Legislature(2003 - 2004)
03/02/2004 08:00 AM House STA
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* first hearing in first committee of referral
+ teleconferenced
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+ teleconferenced
= bill was previously heard/scheduled
HB 466-PERMANENT FUND INVESTMENTS [Contains discussion of HB 156.] Number 2383 CHAIR WEYHRAUCH announced that the next order of business was HOUSE BILL NO. 466, "An Act relating to investments of Alaska permanent fund assets; and providing for an effective date." Number 2365 ROBERT D. STORER, Executive Director, Alaska Permanent Fund Corporation (APFC), Department of Revenue, stated that the department is held to the prudent investor rule. He said the permanent fund "has an extra layer"; in addition to the prudent investor rule, there is a statutory list that defines what may be invested in. He indicated that the list includes one clause that "gives a little additional flexibility." He noted that the modern prudent investor rule started with the enactment of [the Employee Retirement and Income Security Act of 1974] (ERISA). He explained that although ERISA has to do with private pension plans and corporations, everyone uses ERISA where applicable in regard to public funds. Mr. Storer read selections from [29 U.S.C. 1104 - Fiduciary Duties], which read in part as follows: (a) Prudent man standard of care (1) Subject to sections 1103(c) and (d), 1342, and 1344 of this title, a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and ... (B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; (C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so; MR. STORER said that although it was typical in the 70s for a public fund to have a statutory list defining what investments can be made, currently virtually all public funds have eliminated the statutory list and "just follow the prudent investor guideline." Number 2186 MR. STORER directed the committee's attention to a [six-page] handout [included in the committee packet], entitled, "Alaska Permanent Fund." He noted that pages two and three of the handout show all the times that the legislature has expanded the investment flexibility and given the [APFC] more latitude to achieve its investment goals. He indicated his understanding that it is a "misstatement" on the bottom of page three that it reads that HB 156 was sponsored by the Senate Finance Committee in 1999. Notwithstanding that, he highlighted that paragraph, which read as follows: HB 156 allowed the Fund to leverage real estate investments and increased asset allocation limit for stocks to 55 percent of the total market value of the Fund. HB 156 also created the "basket clause" that allows up to 5 percent of the Fund to be invested in alternative investments or to be applied to existing asset allocations to expand their limits. In addition, HB 156 allowed the Permanent Fund to be the sole owner of any real estate property, regardless of value. MR. STORER noted that page four of the handout shows the history of the fund's various asset allocations. For example, he noted that during the early 70s and 80s, the permanent fund was invested exclusively in fixed income securities, "even though it's a long term fund." He revealed that he began working with the APFC in May of 1983, and in June of that year, the [APFC] funded its first "equity managers." He remarked that as of late 1987 the fund was invested in only about 13 percent in the U.S. equity market alone and the [APFC] did not have permission to invest in the international equity market. He stated, "What you see ... right now in the asset allocation is slightly more conservative than other public funds, but a mature fund that ... constructs their portfolios, essentially, the way most public funds invest their money." Number 2061 MR. STORER said HB 466 proposes an increase in investment flexibility. The changes, he noted, will potentially allow the [APFC] to increase its returns and to meet future needs in terms of increasing diversification, as well as to implement strategies more efficiently at a lower cost and address contemporary needs as they occur. MR. STORER revealed that next week the [APFC] will propose a change in its asset allocation, which is something it does every March after a review of the capital market in the beginning of the year. He turned to [a one-page handout included in the committee packet], entitled "Fund's asset allocation and control bands." He explained that the column of numbers on the left is the target number - for example, 37 percent U.S. equity market, while the column of numbers on the right shows bands - for example, plus or minus 7 percent. He explained that the [APDC] tries to create targets and then create "bands around those targets." The corporation does not want to balance "a lot," because that can result in creating transaction costs; however, it does want to "discipline it mechanically," which "forces you to rebalance." Number 1922 MR. STORER stated that the September quarter of 2002 was the worst quarter in the history of the permanent fund, with a negative 7.5 percent rate of return due primarily to a plummeting stock market, which forced the [APFC] to add about $750 million in the equity market to "get back closer to target." He added, "We got permission from the board around October 10. I think we missed the bottom of the bear market by about four days and so we captured very high returns." He noted that "this was not