Legislature(2003 - 2004)
02/09/2004 08:12 AM Senate JUD
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
[The following is a verbatim transcript.] SJR 18-CONST. AM: PF APPROPS/INFLATION-PROOFING CHAIR RALPH SEEKINS: Okay, next we're going to move on to our second item, which is CSSJR 18[STA]. We're looking at version [H]. A little bit of history on this bill - we have had public hearings across the state. We had public hearings this summer in Fairbanks; we had public hearings in Kenai, in Mat-Su and in Anchorage. Today is our last opportunity for public hearings on this particular bill and then for any questions from the members that are present. Do we have anyone who would like to testify today on CSSJR 18? I see Mr. Storer is here from the [Alaska] Permanent Fund [Corporation] and I think the members pretty much understand what the proposal is here. Is there anything that you would wish to add to what you guys have testified on already four times across the state? MR. ROBERT STORER, EXECUTIVE DIRECTOR, ALASKA PERMANENT FUND CORPORATION: Thank you Mr. Chair. We're prepared to answer any questions that you may have. CHAIR SEEKINS: We'll hold you to stand by for any questions. Is there anyone on-line that would like to testify on this bill? [No response.] Anyone in the audience that would like to testify on CSSJR 18? [No response.] Mr. Storer, perhaps you could take the chair in case we do have any questions from members of the committee? Anyone signed up Mr. Hove? [No one signed up.] At this point, we're going to close public testimony on this CS for SJR 18. Public testimony is closed. Questions from the members - any questions, comments? Here's our opportunity to ask the expert as to what the formula that they originated from the trustees of the permanent fund is in this resolution that we're considering today. Senator Therriault? SENATOR THERRIAULT: Mr. Storer, I know one of the concerns that has come up is that with the allowable up to five percent draw, there could be some erosion of the principal in a down investment market or climate. I know that you have run some models historically looking back to see [indisc.] toss around some different ideas of how we could prevent that from happening. I'm wondering if you could just go over that? MR. STORER: Thank you, Mr. Chair. I'm Bob Storer, the Executive Director of the Alaska Permanent Fund Corporation. Senator Therriault, I have handouts from two views if I could ask that those be distributed? We take the longer term view so the first thing we looked at was what was the real rate of return based on a 10-year rolling average of the history of the fund. And if you look at that, you'll see that in all time periods - I should describe the chart - zero and above is the excess return - earnings of the fund above inflation so zero and below would incorporate inflation. This is zero and above is the real rate of return of the permanent fund. And then we've driven a red line through the 5 percent real rate of return because, of course, that's our proposed constitutional amendment. You'll see on a rolling 10-year period, during all time frames, we have been able to achieve a 5 percent real rate of return and that includes the most recent period where we experienced not only very high rates of return in the bull market but a 3-year bear market as well. In fact, we earned a 5.3 percent real rate of return for that 10-year period and you'll see it's trending back and we've extrapolated what we think we'll earn through this whole fiscal year. So that's one way of looking at it. But many people have said well what happens, you've got - it's on a rolling 5-year rate of return, so what happens if you look at a 5-year rolling rate of return perspective and you'll see I've also provided a graph for you on that as well. And you'll note that in virtually all periods we have earned an excess rate of return of 5 percent real, with the exception of most recent history when we had the 3-year bear market and you'll see that over those 5-year observations most recently, we still were able to achieve a real rate of return, albeit below 5 percent, slightly above probably about 1 percent, etcetera. Now it's trending upwards because the returns have been so good over that period. This chart highlights what I believe is the importance of the POMV, which is limiting or creating the discipline to not overspend in the good years. If you look at that chart, by not overspending, and the legislature did not, they created the cushion, the reserves that actually would allow us to meet, or allow decision makers to meet, the payments in the down years. So I think this chart illustrates, in my mind, the importance of the discipline in the good years to create a reserve for the down years. CHAIR SEEKINS: Go ahead Senator Therriault. SENATOR THERRIAULT: Just so I can make sure I understand this - so the zero line incorporates covering inflation? MR. STORER: Correct. CHAIR SEEKINS: Senator French? SENATOR HOLLIS FRENCH: Mr. Storer, I had a conversation with Mr. Bartholomew this summer and I explained my chief reservation about this proposal and that is in the same