Legislature(2021 - 2022)ADAMS 519
01/24/2022 01:30 PM House FINANCE
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| Audio | Topic |
|---|---|
| Start | |
| Presentation: Permanent Fund Performance Measures and Impact of Ad Hoc Draws by Callan and Associates | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
HOUSE FINANCE COMMITTEE
January 24, 2022
2:49 p.m.
2:49:41 PM
CALL TO ORDER
Co-Chair Merrick called the House Finance Committee meeting
to order at 2:49 p.m.
MEMBERS PRESENT
Representative Neal Foster, Co-Chair
Representative Kelly Merrick, Co-Chair
Representative Dan Ortiz, Vice-Chair
Representative Ben Carpenter
Representative Bryce Edgmon
Representative DeLena Johnson
Representative Andy Josephson
Representative Bart LeBon
Representative Sara Rasmussen (via teleconference)
Representative Adam Wool
MEMBERS ABSENT
None
ALSO PRESENT
Greg Allen, Chief Executive Officer, Chief Research
Officer, Callan and Associates.
PRESENT VIA TELECONFERENCE
Steve Center, Senior Vice President, Callan and Associates
SUMMARY
PRESENTATION: PERMANENT FUND PERFORMANCE MEASURES AND
IMPACT OF AD HOC DRAWS BY CALLAN AND ASSOCIATES
Co-Chair Merrick reviewed the agenda for the meeting.
^PRESENTATION: PERMANENT FUND PERFORMANCE MEASURES AND
IMPACT OF AD HOC DRAWS BY CALLAN AND ASSOCIATES
2:50:39 PM
GREG ALLEN, CHIEF EXECUTIVE OFFICER, CHIEF RESEARCH
OFFICER, CALLAN AND ASSOCIATES, introduced the PowerPoint
Presentation: "Permanent Fund Performance Review, and
Simulation Model Results." He relayed he had been modeling
the Alaska Permanent Fund since the late 1990s. He was
asked to analyze effects from an ad hoc draw on the Earning
Reserve Account (ERA) and its effects on the percent of
market value (POMV) rule. He would first give a performance
review. He began with slide 3 titled Broad Capital Market
Performance." He indicated that the bar charts represented
returns for various asset classes over certain time periods
ending on September 30, 2021. He drew attention to the one
year bar depicting small capital equity returns at 47
percent, large capital equity at 30 percent, and non-U.S.
Equity at 24.4 percent. He highlighted the strength of the
equity markets for the year. He pointed to the 16.6 percent
return over 10 years that reflected exceptional returns.
2:53:22 PM
Vice-Chair Ortiz asked for Mr. Allen to explain large caps
versus small caps. Mr. Allen replied that large caps were
the largest businesses like Apple, Facebook, IBM, and
ExxonMobil. He added that small caps were domestically
focused firms worth a market cap of $3 billion.
Co-Chair Merrick indicated that Representative Rasmussen
joined the meeting via teleconference.
Mr. Allen moved to slide 4 titled Global Equity Market
Performance. He reported that the U.S. equity market had
dominated market performance, but global investment was
important in the long run. The difference between global
and domestic markets was "striking" over the last 10 years.
2:54:58 PM
Mr. Allen moved to slide 5 titled "Market Environment He
pointed to the fourth row from the bottom of the table
reflecting the private equity index and noted that the
return was the highest assets class in the one year period
ending on September 30, 2021, at 58.8 percent and had
proven to be a very successful investment for the fund over
a number of years.
2:55:50 PM
Mr. Allen turned to slide 6 titled "Callan Periodic Table
of Investment Returns." He relayed that the chart was
included to show that the same asset class was not always
the best performer year after year. He highlighted the U.S.
Large Cap Equity and noted that it remained in the top half
of the chart for over 10 years. The Permanent Fund (PF)
returns were represented in white and hovered in the middle
because it owned all the types of asset classes on the
chart.
Co-Chair Merrick indicated the Co-Chair Foster,
Representative Edgmon, and Representative Wool joined the
meeting.
Mr. Allen turned to slide 7 titled "APFC Total Fund
Cumulative Returns." He communicated that the bar graph
showed the return of the Alaska Permanent Fund
Corporation's portfolio in blue. The green bar represented
its performance benchmark, and the brown bar depicted its
objective of CPI plus 5 percent. He detailed that the fund
was up 26.6 percent for the year; the CPI plus 5 percent
was 10.9 percent. The current year's gains could easily
support a 5 percent POMV draw. Mr. Allen indicated that
slide 8, also titled "APFC Total Fund Cumulative Returns,
showed a longer period of returns. He reported that the
Permanent Fund exceeded all benchmarks at 8 percent for 20
years and the performance was remarkable, especially over
the last 3 years.