any special insight on what was going on in the bear market," but was an example of how a disciplined approach works. He stated that his point in bringing this up is that "after four years of study, we're about to implement some strategies that will use the basket clause." Number 1861 MR. STORER continued as follows: We are ... banging up against our statutory limitations very soon. ... That means if the equity market continues - if these strategies that we ... employ using the basket clause work - we will be forced to liquidate the assets. Not because the capital markets tell us to do [so], not because our advisors are saying we need to liquidate or take profits or redirect that money. We will be forced to liquidate because statutes will not allow us to gain the benefits of the ... full rising market. So, there is a big negative, I believe, to our statutory limitations, which forces us to take potential gain off the table, because of statutory limitations, not what the financial markets are telling us. Number 1794 MR. STORER turned attention to the last page of the of the previously noted six-page handout, which addresses potential questions. He noted that one question may be, "Will you ... take on too much risk?" He continued: We've all said we have this target [of] hitting a 5 percent real rate of return over time, and we're comfortable making that statement. But what if, to achieve a higher rate of return, ... our constitutional amendment doesn't pass and we, one way or another, ... believe we should strive for a higher rate of return ... and accept more risk than is prudent?" And that is a risk. You can't say, "That will never happen, it has never happened, I see no evidence it will happen." I ... have worked with about every trustee of the permanent fund with the exception of about four in the beginning. ... I've worked with every executive director. I've worked for or with every chief investment officer [of] the Alaska Permanent Fund, and I will tell you, in the history of the permanent fund, there has never been an inclination of striving for too much risk. When you become a fiduciary and have responsibility of managing the fund, it's inherent in the process that you take your responsibility very, very seriously, and so there's no history - no suggestion - that the permanent fund would be prepared to reach too far for a return. Number 1700 How will the board of trustees use this flexibility? That becomes a tougher question. One is obviously because [of] the statutory limitations; we would use it to allow our investments [to] rise to what we hope are their potential. As I noted at the beginning of my presentation, we're trying to set the permanent fund up to meet future flexibility, and so there's a "nonpredictive" element about how you would use it. ... If you ask me right now what [we would] look at, one of course is being able to increase our returns by letting our winners continue on. We might look at some high yield. High yield is: the pejorative term is "junk bonds." There's really two categories of high yields; you can really divide a line between the two. ...There is a category of high yield that's very close to investment-grade corporate debt. They've worked out their problems and they are in the process of probably being upgraded and become investment debts. That's a more conservative approach, if that's not an oxymoron. Then there's the other, where you're taking bigger bets on companies that have huge problems and then you expect equity-like returns. We may, over the next year - and I've not posed this question with the board - but we may start taking a look at the more conservative approach. Be mindful that we will educate ourselves for as much as a year or two years on a subject before we discard it or make sense [of it]. As I noted, we got permission for the basket clause in 1999. We are only now, after years of study, beginning to implement some of the strategies that use the basket clause. So, when I say ... something like that, I'm saying this is something we may evaluate. Number 1549 MR. STORER turned to the question of derivatives. He explained that derivatives are financial instruments where "their return is derived from some other investment instrument." For example, he noted that a measure for large-cap equities is the S&P [Standard & Poors] 500 index. He noted that there are futures and forward contracts that base their return on the performance of the S&P 500 index. He continued as follows: We use derivatives now, in a sense. We will hedge currency. When we bank an international investment we may hedge that currency risk before we buy the currency to pay off the security. Our managers do that. So, there are any number of ways to use derivatives; they all aren't all bad. When you see derivatives and you see negative headlines, ... typically it's because they've used derivatives for leveraging the portfolio in a rather significant manner, and it's not the use of the derivative so much as increasing the risk by using the leverage. Number 1456 CHAIR WEYHRAUCH asked Mr. Storer if the basket clause got its name when it was adopted in 1999, or was it a term that "just grew." MR. STORER offered his belief that it became a term of art "during that process." CHAIR WEYHRAUCH said when he hears the word "basket," he thinks of a basket used in a grocery store and "picking and choosing small amounts to go throughout the line." He asked Mr. Storer, "Is that how the public would