area that I think Senator Therriault was just asking about and that is the inflation proofing. The quarterly report you guys mailed out to me at my home late in the summer, early September, showed that the annualized 5-year return for the years ending June 30, 2003, that is going back 5 years from there, the total fund returned 3.39 percent. That's the kind of scenario I guess that most - at least I am concerned about, that we could go into a time that we're not making a lot of money and we're taking this 5 percent out and you start to claw into the fund. I think that really sort of highlights one of the difficulties in the proposal, and that is that if you really believe you can take out 5 percent regularly, after inflation proofing, and if one of the chief selling points of the model is that it provides a predictable payout, that is somewhat undercut by the idea that, well, you don't have to take that 5 percent in bad years. I think that's one of the faults, if you will, in the premise of the POMV is that you're going to have this predictable 5 percent payout except in bad years when you don't do that. Once I think you go to telling folks you're going to have a 5 percent payout, it's going to be very, very difficult to take something less than 5 percent. So I guess my concern is that in bad years, in years where you get a 3.39 percent annualized return, you haven't made your 5 percent and you haven't inflation proofed either. That strikes me as clawing into the principal of the fund. CHAIR SEEKINS: Let me ask a couple of questions so that we can take a look at this when we talk about this. You know I've been a used car salesman for a long time. What's the present market value of the fund, roughly? MR. STORER: It's in excess of $27 billion right now. CHAIR SEEKINS: Okay, so we've got 27 billion. What's the principal of the fund? MR. STORER: That's - I was afraid you were going to ask me that. I've been traveling so much but I think it's about $22.5 billion. CHAIR SEEKINS: So with that in mind, we've got $4.5 billion in market value that exceeds the current principal value of the fund? MR. STORER: Um-hum. CHAIR SEEKINS: So we'd have to have a couple of really bad years before we started eating into the principal if we started now with a 5 percent payout - is that correct? MR. STORER: That is correct. CHAIR SEEKINS: So there's a cushion already there that exists because of the discipline of the legislature in the past and so we should not confuse market value as principal - am I correct there Mr. Storer? MR. STORER: I think that's an important issue. I think you've - in my mind, I'd like to address a couple of things there. Everywhere I've seen in the United States over the last - as a result of the bear market, is everyone got caught overspending. Not everyone, but I can cite you example after example of overspending in the good years - they got caught up in the bull market mania. I believe the best way - this is what I believe personally, I believe it strongly - the best way to protect the principal is to create the discipline not to overspend. If I add some responses to Senator French's comments, I've thought about that a lot over the summer because I know it's important not just to you but to many people, and my response has always been as it relates to the POMV, and again I send you to the 10-year period, which says that in fact, we have been able to achieve that goal but we well may not in the future. The problem exists under the current system as well and we can't forget that. So then it becomes each system has a set of decisions or parameters around it based on the statutes, or the guidelines, or what matters. You are correct, if decision makers wished in a low real rate of return period to distribute 5 percent, we say the stability, the predictability - it's there or it's not there. Under the current system, and you know we have varying scenarios, we had a real rate of return there - what happens if we get a negative real rate of return? Under the current system, depending, you have the same problems but you can also hit that principal and theoretically go several years without any payment at all. Then you've got this 22 - 27 billion dollar fund that does nothing until the market value goes back above. And so it's a decision. It's an important decision. One gives you the flexibility. The other, in a really bad scenario, you wait or you change the Constitution to eliminate principal then. So the problem doesn't go away in either way. It just manifests itself in a slightly different way. CHAIR SEEKINS: And so, I see - as you know I was on the Permanent Fund Board of Trustees and I can see all kinds of different scenarios where even the current system could be used to actually spend into the principal by selling losers and other different ways to be able to do that to produce revenue into - well it wouldn't produce revenue but we could actually spend into the principal at this time. Is that correct? MR. STORER: If you - on the current, you can take income - if realized income is available you can distribute that. So if you had realized income and then unrealized losses, you