2:58:24 PM
Mr. Allen moved to slide 9 titled "APFC Total Fund versus
Callan Large Public Fund Databasedisplaying the
annualized return rankings relative to large public funds.
He pointed to the gray area that represented returns from
the tenth to ninetieth percentile. The permanent fund was
represented by a blue dot that showed the PF in the top
fourth percentile for the current year, twelfth percentile
for 5 years, and thirty-eighth percentile for 20 years. The
permanent fund outperformed 62 percent of the funds in the
database.
Mr. Allen highlighted Slide 11 titled APFC Total Fund
versus Callan Large Endowment Database." He indicated that
the large endowments all had assets over $1 billion. The PF
ranked in the middle versus the top because endowments
typically invested in private equity. He commented that the
PF had been firing on all cylinders" and performing well
except for the real estate fund that was in repair. He
offered that Callan worked with very large funds and he
considered the PF performance outstanding.
3:00:54 PM
Mr. Allen discuss Slide 11 titled "APFC Total Fund versus
Callan Large Public Fund Database" portraying the
annualized risk rankings using the standard deviation; the
fund's risk relative to peer funds. He remarked that
efficient portfolios had high returns and low risk. The PF
relative to large public funds had high returns and low
risk and was ranked in the middle compared to endowments.
3:01:33 PM
Representative Edgmon asked Mr. Allen to repeat the
information regarding endowments. Mr. Allen responded that
he was comparing large pension funds to endowments like
Yale or Harvard. He explained that endowments' investment
strategy was to heavily invest in private equity. The
public funds had been slow to adopt practices around
private equity. The PF invested in private equity fairly
early, roughly 18 years ago. Private equity was a long term
investment strategy rather than a short term investment
that looked like a "J" curve. Private equities were the top
performing assets in the prior year. He elucidated that the
PF had morphed into an endowment fund. An endowment created
sustainable resources into the future, and the PF invested
like an endowment, which was why its performance was so
notable. Representative Edgmon used a sports metaphor to
describe the incredible market returns over the last year.
He wondered if the year was unusual. Mr. Allen responded
that since 2008 investments had risen, which benefitted the
private equity markets and therefore, the PF. He offered
that in general, Callan believed in investing in private
equity; it was the highest asset class over the long run.
However, he also advocated for investment diversity. He
remarked that the last 12 years yielded "extraordinary"
investments and he did not expect the market to crash.
3:05:27 PM
Vice-Chair Ortiz asked Mr. Allen to explain what it meant
to be invested in private equity. Mr. Allen responded that
private equity investors invested capital in a company or
startup that was not publicly listed or traded and was a
form of venture capital. He elaborated that the private
investors were betting on long-term growth of the company
that would ultimately be publicly traded, which was very
lucrative. They were investing in risky companies but were
also diversifying investments. The advantage for private
equity investors was "private ownership," which was not
subject to the same regulations as public companies and did
not involve shareholders. It required patience because it
was impossible to get money out of a private investment
before it paid off.
3:07:53 PM
Representative LeBon appreciate the information on private
equity. He commented that the Alaska Permanent Fund
Corporation (APFC) was proactive in its investing. He
believed that it was necessary to have talented staff to
make good investment decisions. He asked if Mr. Allen had
an opinion of the investors at the APFC. Mr. Allen
responded in the affirmative and voiced that he was amazed
at the ability of APFC to have developed the stable staff
they had, which was challenging with job competition from
the east and west coasts. The largest challenge was
competition from higher wages in the private sector. He
highly regarded the APFC's investment staff.
3:10:26 PM
Representative LeBon asked if APFC offered a competitive
bonus program in comparison to others. Mr. Allen responded
that it was better than bonuses paid at the average public
fund that typically did not pay bonuses. He offered that in
some ways it was a reward just working for the PF. There
was a certain amount of prestige working at APFC, which was
attractive in itself. He noted that working for a
successful $80 billion sovereign wealth fund was a unique
situation.
3:12:05 PM
Representative Wool asked about the risk rankings. He asked
if the trade-off for private equity investments was more
risk. Mr. Allen replied that although private equity was
riskier because it was not publicly traded it was not
priced daily like stocks. Therefore, private equity was
less risky when measured against standard deviations.
Therefore, the PF ranked high in earnings and low in risk
because of its private equity assets. He indicated that
private equity reported every quarter, which had a
smoothing effect on earnings; if everything went down,
private equity would decrease more, but it was more
disguised. He noted that the PF "drifted into an endowment
model" and was ahead of other large public funds in its
investing strategy. The public funds were doing better but
were probably 8 years behind the APFC.