view what a basket clause is, in terms of the larger scale when you're dealing with investments in the permanent fund?" MR. STORER mentioned diversification. He stated, "So, even if one gets the ability through the basket clause to make investments, we are still driven by diversification. And our point would be to fill that basket with a bunch of diversified options that would not put risk in any (indisc. - overlapping voices)." In response to a follow-up question from Chair Weyhrauch, he confirmed that "we're asking to make the basket bigger," or to increase the flexibility. Number 1365 REPRESENTATIVE SEATON asked if part of [the intent] is to be able to maintain assets that have appreciated and may "go up more." He clarified that he is trying to figure out "the 15 percent." He asked, "Does that mean that the funds could then take international equities to 31 percent, with the 15 percent, less the 16 percent, currently, if the fund thought ... international assets are going up and ... we've had a good run in our investments here and we want them to continue, so we'll use our authority to increase ... that allocation to 30 percent?" MR. STORER responded that that technically - emphasis on the word "technically" - could be correct. However, he stated that it would also be unlikely, keeping in mind that the goal is a fully diversified portfolio. He revealed that next week the [APDC] will recommend increasing the international equity allocation from 16 to 18 percent. He added, "In fact, I think we're more like 17 [percent] as it now stands. We're also using parts of the basket clause." He continued as follows: So, the fundamental question would be, "If one used the entire basket clause to increase a single asset class, would it still meet the rules of diversification and [the modern] prudent [investor rule]?" I am well aware of many public funds that have been invested in excess of 25 percent in the international equity markets, but as a practical matter, that would be unlikely that we would use what I call the privilege of an increased basket clause in any single thing. ... As [of] now we aren't going to use it in a number of options that will behave differently in different market environments. Number 1234 REPRESENTATIVE SEATON asked for examples of "what these other new investments" are. Number 1168 MR. STORER responded as follows: As noted, we do have a 55 percent limitation in the stock market; that is unique in public funds throughout the country where you follow the prudent investor rule. There are no limitations whatsoever. So, I would like to preface my response by saying that even with the increased basket clause, our constraints would still constrain us to being one of the more conservative public funds in the country. So, even if we increase it, we're still not going to have the ability to take as much risk as other public funds may. And of course, risk is not necessarily pejorative; you should be rewarded for being compensated for that risk. As an immediate objective we will probably use the basket clause to not be forced to sell stocks in the ... equities if we exceed the statutory limit, because we would apply ... that basket clause to the additional equities. ... We don't believe that is bad at all. What we're doing is we're letting ... the markets define when to rebalance, we're not letting ... arbitrary constraints tell us when to apply. So, one immediate use would be simply to benefit from the appreciation of the markets and not be forced to sell for arbitrary reasons. [Regarding] the balance of it, we would ... educate ourselves on any number of things. I mentioned an example - potentially high yield. We've looked at it modestly. We have looked at private equity and we're starting a modest program in private equity, which, by definition, that's "nonpublicly" traded investments. ... It's a diversified portfolio that could have some venture capital, some buyouts in it. Typically you expect to earn about 5 percent return in excess of the publicly traded markets [when] you do something like that. Number 0997 MR. STORER mentioned absolute return strategy and hedge fund. He said that he is about to recommend something that's kind of unique. He continued as follows: I'm introducing, for the first time ever, ... a pilot program. These are very sophisticated investment approaches; we've studied it for well over a year. And there's a lot more to be learned, but the only way I think we can learn beyond here is live. And so, I'm recommending that we invest a modest amount in a pilot absolute return strategy. We're going to define it as very low risk. Our objective is to have ... targeted risk that is equal to or less than the bond market. That'll be part of the criteria. ... I think everyone in this room will agree that sometimes things exist in government perpetually, and to make it truly a pilot program, I'm recommending a sunset clause ... so that the program will expire within 30 months, so that not only by policy it will die, but our contracts with the experts will expire in 36 months, as well. So, the only way we can continue forward on that one is to take the knowledge we've learned and vote it up, rather than it just [becoming] perpetual. So, that is another use, and I'd like to think that's a conservative approach to a very sophisticated investment strategy. So, those are sort of on the immediate table. I spoke last week in front of [the Senate State Affairs Standing Committee], and