could pay out and then the value of the fund would be below principal, as an example. CHAIR SEEKINS: What do we do with rents and royalties? Where do we classify those? MR. STORER: Those are realized income. CHAIR SEEKINS: So we could be losing in the market and not sell it because that's unrealized losses. MR. STORER: That is correct. CHAIR SEEKINS: And be bringing in rents and royalties that we call realized income and that goes to distribution even though we're losing our shirt in the markets? MR. STORER: Under the current system that's correct, Mr. Chairman. And the other question in all of this is, under the current system is would inflation proofing continue or not. It always has in the past through the statutory process. CHAIR SEEKINS: I always ask the question on that - if I was looking at my own family, you know, the question I ask is would I inflation proof it if I couldn't feed my kids? Easy decision but if I look at this then, if I understand my math was wrong as I look at it, $27 billion market fund - market value, $22.5 [billion] principal - that's $4.5 billion between principal and market value. If we were taking 5 percent of that market value now, it would take us three years to get down to principal? MR. STORER: If we didn't earn anything. CHAIR SEEKINS: If we didn't earn anything, so there's a cushion that's there and I don't think a lot of people in the state understand that that cushion exists because they only think in terms of the market value, not the principal value. MR. STORER: At one time, Mr. Chair, 25 percent of the fund was either realized income or unrealized gains, in about 1999, early 2000. CHAIR SEEKINS: Okay. Senator French? SENATOR FRENCH: But my understanding is when you enact the POMV, you eradicate that difference. As soon as you enact POMV, you stop thinking about principal and earnings. You make one big pot of money, and it's going to be about $27 billion and from that day forward, Alaskans are going to regard that as their permanent fund and they're not going to differentiate between what it's earned and what it hasn't earned. And I think from that day forward, we're going to have to give them some reasonable and, I think, explicit promise of inflation proofing. If these models hold true, then for us to write inflation proofing in the Constitution is no risk at all to the fiscal stability of the state. But, if I can finish, I have concerns about whether this model is going to hold true over the long run. We haven't seen a crushing period of inflation for some time now, not since the late '70s and early '80s. The first president I ever voted for was Jimmy Carter. Then I moved to Alaska and found out what a bad idea that was from many Alaskans' point of view. And during that time period, there was terrible, terrible inflation and I think, given the federal deficits that are being run up here in this country, the largest ever in the history of the nation, sooner or later the bond market is going to have to react to that and I think interest rates are going to have to go up. And so I'm just concerned that unless we put some positive guarantee of inflation proofing on paper - because in your system, inflation proofing is implicit and I'd like to make it explicit. I guess that's my chief concern. MR. STORER: Mr. Chair, first off I've looked at a lot of scenarios and the worst case scenario, in either case I believe, is, I'll call it hyper-inflation. We can handle rising inflation to some degree but if we revisit the '70s - the '70s, like the Depression, were the two very singular events. Can they happen again? Of course they can happen. That's the worst-case scenario under either scenario. It seems to be, well, if it happens, it's not in the foreseeable future. But the one thing I want - a couple of elected officials have asked me to provide statutory guidance, statutory insight that essentially addresses precisely what you're talking about - about memorializing the guidance by statute. CHAIR SEEKINS: And I understand that. In fact, I would support that. Go ahead, Senator Therriault. SENATOR THERRIAULT: If we got into a situation like the '70s with staggering inflation, under the current system we have a big problem too. MR. STORER: That's the worst-case scenario, there's no question about it. For a long time I've run models just trying to find what is the worst-case scenario. It gets postponed for a few years but you would have a big issue in terms of maintaining purchasing power and, at least historically, you would see low returns in bonds and equities during that period as well. SENATOR THERRIAULT: So the current system has not only the instability of the dividend roller coaster, but it's more susceptible to hyperinflation and the erosion that would accrue to the fund? MR. STORER: I believe it is. I believe it is because of that line that it is principal that you cannot go below and there would be - the question was - it becomes would inflation proofing be abandoned in that scenario? I personally find it hard to believe it would not be because the only way you could access income, or the first line would be to abandon inflation proofing so