3:14:58 PM
Representative Edgmon noted the POMV structure and the
current draw rate of 5 percent. He asked how Alaska
compared to other wealth funds and their percentage draws,
which he heard was lower at 3 percent and 4 percent. He
wondered how the draw effected earnings and returns as well
as risk. Mr. Allen replied that the lower the percentage
draw meant the PF could take less risk and meets it
objective. He explained that there was short-term and long-
term risk. Callan calculated that the 5 percent draw was
more like a 4.6 percent draw due to high returns. He
believed that the current percentage was likely sustainable
over the long run, with enough to cover the 5 percent and
inflation. Endowments only withdraw the necessary amount in
order to preserve the purchasing power for the next
generation and the amount had to be adjusted for inflation.
The fund needed to grow by 4.6 percent and 2.25 percent for
inflation, which put it in the middle of the risk range.
He exemplified that if the board needed to take some equity
off the table and put more into bonds, then the percentage
of the draw would need to decrease. He indicated that a
typical endowment took a 4.5 percent to 5 percent draw,
which was universally considered sustainable. He expressed
concern regarding the legacy of the constitutional language
creating the ERA. He voiced that it was outdated and a POMV
was a better way because if the ERA ran out of money the
state could reach a zero draw. He argued that the language
was in conflict with the POMV, and he would further discuss
the issue during the presentation.
3:19:43 PM
Representative Edgmon requested that the presenter slow
down his explanations to better follow the information.
3:20:05 PM
Mr. Allen moved to slide 14 titled "Simulation Model
Results. He related that Callan built a model of the PF in
the late 1990's that generated a whole range of
probabilities. He recalled times when there were proposals
to withdraw all the money out of the ERA each year, which
was the impetus for the model. He outlined that he would
review Accounting Concepts and History and the Spending
Rule and Appropriation History of the fund. He would then
discuss modeling scenarios with ad hoc draws and the range
of outcomes.
3:22:00 PM
Representative Johnson asked Mr. Allen to provide more of
his personal history and background. Mr. Allen reiterated
that Callan was a consultant to the PF. He relayed that the
APFC board expected Callan to comment on the performance of
the fund. Callan also helped the APFC to find outside
investment managers when needed. In addition, they advised
the board on asset allocations and modeling. Callan had
worked for the APFC board for over 30 years.
Representative Wool asked if Callan had consultants
singularly assigned to the APFC. Mr. Allen replied in the
negative.
3:25:20 PM
Mr. Allen moved to slide 15 titled "Statutory Net Income
(Realized Return):
Statutory Net Income (SNI) in each year is the sum of
total income (dividends, coupon payments, real estate
income, etc.), plus realized capital gains minus
realized capital losses.
Gains are realized when assets are sold for an amount
above their purchase price (cost basis).
Gains realization events include annual turnover in
equity and bond accounts, rebalancing related
turnover, sales to fund distributions, distributions
from private market investments, etc.
Mr. Allen indicated that another component that turned into
SNI was realized gains. The fund had never in its history
had as much unrealized gains. He reported that SNI fed the
ERA.
Representative LeBon spoke of the importance of inflation
proofing the principle to maintain the PF's future value.
Mr. Allen concurred with Representative LeBon's statement.
He thought inflation proofing was critical to maintaining
the purchasing power of the fund.
3:28:18 PM
Mr. Allen discussed Slide 16 titled "Earnings Reserve
Account
Beginning Realized ERA $11.5B + Statutory Net Income
$7.9B Appropriations to Principal Distribution
$3.1B = Ending Realized ERA $16.3B + Pro Rata
Unrealized Gains $4.8B = Ending ERA Balance $21.2B =
Earnings Reserve Account is equal to total cumulative
Statutory Net Income minus total cumulative spending
minus total cumulative appropriations to Principal
plus a pro-rata share of unrealized gains or losses.
ERA receives a pro-rata share of unrealized gains or
losses based on the size of the ERA relative to the
size of Principal.
ERA receives 100% of SNI if SNI is positive.
ERA receives pro-rata share of SNI if SNI is negative.
Mr. Allen summarized that the ERA and principle split the
market value of the fund. He reviewed the formula on the
slide that determined the ERA balance and offered that the
ERA could easily pay the POMV draw in the current year.
3:29:45 PM
Mr. Allen examined Slide 17 titled Historical Statutory
Net Income Last Ten Years:
Statutory Net Income has been positive in all of the
last ten years.
"Normal" years have been in the $3 - $4 billion range.
