necessary to over-commit in order to reach the level desired. The
mechanism to avoid a situation of over-commitment is to include
"contractual obligations and a statutory limitation". Those are
necessary even though "it would be highly unlikely" for all of the
commitments "to be called at one time".
6:35:20 PM
Senator Stedman acknowledged.
[NOTE: Co-Chair Green resumed chair of the meeting.]
Senator Stedman spoke to the "bigger issue" of the underfunding of
the Public Employees Retirement System (PERS) and the Teachers
Retirement System (TRS). Efforts are being taken to address that
$5,700,000,000 under-funding situation. To that point, he
questioned whether this would be the appropriate time to consider
the proposal being advanced in this bill. He suggested that a
better time would be to address it in January and February 2006
when the Committee could review the portfolio of the PERS and TRS
Trust Assets and the Permanent Fund (PF). He noted that ASPIB does
not currently operate under the auspice of a statutory list, and
that they currently "have more volatility, and they seem to have a
little higher return on the upside and a lower one on the down
side." He argued that it would be "a nice fit" for the Finance
Committee to address "this issue at the same time because they are
very closely related. The education" that would be gained on the
part of both the public and the Legislature were those efforts to
"run simultaneously" or in close sequence would be beneficial.
6:37:31 PM
Senator Stedman noted that the five-percent allocation increase the
Legislature had provided APFC through the basket clause does not
appear to be "maxed out yet" so a delay in addressing this
legislation would not place "the PF at any major disadvantage". He
"recognized" that over the last decade the PF has endeavored to
move away from the statutory list.
6:37:48 PM
Mr. Burns spoke to the timing issue by conveying that APFC is
convinced that the proposal being forwarded "is the right concept".
In addition, APFC is convinced that the current process is "hurting
the Fund's performance". Yesterday, for example, the Fund increased
in value for approximately $250,000,000, which is less than one-
percent. To that point, he questioned whether waiting to act on
this proposal would be the right thing to do considering the Fund's
volatility. "We would love to be part of the State's process "of
re-thinking how the State invests its assets", however, it should
be noted that, were this legislation adopted, it would not become
effective until January 1, 2006. Adopting this proposal now would
allow time for regulations to be developed so that the process
could begin in January. It would also allow APFC to develop a
report "as a precursor to how you deal with the new" PERS and TRS
Board and the PERS/TRS assets. That "would be very timely".
6:39:23 PM
Senator Stedman pointed out that many of the asset classes being
considered "are already liquid". Therefore, he questioned "the
accuracy of pricing; at best they're estimates". The true value is
provided when the asset is liquidated.
6:39:39 PM
Mr. Burns agreed to Senator Stedman's comments as they pertain to
"the real estate side". Those prices are re-evaluated every other
or every third year. While those changes in value are not reflected
in the Fund's financial statements, they are considered in the
Fund's performance. "You don't know what real estate's worth until
you sell it." Some of the Fund's longer term liquid assets in terms
of the Efficient Frontier", as opposed to assets we have, again,
are historical performances of these asset categories". Each dot on
the aforementioned graph represents "historical costs". Therefore
rather than reflecting performance, the graph would present asset
allocation.
6:40:41 PM
Senator Stedman stated that in order "to calculate standard
deviation, you have to have a movement in price". Absent a movement
in price, "you have to estimate or guessimate it". Therefore when
considering "inactively traded security you've got daily monthly or
weekly pricing" which could be used "to gauge that standard
deviation that moves over time".
6:41:14 PM
Mr. Burns agreed, with the exception being for instance that such
things as private equity "is a liquid, it's not priced daily, but
the standard deviation is figured from its historical movement", or
"its actual movement over time". There is enough history from which
to develop standard deviations and historical returns for all these
asset classes. The historical performance upon which we are basing
asset allocation is "there for all the asset categories".
6:41:57 PM
Senator Stedman responded "that, at best it's a smoothing issue
with the price movements". Absent movement in the market from which
"to actually gauge what it is, you're going to have points when you
sell it and points when you buy it".
Senator Stedman reiterated that ASPIB, which does not operate with
statutory list constraints, would appear to have more volatility
than the PF, "with higher highs and lower lows". He was uncertain
as to whether the Legislature "wouldn't be better served" to
address these situations "at a similar timeframe" when time could
be provided to thoroughly make a decision.
6:43:18 PM
Co-Chair Green noted that "it has been interesting … to watch the
transition over the years and how it's moved very slowly … from the
different percentages and the changes …. It is always a tough
conversation."
Mr. Burns stated that when discussing "the valuations of some of
these assets…" it must be noted that the PF is not solely basing
the standard deviation on how the PF assets perform, but also on
the information of APFC's consultant who has a universe of a 110
funds similar to the PF. "It's how these assets perform over that
universe." He "agreed completely with the assessment that as we get
into these in small amounts, our experience won't be that additive
to what the universe is for quite a while, but the universe is
there and, for our purposes and planning, it's a very valid
timeframe and returns."
