Legislature(2023 - 2024)ADAMS 519
02/16/2023 01:30 PM House FINANCE
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| Audio | Topic |
|---|---|
| Start | |
| Presentation: Capital Markets Forecasts and Sustainability of the Pomv Draw | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
HOUSE FINANCE COMMITTEE
February 16, 2023
1:34 p.m.
1:34:06 PM
CALL TO ORDER
Co-Chair Johnson called the House Finance Committee meeting
to order at 1:34 p.m.
MEMBERS PRESENT
Representative Bryce Edgmon, Co-Chair
Representative Neal Foster, Co-Chair
Representative DeLena Johnson, Co-Chair
Representative Julie Coulombe
Representative Mike Cronk
Representative Alyse Galvin
Representative Sara Hannan
Representative Andy Josephson
Representative Dan Ortiz
Representative Will Stapp
Representative Frank Tomaszewski
MEMBERS ABSENT
None
ALSO PRESENT
Steven J. Center, Senior Vice President and Investment
Consultant, Callan.
SUMMARY
PRESENTATION: CAPITAL MARKETS FORECASTS AND SUSTAINABILITY
OF THE POMV DRAW
Co-Chair Johnson reviewed the meeting agenda.
^PRESENTATION: CAPITAL MARKETS FORECASTS AND SUSTAINABILITY
OF THE POMV DRAW
1:35:06 PM
STEVEN J. CENTER, SENIOR VICE PRESIDENT AND INVESTMENT
CONSULTANT, CALLAN, provided a PowerPoint presentation
titled "Callan: Capital Market Outlook and Alaska Permanent
Fund Performance Update," dated February 16, 2023 (copy on
file). He shared that Callan was the investment consultant
for the Alaska Permanent Fund Corporation (APFC) for over
30 years. He had personally worked with Callan for 12 years
and for APFC for eight years. Callan was also the
consultant for the Alaska Retirement Management Board
(ARMB). He reviewed an outline on slide 2. He would begin
by talking about Callan's capital market expectation
process where it set the 10-year forecasts for various
areas of the institutional investment space. Callan used
the forecasts to help clients set their overall asset
allocation targets for the next 10 years. The targets were
used as a way to inform potential returns and risk levels
for asset pools as a whole. His presentation would also
cover the Permanent Fund portfolio and how it was currently
positioned within the context of Callan's capital market
expectations (possible return scenarios over the next 10
years). The presentation also included slides covering
recent performance of the fund relative to benchmarks and
peers.
1:37:29 PM
Mr. Center addressed slide 3 titled "Callan Capital Market
Projection Process." He detailed that Callan worked with
over 400 institutional investment pools including sovereign
wealth funds like the Permanent Fund, large endowment
funds, and large corporate and public retirement plans.
Callan made 10-year projections for various asset classes
to help clients make the most important decision they could
make: how to invest their assets going forward. Callan's
capital markets research team consisted of economists,
actuaries, and investment consultants who collaborated
every January to help create the 10-year return projection
for the various asset classes. He explained that each of
the projections included expected return, expected
volatility (risk level), and correlation (how the asset
classes behave with each other over time). The projections
needed to be defensible, they needed to make sense, and did
not typically change widely year over year, but they did
evolve over time. He noted that when projections for
equities for the next 10 years went up or down, Callan
lowered its expected returns.
Mr. Center continued to address slide 3. He explained that
Callan's fixed income expectations had changed dramatically
for the next 10 years given how active the Fed had been in
2022. He noted such an occurrence was pretty rare. Callan
also made inflation projections given its important role
for anyone investing for the long-term. He reported that
Callan's projections were compared against other firms
undertaking the same process; historically, Callan's
projections had been near the middle of the pack when
compared to other consultants, investment managers, and
banks. Callan had been employing its process for 35 years,
which had been created by his colleague Greg Allen.