you're no longer maintaining your purchasing power anyway. SENATOR THERRIAULT: Mr. Chairman, it is true, as far as the wording here, Section 3 is a one time deposit of $4.5 billion that the legislature would be putting before the people and the people would vote on [whether] that $4.5 billion deposit from the earnings reserve would go into the principal, establishing a new level for principal. So I just wanted to clarify that. But, with regards to the 5 percent draw, the language says you may take up to - it may not exceed 5 percent. It doesn't say thou shalt take 5 percent each year. And, in fact, because you've got 4 or 5-year averaging, you are actually drawing off less than 5 percent. It's more like 4.75 or 4.8. Is that correct? Because you've got a growing fund - you've got new resources that are going in, you've got inflation proofing going in, so when you take the 5-year average of a growing fund, it's actually less than 5 percent of that year's market value. MR. STORER: Through the chair, that's absolutely correct. If you look at the snapshot of the payout versus the ending value of the fund, it looks more like around 4 and three-quarters percent. SENATOR THERRIAULT: So we look back on the history. The 10-year history shows that from a 10-year look back that we could have paid the 5 percent and if we want additional protection, we can consider statutory language or if somebody wants to propose or come up with a way sensibly to put it into the Constitution, you could have language that says if you get into a situation where you're going to dip down below that line, then you put the brakes on and your allowable draw is even less. CHAIR SEEKINS: I think it's very easy for us - I always - what I hear now - people say is well, it could erode the principal, we could be dipping into the principal and that's why I wanted to make it very clear that there's a $4.5 billion buffer from where the fund is now until we get to the principal. So that, in my mind, kind of satisfies that argument. And secondly, you know, I'm concerned about the faults of the current system where our growing fund causes us to overspend. We can exceed that 5 percent if we wanted to in overspending and how we do it, including inflation proofing - inflation proofing appreciating assets, which sometimes doesn't make that much sense to me unless somebody else is willing to do it for me, but, when I look at the current method, and if I try to characterize - let me ask you a question. How many investment funds and investment managers are just looking ... [END OF SIDE A]. TAPE 04-4, SIDE B CHAIR SEEKINS: ... current method of handling endowment funds? MR. STORER: Mr. Chair, the answer is not many because there are already - rushing to our methodology? CHAIR SEEKINS: Yes, our current methodology. MR. STORER: 85 percent of the endowments, the universities use some variant of what we're proposing. I'm not sure that I'm aware of any entity that still lives off the concept of realized income. Even accounting standards changed in the mid-'90s to recognize that appreciation is income as well. CHAIR SEEKINS: So we're not thinking up something new and a lot of other financial minds have said how can we best preserve our endowment without, you know, over the long term eroding it to nothing? And a percent of market value methodology is what they have found to be the best way to do that. Am I correct? MR. STORER: That is correct and there's many examples in Alaska that have adopted the percentage of market value payout as well. CHAIR SEEKINS: For example? MR. STORER: For example Anchorage. I was just talking to Senator Stedman - Sitka. I know the University of Alaska at Fairbanks - the foundation for years in Alaska has that methodology. CHAIR SEEKINS: The City of Fairbanks. MR. STORER: The City of Fairbanks has one. Bob Bartholomew in our office, the chief operating officer, was just in Barrow and he said that they've adopted the POMV as well. I'm not sure whether Valdez has or not. CHAIR SEEKINS: Okay. Senator Therriault? SENATOR THERRIAULT: Bob, you're a fiduciary for the permanent fund so you understand the fiduciary duty or obligation. Do you think it would be fair to characterize that if we had POMV, and you proposed to go to our current system, would you be subjecting yourself to possible litigation for breaking your fiduciary obligation - taking us to a system that is more subject to the ups and downs of the markets and more subject to the dangers of high inflation? MR. STORER: I'm sorry - if we? CHAIR SEEKINS: If we... SENATOR THERRIAULT: The POMV. CHAIR SEEKINS: If we had the POMV. SENATOR THERRIAULT: And you were proposing that we go to the system that we have currently, which is more of a roller coaster and more subject to inflation, would you possibly be setting yourself up for a claim that you have broken your fiduciary obligation? MR. STORER: One of the keys in a fiduciary is showing a process to make an informed decision. So if I was trying to convert us back, I would - within that obligation would be to show you a process that why - to give you an informed decision and I don't think I would be breaking my