I did the cornucopia of opportunities, most of which I don't personally agree make any sense. When people invest in timber, it usually means timber in Indonesia or overseas. And can you imagine investing in timber in a small way and then [ending] up with an environmental nightmare in a country where you have no control. So, I'm giving you a bad example, in my opinion. So, we have to work through all these things. Number 0760 REPRESENTATIVE BERKOWITZ said he would quarrel with Mr. Storer's assertion that the list forces conservative investments. Conversely, he said it seems to him to force imprudent investments. He said sometimes there might emerge conflicts between the list in Title 37 and the explanation of what a prudent investor should do in Title 13. He said, "When you're forced to sell assets because you're going up against the upper limits, that's not conservative ...." Number 0740 MR. STORER concurred with Representative Berkowitz's statement. He said that he has been "at or near" the permanent fund and has long thought that the statutory list could become so restrictive that "it belongs in the Smithsonian rather than as an investment tool." He stated, "We have not suffered, to date, but I think ... that we need to create a flexibility to manage the fund successfully in the future." Number 0682 REPRESENTATIVE GRUENBERG indicated that he may be offering an amendment that would eliminate the [limitations] and allow the board to just invest under the prudent person rule. He asked Chair Weyhrauch if the bill would not be moved out of committee today, because he indicated that he has questions to ask to which he would like answers at the next meeting. CHAIR WEYHRAUCH stated that it is not his intention to move the bill today. Number 0487 RONALD W. LORENSEN, Attorney at Law, Simpson, Tillinghast, Sorensen & Longenbaugh, P.C., told the committee that that firm is outside counsel to the APFC. He stated that he has worked with Mr. Storer and the board on the proposed legislation before the committee. He announced that he would limit his testimony to addressing the changes sought in the bill. Both sections, he noted, would make amendments to AS 37.13.120. He stated that AS 37.13 is the chapter that deals with the APFC and is described as the legal or statutory list. Section 120 is approximately four pages long, he noted, with subsection (g) setting out the legal list of those investments that the [APFC] is authorized to invest in. Other subsections within Section 120 provide either limitations or guidance with respect to the investments of the fund. For example, he said, subsection (a) is the provision that deals with the prudent investor rule as it applies to the fund, while subsection (k) is the subsection that created the basket clause in 1999. Subsection (k) would be amended by the bill to add references to two additional subsections within Section 120, as exceptions to the operation of the basket clause. Those additions are subsections (h) and (j). MR. LORENSEN stated that subsection (h) would prohibit the corporation from investing in futures contracts, except in specific circumstances. He continued as follows: That limitation, although it makes sense in the scheme of the existing statutory list, creates some difficulties in terms of flexibility, with respect to the basket clause. ... The example I have most in mind is in the area of hedge funds, where hedge funds may invest, as part of their strategy, some portion of the funds under management in various forms of futures contracts. This limitation page would prohibit the basket clause from being used for those kinds of hedge fund investments. It certainly was not the intention at the time that the basket clause was proposed to the legislature that that limitation exist to apply to the basket clause; it was just, basically, something that hadn't been anticipated or perceived as a problem at the time. MR. LORENSEN stated that subsection (j) is a provision in Section 120 that states that the [APFC] may not invest in bonds, basically, where the interest payment on a bond has been defaulted in the last five years. And again, that's a prudent rule, with respect to fixed income as a class of investment, but it creates difficulties when you're talking about alternative forms of investment, such as high yield investments, which Mr. Storer's also described as what some people call, "junk bonds," where you're looking for a higher return. And the reason you're looking for a higher return is because you are investing in a class of bonds which is more risky, and frequently ... that risk is demonstrated by the fact that interest payments have not been made within the last five years. [The committee took a brief at-ease.] TAPE 04-26, SIDE A Number 0001 MR. LORENSEN continued as follows: So, adding [subsection] (j) in Section 2 of the bill, to the exceptions for the operation of the basket clause, would permit a portion of the assets of the permanent fund to be invested in certain alternative investments, which use - as a part of their investment strategy - investing in bonds, which have a higher risk of default, but also the counter veiling consideration is that they have a higher potential for an increased return. MR. LORENSEN turned to the other change proposed in Section 2 of the bill, which is to increase the limit on the size of the basket clause from 5 percent to 15 percent. He noted that there had already been discussion on the issue. Section 1, he