Co-Chair Wilken recalled this being the third time that APFC has
asked this Committee to change the Statute that controls how the
Fund could be invested. Both of the previous requests were approved
and the Fund continues, "to exceed all of our expectations". While
being appreciative of Senator Stedman's concerns, he calculated
that a one percent change that would equate to $300,000,000 a year
or $6,000,000 a week, could be lost were this legislation not
advanced. That would fund a lot of education needs in the State.
Therefore delaying this legislation a year would cost the State a
significant amount of money.
Mr. Burns affirmed that Co-Chair Wilken's calculations were
correct. "Time is not your friend on this." Delaying this process
would not correct "what all of our experts and consultants" have
concluded we are doing to ourselves. "This fund is very deliberate
in its approach to things", and therefore, a lengthy process is
involved. This issue has been discussed for quite a while and APFC
is "convinced that this is the right thing to do".
6:46:39 PM
Senator Stedman argued against the correctness of the math, as it
is dependent on the market. Were the market to advance "sharply
higher", he would expect the returns to be larger. Were the market
to continue flat or to decline, as reflected by ASPIB's portfolio,
the results might be "average or worse". Therefore, the movement
from the point at which the policy was implemented "to the
measuring point" would be a factor. "Markets do not always go up"
and were the measurements taken "on an up day that's one
measurement period" and were they taken on a "down day" that would
be another period. "It's not a linear relationship."
Mr. Burns concurred that markets move both ways. He had considered
Co-Chair Wilken's remarks to reflect "the opportunity" that might
be there.
Co-Chair Wilken remarked that that is a measure of risk. However,
he noted that, as reflected on the aforementioned Efficient
Frontier graph that the State would not be changing its risk factor
were this legislation adopted. "The fluctuation up and down would
be the same regardless" of whether the status quo was continued or
changed to the asset allocation being proposed.
Mr. Burns affirmed that changing to the proposed asset allocation
would not alter the standard deviation. "What is equally important"
to note is that the point at which the proposed allocation would
achieve the same yield as the status quo, as reflected by the
"Expected Return" point on the proposed asset allocation graph-
line, would be a point of reduced risk. This would provide "quite
an opportunity".
Co-Chair Wilken voiced appreciation for the inclusion of the
language reflected at the bottom of page four on the aforementioned
handout that reads as follows.
Increasing the Fund's investment options would allow the
Trustees greater flexibility in managing the Fund for the
benefit of all Alaskans, whether it is for greater return,
lower risk or both. This is especially important as the
Legislature begins to contemplate the use of Fund earnings for
more than just the dividend program.
Senator Stedman understood that "the Efficient Frontier is a
dynamic instrument" and would change according to the measurement
period being considered. "It's not static line." The line would
appear different according to the time period.
6:49:43 PM
Mr. Burns clarified that the Efficient Frontier chart being
referenced "is not a point in time, that is an accumulation of
time; those are historical numbers". He was uncertain as to whether
the graph depicted the scenario for either the past five or ten
years.
Senator Stedman understood that to be the case. His point is that
the line would change for any ten-year rolling average.
Mr. Burns concurred that the slope of the line on the graph would
change according to the timeframe.
Senator Stedman agreed that, "theoretically, these investments
should produce and allow the portfolio to receive a higher return
for less volatility".
Mr. Burns responded that that is exactly the point.
6:50:43 PM
Senator Olson asked how significant the three-percentage point
standard deviation reflected on the aforementioned Efficient
Frontier graph is when compared to other investment scenarios.
Mr. Burns responded that the standard deviation in relationship to
today's 10.29 percent return would be "pretty significant".
Senator Olson asked how the three percent standard deviation would
compare to other similar investment portfolios.
Mr. Burns communicated that the PF portfolio is a fairly
"conservative asset mix". It is very different from a pension fund,
which has fixed liabilities. While he did not consider the Fund's
standard deviation to be "out of line", he expressed that it is out
of line when considered the return it is generating. "That's the
ratio" that should be considered.
6:52:06 PM
Senator Stedman commented that the portfolio's assets have evolved
to a 60-percent equities and 40-percent bonds balance. He
understood that since the market experienced "turbulent" times
around the year 2000, there has been a tendency "for asset managers
to look out away from the equity markets that are traded" on such
things as the New York stock exchange and to "try to go into other
asset classes to tone down the volatility" and to achieve more
diversitility.
6:53:03 PM
Mr. Burns affirmed this to be true. The PF has a very diverse
portfolio including investments in worldwide equity markets; in
small, mid, and large capitalized markets; and emerging markets.
Efforts are exerted to achieve a good balance. He anticipated that
"the bigger change" would be the shift "to absolute return
strategies" rather than fixed income markets in an effort to remove
volatility.
AT EASE 6:54:00 PM / 6:54:23 PM
Co-Chair Wilken moved to report the bill from Committee with
individual recommendations and accompanying fiscal notes.
AT EASE 6:54:42 PM / 6:56:35 PM
There being no objection, CS HB 215(FIN) was REPORTED from
Committee with zero fiscal note #1 dated April 8, 2005 from the
Department of Revenue.
6:56:53 PM
AT EASE 6:57:21 PM / 7:12:54 PM
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