fiduciary responsibility. I think it would be a real challenge though, to convert from a POMV to realized income when you realize there's so many complexities in terms of our equity portfolio structure and the appreciation of those assets. CHAIR SEEKINS: If I could reword that just a little bit then - would recommending that someone go from a percentage of market value process, similar to one that's been recommended, to the current realized income, would it be in compliance with reasonable person responsibilities? I mean you... MR. STORER: It would be a challenge. CHAIR SEEKINS: It would be a challenge. I'll leave it at that. MR. STORER: But it would be - as I noted earlier, it would be inconsistent with current accounting standards. So, one of the challenges would be to say if current accounting standards recognize appreciation of the assets as earnings, then why are you saying that that doesn't matter and only realized income matters? That would be a challenge. CHAIR SEEKINS: So if we divorce ourselves, if we separate how any distribution would be used from the process, the process is the one that's most currently adopted by major endowments, financial advisors across the nation if not the world. MR. STORER: True, Mr. Chair. The permanent fund is about 27 years old now and if you look at our statutes - distribution, inflation proofing, they're 27 years old. We've [indisc.] additions to try and meet contemporary investment standards in there but they're 27 years old. Our realized income statutes made sense back then. I think you've all seen a slide that shows how our asset allocation has changed. I think our objective is to create a permanent fund that can meet the needs of the legislature, the citizens of Alaska, and also address contemporary investment management issues and that's what we're trying to do. CHAIR SEEKINS: Senator French? SENATOR FRENCH: Thank you. Call me hard headed but I'm really stuck on the inflation proofing issue and I think this chart makes my point as well as it makes yours. I'm not against modernizing the way the fund is handled, but if this model holds true, you can write into the Constitution, you must inflation proof the fund before distributing earnings and as long as you are, you know, over the last five years you would have beaten 5 percent - oh, I'm sorry - back to 1994, to the beginning of this chart, you would have beaten 5 percent every single one of those 10-year rolling averages and so you'd have exactly what you want, which is a predictable payout, and exactly what I want, which is concrete inflation proofing. Am I misunderstanding this chart? MR. STORER: No. That chart - there'll be some point where that chart will go below the 5 percent. SENATOR FRENCH: Sooner or later in time. MR. STORER: Yes. SENATOR FRENCH: It just happens. MR. STORER: Yes. It will happen. And, if I arrived here in May of '83 and we were having this conversation, you would say Storer, you're crazy, you can't achieve it, so that's an example and all of that. The question for all of you in regards to that in my mind is predictability and stability versus that piece then, which would eliminate some of the predictability or stability of payout, wherever it goes. That's there in the discussion point. And whether - how one wants to have that decision, either have that decision taken away, have that decision by statute, or address it every year, etcetera, that's the debate. What we're proposing gives greater predictability, greater stability to the payout over time, but the potential exists that at some time you could go below what we now call principal. The other side of the coin, the benefit, is you're not going to overspend in the good years. So, in a perfect world, if it happens in this environment, you've got the cushion to where you never have to go there. CHAIR SEEKINS: I think, as a way of comment, I think inflation proofing is important but, as I said earlier, it's not a hard decision for me - if I was going to inflation proof my if I couldn't feed my kids. I think the legislature deserves to have that kind of flexibility if we get into that kind of a situation. The state's going bankrupt and our Constitution says we must inflation proof our fund. I don't think that that's good fiduciary responsibility for the legislature to even think about that and so, in many respects, when I look, Mr. Storer, at how we inflation proof now, we're inflation proofing appreciating assets, which in many schools of thought would not be something that most people would do. Am I again fairly close to correct on that? MR. STORER: Mr. Chair, to use the POMV you don't need to inflation proof it because you are investing in inflation proofing assets so it occurs. The problem we have is those inflation proofing assets, such as equities, can be converted into profits and then those profits can be distributed and so POMV actually does memorialize inflation proofing - the appreciation as well. The current statutes do not guarantee inflation proofing. You still have the same debate either way, which is inflation proof or make a payment. CHAIR SEEKINS: In your estimation, for the coming fiscal