specified, addresses the potential restrictions on the investment ability of the permanent fund in alternative investments. Mr. Lorensen paraphrased Section 1 of the bill, which read as follows: *Section 1. AS 37.13.120(e) is amended to read: (e) The corporation may not borrow money or guarantee from principal of the fund the obligations of others except as provided in this subsection. With respect to [REAL PROPERTY] investments of the fund, the corporation may, through an entity in which the investment is made, borrow money if the borrowing is without recourse to the corporation and the fund. MR. LORENSEN explained that the idea is as long as the fund itself is protected by some intervening legal entity, it is currently permissible "for real estate only" to make investments that might involve borrowing money as part of the investment strategy. He added, "And, of course, there we're talking about leverage, basically." He continued as follows: Now that we look at various available forms of alternative investments, we see that certain kinds of hedge funds, and potentially also certain kinds of private equity funds, do - as a part of their investment strategy - invest ... through limited partnerships. It's never the [APFC] itself that would be the investor, but the [APFC] would purchase an interest in a limited partnership, for instance. And the limited partnerships, again, may enter into borrowing for leverage purposes, as a part of the investment strategy. And so, here the recommendation is simply to delete the ... limitation on real property and make it available for any kind of investment of the fund, so long as it is done through a separate legal entity and so long as there is no recourse back against the fund. Number 0356 REPRESENTATIVE LYNN asked how 15 percent was chosen in Section 2 of the bill. MR. LORENSEN deferred to Mr. Storer. Number 0419 MR. STORER replied that "we" want as much investment flexibility as possible and the constitution [allows] investments as designated by law, which would be 15 percent. He added, "I would note that if you looked at other public funds, it's silent by virtue of their rules. Their rules would be 100 percent, not 15 percent. So, 15 percent still [is a] far more conservative constraint than others." REPRESENTATIVE LYNN asked if the 15 percent was "pushing the envelope" or whether it was "still plenty of room." MR. STORER responded that he personally doesn't think it's pushing the envelope at all. Conversely, he opined it's the maximum that "we" can use and still fall within the direction that the constitution allows. He observed that where he has seen public funds that have no constraints, those funds are still managed in well-diversified portfolios. He said he doesn't see undue risk in being allowed that extra flexibility. Number 0610 REPRESENTATIVE GRUENBERG asked, "What do you mean by 'not withstanding these other subsections'?" Number 0652 MR. LORENSEN replied as follows: "Notwithstanding", in this context means that even though these limitations exist, they do not apply to the basket clause. Number 0670 REPRESENTATIVE SEATON, indicating [the language to be deleted regarding] real estate in Section 1 of the bill, asked, "Is that because they're real estate mortgages?" MR. LORENSEN answered that he thinks real estate mortgages are probably the best example of how real estate investments are made by the permanent fund. He noted that the permanent fund actually has "a fairly low percentage of its assets in real estate that is actually leveraged or is borrowed." He said some of the real estate properties that are purchased by the [APFC] do have a borrowing, leverage, or mortgage component to them, and "this was inserted in 1999 to make it clear that that was permissible, so long as it was done through a separate title- holding entity." Number 0750 MR. STORER added that the [APFC] leveraged its "direct real estate portfolio approximately 15 percent; it's an incremental return." He stated that that's still conservative by virtually all standards. For example, he proffered that publicly traded real estate investment trusts "tend to run about 40-60 percent leverage." He offered his understanding that most public funds actually use more leverage - particularly in the last few years with the lower interest rate. REPRESENTATIVE SEATON asked, "Is that, basically, the futures market that we're talking about, whereas real estate is more mortgaged?" MR. LORENSEN answered no. He continued as follows: Maybe the best example has nothing to do with either mortgages or real estate, but is in the area of private equity, where ... there are leveraged buyouts and that sort of investment activity as part of the strategy. And so, there will be a borrowing component in these private equity transactions, which is - again - nothing to do with real estate, specifically, but just is a way to finance the underlying transaction. And so, to the extent that a particular private equity investment involves a leverage aspect, we would like to see this language in place to make it clear that that's permissible. Private equity is now permissible to the extent of the cap created by the basket clause. Number 0903 MR. STORER added that "we" view "this" as a cleanup to the original intent of the basket clause. He said he hopes the committee agrees. MR. LORENSEN concurred. Number 0948 CHAIR WEYHRAUCH announced that HB 466 was heard and held.
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