2018 and 2021 experienced outsized Statutory Net
Income due to:
Strong equity markets;
High unrealized gains balances;
Increased rebalancing activity
resulting in Equity sales;
Private markets transactions.
Mr. Allen reported that in 2021 the PF had large, realized
income gains of $8 billion.
3:30:35 PM
Mr. Allen moved to slide 18 titled "Historical Earnings
Reserve Account Last Ten Years:"
With healthy Statutory Net income levels Earnings
Reserve balance has grown consistently since 2012.
As ERA balance grows proportion of unrealized gains
allocated to ERA increases.
In 2020 $4 billion of ERA was appropriated to
Principal. This had the knock-on effect of reducing
the percent of unrealized gains allocated to ERA.
Unrealized ERA as percent of total at an historic high
at the end of 2021.
Mr. Allen pointed to 2012 and noted that the ERA balance
was only 2.2 billion when the state did not have the POMV
and only paid out the dividend formula, which was a much
smaller draw.
3:31:27 PM
Mr. Allen continued to Slide 19 titled "Historical
Principal Account Balance _ Last Ten Years.
The Principal Account balance has grown steadily over
time as a result of oil revenue and inflation proofing
appropriations.
$4 billion appropriation to Principal in 2020. Another
one scheduled in 2022.
The unrealized portion as a percentage of total is at
its highest point in the last ten years.
The unrealized portion of Principal causes some
asymmetrical volatility in the principal balance over
time, as Principal absorbs entire unrealized loss
balance.
3:31:48 PM
Mr. Allen turned to Slide 20 titled "Historical Ending
Market Value Last Ten Years:"
Market value has grown steadily over last ten years.
Slight drop in FY 2020 as markets hadn't fully
recovered in June.
Extraordinary increase in FY 2021 with market
recovery.
APFC Public and Private Equity portfolios contributed
significantly to this growth in 2021.
Mr. Allen highlighted the incredible gain in market value
between 2020 and 2021 [$65.3 billion to 81.9 billion].
3:32:15 PM
Mr. Allen moved to the Monte Carlo Simulation on slide 21
titled "
Stochastic modelling assumes median market outcomes in
each year.
Results are generally intuitive, and the models are
easier to build.
No need to consider "corner cases" or things that
happen at the limits.
Lend themselves to graphical representations of
variables over time.
Simulation modelling assumes a range of potential
market outcomes in each year.
Captures the impact of volatility.
Requires you to consider things that happen at the
limits (negative SNI, zero ERA, net unrealized losses
(cost basis below market value), etc.).
Results are less intuitive and more difficult to
represent graphically over time.
Assigns probabilities to various ranges of outcomes
for variables of interest (versus point estimates).
Requires multi-dimensional assumptions for market
variables (return, standard deviation, correlation,
auto-correlation, etc.).
Mr. Allen explained that Callan created 2,000 scenarios
based on varying assumptions for stocks, bonds, interest
rates, inflation, currencies, etc.
3:33:01 PM
Representative Josephson thought the presentation was very
helpful. He referred to slide 18 regarding the historical
ERA earnings reporting roughly $21 billion in 2021. The PF
reported that the ERA total was $15.7 billion with the
uncommitted amount at $8.9 billion (POMV draw plus
unrealized gains). He wondered what the real balance was.
Mr. Allen was unsure of the exact amount. The ERA balance
was reported on the last day of the fiscal year. He
elaborated that since the first day of FY 22 on July 1,
2021, the balance was the $21.2 billion minus $4 billion
that was withdrawn at the end of the fiscal year. He knew
that since July 1, 2021, there had been significant
realized gains and would likely be larger than the prior
estimate. Representative Josephson noted having heard that
the account balance should reflect 3 times the draw.
Therefore, the $8.9 billion number looked comfortable to
him. He noted the legislator from Sitka having suggested
moving $8 billion into the principle of the fund. He asked
for comment. Mr. Allen advised that the more in the ERA
the better." He conveyed that the ERA was an artificial
concept and irrelevant since moving to the POMV endowment
model. He recommended that the legislature
constitutionalize the spending rule and eliminate the ERA
and the concept of principle. He stressed the importance of
constitutionalizing the POMV formula, and the POMV
percentage. He understood that the legislature could spend
as much as it wanted out of the ERA and contended that
having unstable spending was a distraction" for the PF
managers. He maintained that most endowments only had a
spending rule, and the withdraw amount was known and could
not be violated. He elaborated that currently, the more
money in the ERA the better because it did not "get in the
way of the spending rule. However, he cautioned that
withdrawing to principle from the ERA as a way to curtail
spending was risky, especially in years markets were down
significantly; the ERA balance would become negligible. He
suggested that an ERA 4 times the draw was better, but it
only worked under the discipline not to overspend and to
follow the rules. He emphasized maintaining the 5 percent
spending rule because an extra draw of $2 billion or $3
billion hurts the value of the fund and "was basically
taking money from the future and giving it to the present."