year, what would inflation proofing be in total dollars? MR. STORER: I'm going to say about 575 - I don't think it's 600 million. Inflation is a bit over 2 percent right now and the fund is such - I guess more like 500 million. CHAIR SEEKINS: So $500 million that we'll put into inflation proofing, regardless of what other needs the state has. MR. STORER: Correct. CHAIR SEEKINS: Thank you. Senator Therriault? SENATOR THERRIAULT: Thank you. At looking at this chart I think - something that this chart also points out that - in addition to the inflation proofing we have - the legislature has continued to put excess money into the permanent fund and that's basically what the hills - the peaks are here is the retention in the fund of excess dollars above and beyond the 25 percent contribution every year above and beyond inflation. If you look back over the years, of course, we've dumped in billions and billions of dollars in just additional cash deposits too. So the allowance over a long period of time, you know, coming close to this line or slightly dipping below and then going back up, you made your extra deposits, you retained the extra value here to protect yourself against that and, you know, in addition, we could put something on the books that would limit the draw, you know put some dampers on the draw in any period that you did get below. MR. STORER: That is correct and also the legislature, if this were the February 2000 and 25 percent of the fund was profits, the legislature displayed the discipline that we're asking for and did not overspend, did not exceed the 5 percent and that gave us the cushion to work through a very severe bear market - a 3-year bear market to where we were able to make the distributions, we were able to inflation proof. Why? Because that discipline was there, both in the special appropriations to the fund and not taking more of the earnings than is necessary, reasonable. CHAIR SEEKINS: Senator Therriault, go ahead. SENATOR THERRIAULT: Thank you Mr. Chairman. So with the current situation, if you are concerned about the legislature eroding the value of the fund, and we're getting into a tight revenue scenario and more and more pressure to come up with money, with that $4.5 billion sitting out there that can be realized, that should be weighing on your mind I would think. MR. STORER: It's available for consideration. CHAIR SEEKINS: Mr. Storer, conceivably the legislature could establish - to answer the question, the concern about eating into the principal of the fund, which has been dedicated there and I think is defined legally - am I correct there - what the principal is? MR. STORER: It is. CHAIR SEEKINS: So there's a legal definition of what we consider the principal of the fund. MR. STORER: Um-huh. CHAIR SEEKINS: If we were to say okay, as a legislature, we could take that principal fund as of the end of the last fiscal year, we could deposit into it the royalty income that we get in from oil and natural resources. And, in addition to that, we could theoretically take an average inflation proofing over the last two or three or four - we do 2 years now, don't we? MR. STORER: We take 1 year, Mr. Chair, but it's the rate of change between the 2 years. CHAIR SEEKINS: We could add an inflation proofing number and establish a statutory principal number, which the legislature could use and say you can't spend below this line and still keep track of what the principal of the fund is after inflation proofing and compare that to the market value to be able to see whether or not we really are, through disbursement of the market value, eating into the principal of the fund and use that as legislative guidance. MR. STORER: There's any number of pieces like that - using a 10- year rolling average, a 5-year RIT (ph), redefining principal in the statutes, recognizing the impact of inflation on - principal is a notational number. It's a recordkeeping number. It has nothing to do with how we manage the money so you can convert that recordkeeping number by statute. My Director of Finance, [indisc.] but that's okay, because it's one more thing to keep track of. But that's another way of doing it and then you'd have to change the statutes or address it through statutory change. CHAIR SEEKINS: And by doing that we could provide some indication of the fiscal responsibility of the legislature to the people of the state of Alaska as we go forward. MR. STORER: It would be a more rigorous process if that occurs. CHAIR SEEKINS: Okay. Other questions? Hearing none, I want to thank you very much, Mr. Storer, for coming to talk with us today and we will move next - I think we're going to give the full committee the opportunity to take a look and we'll address this when everyone can be here - Senator Ellis, Senator Ogan as well. So we'll move on from SJR 18 and set it aside and go to [SJR] 19 and I see representatives here. We've got Representative Croft, welcome to the committee, and representing Senator Lincoln, if you gentlemen will put yourselves on the record, welcome to the committee and we're eager to hear your testimony.
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