He opined that implementing a spending rule simplified
everything.
3:39:00 PM
Representative Josephson asked what he meant by the word
"distraction." Mr. Allen replied that the uncertainty of
not knowing how much a draw would be made it difficult to
manage the fund effectively.
Representative Rasmussen spoke of political realities. She
asked if there was a way to quantify the benefit of a one-
time extra draw from the ERA. Mr. Allen thought that the
modeling would answer her question. He requested that
Representative Rasmussen clarify her question.
Representative Rasmussen wanted to know if there was a way
to quantify a benefit if the PF was consolidated into one
account. She thought that a one-time overdraw might be a
political concession to win constitutionalizing the
spending rule to ensure an overdraw would never happen
again. Mr. Allen deemed that the benefit would take some of
the worst case scenarios off the table. He would further
answer when he got to more relevant slides and thought they
would clarify the benefits of eliminating the ERA construct
and maintaining only the POMV model.
3:42:44 PM
Mr. Allen relayed that the next slide showed the scenario
reflecting the annual return year-after-year. He discussed
Slide 22 titled "Projected Returns (No Volatility)":
This results in unrealistically smooth paths for
financial variables (EMV, ERA, Principal, etc.).
Does not reflect the impact of year-to-year market
volatility on financial variables of interest.
Monte Carlo simulation introduces volatility.
Mr. Allen commented that the PF never had the same returns
for two years in a row and the model was unrealistic. He
briefly portrayed Slide 23 titled "Projected ERA Balance
(No Volatility)":
ERA Balance expected to grow in early years due to
Statutory Net Income being amplified by current high
unrealized gains balances.
ERA balance stabilizes in 2024 once unrealized gains
normalize.
After 2024 median projected draw and Statutory Net
Income are similar in size resulting in relatively
flat ERA.
Mr. Allen turned to next scenario showing the first example
of bad returns with volatility (Trial 178). He described
the scenario on Slide 24 titled "Simulated Returns with
th
Volatility 95 Percentile Tail Risk Scenario
Bad outcomes for the ERA balance generally have
multiple low or negative return years in a row and do
not necessarily contain a "really bad" year
Large negative single years (like 2008) feel terrible,
but the ERA is generally robust to those events as
long as here is a recovery soon after.
In this hypothetical scenario ("Trial 178") the
current ERA holds up pretty well until 2027 in spite
of persistent negative returns in 23-26.
Mr. Allen explained that in 2022 the PF experienced 7
percent growth but in 2023 to 2026 experienced negative
growth from -7 percent to -10 percent. In 2027, the PF
experienced very slight growth but experienced a negative
18 percent in 2028. He stressed that a bad case scenario
for the PF was multiple negative years and really low
returning years. He turned to the next slide that portrayed
the consequences on the SNI.
Mr. Allen moved to slide 25 titled "Simulated Statutory Net
Income with Volatility 95th Percentile Tail Risk
Scenario:"
High SNI in 2022 due to positive total return and
current high unrealized gains.
Negative returns in 2023-2025 (combined with gains
realization from rebalancing and draws) wipes out
current unrealized gains resulting in unrealized
losses at total portfolio level.
Turnover then results in net realized losses in 26,
27, 28 and 29.
ERA balance is small relative to principal, so ERA
gets a small proportion of net realized losses
(negative SNI) in 26, 27, and 28.
Mr. Allen moved to slide 26 titled "Simulated Statutory Net
Income with Volatility 95th Percentile Tail Risk
Scenario:"
2022 return slightly above median resulting in 2022
ERA being slightly above result on previous slide (so
far so good).
Declining SNI (due to gains realization and negative
returns) combined with cumulative effect of POMV draw
erodes ERA balance until it is exhausted in 2028.
ERA balance remains at zero in 2029 due to zero SNI in
that year.
Slight positive SNI in 2030 bumps ERA up to about
$700 million in 2030.
Mr. Allen voiced that a zero ERA meant that there would be
no POMV payout and illustrated the problem with the ERA;
the balance could be depleted and could limit the POMV. He
pointed out that the scenario began with the largest ERA
| Document Name | Date/Time | Subjects |
|---|---|---|
| Callan.APFC.House.Senate.Fin.Com.Discussion.pdf |
HFIN 1/24/2022 1:30:00 PM |
HFIN - Callan presentation |