1:40:08 PM
Mr. Center turned to slide 4 titled "Callan Capital Market
Projection Process: Historical Rolling 10-year Return US
Large Cap Equity." He began with public equity because
almost everyone knew what a stock was: the purchase of a
share of an individual company. He detailed that most
institutional investors held a good amount of public equity
and it was important for Callan to get as close to accuracy
as possible. He noted the presentation would include some
point estimates. He pointed to the green line reflecting
Callan's 2023 projection of 7.2 percent for U.S. large cap
equity. He underscored that the figure should not be
considered as set in stone. He emphasized that Callan could
not predict what the equity market would do in the next 10
years. He highlighted that Callan was projecting a range of
outcomes, which would be shown on a subsequent slide. He
explained that 7.2 percent was the midpoint of Callan's
projected range.
Mr. Center continued to review slide 4. He indicated that
historical performance for the S&P 500 over 10-year periods
was represented by a blue line. He pointed out that it had
been a very volatile period over the past 100 or so years.
The S&P 500 performance had ranged from about -4 percent to
almost 20 percent in a 10-year period. The average 10-year
performance for the S&P 500 was 10.5 percent over time
(shown as a gray line). He would address how Callan had
reached its 7.2 percent projection on subsequent slides.
1:42:13 PM
Mr. Center moved to slide 5 and showed a chart reflecting
the historical rolling 20-year return for U.S. large cap
equity. He highlighted the average 20-year return for the
S&P 500 of 10.8 percent. He explained it was another
datapoint to demonstrate that Callan's 7.2 percent
projection was defensible and within the range of outcomes
over the next 10 years.
Mr. Center turned to slide 6 titled "Stock Market Returns
by Calendar Year." The slide showed individual calendar
performance for the S&P 500. He highlighted multiple
columns shown on the slide and explained that each calendar
year was placed in a column based on its performance. The
tallest column reflected performance between zero and 10
percent. He drew attention to highlighted numbers on the
slide. The far left showed a return of -37 percent in 2008
resulting from the global financial crisis. There was a -22
percent return in 2002 due to the burst of the dot-com
bubble. He pointed out the -18 percent return in 2022. He
stated that negative returns happened, but the distribution
shown on the slide was normal and had an average positive
return of about 10 percent. He remarked there had been some
very good years over the past 10 years. He noted returns
had exceeded 10 percent in 2014, 2016, and 2020. He stated
that recent returns had been pretty good even with the past
year's performance. The gray box on the slide showed the
five-year return (including the past year) was 9.4 percent
and the 10-year return was 12.6 percent.
1:44:41 PM
Mr. Center advanced to slide 7 titled "Post-Pandemic Market
Performance." He noted that 2022 had been a pretty painful
year for equity markets and a very painful year for bond
markets. He relayed it had been the worst calendar year on
record for the U.S. bond market by a four times multiple.
He elaborated that even with the bad performance in U.S.
stock and bond markets, performance was ahead of the peak
prior to the COVID-19 crisis. He pointed to two charts on
the slide: the left chart reflected the S&P 500 U.S. equity
market and the chart on the right reflected a 60/40 blend
of stocks and bonds respectively. The orange dotted line on
both charts represented the pre-pandemic peak. He explained
that even with the pullback in 2022, the returns were still
ahead of the pre-pandemic peaks. He added it would require
a pretty substantial drawdown to get down to the pre-
pandemic peak: a drawdown of about 15 percent in the equity
markets and a drawdown of about 8 percent in a blended
stock and bond portfolio. He noted that things had been
going pretty well in the public markets in 2023 thus far.
Mr. Center moved to slide 8 titled "2022 Equity Drawdown: A
More 'Typical' Correction?" He relayed that Callan had
started creating the slide during the COVID-19 crisis,
primarily because the COVID drawdown had been so dramatic
and had occurred in a snap. He reported it resulted in a
full bear market within about 32 trading days [and lasted
from February 2020 through March 2020], whereas the dot-com
bubble (shown in dark blue) and the global financial crisis
(shown in teal) drawdowns were far more drawn out. He
elaborated that the dot-com drawdown took about 520 trading
days (two full years), and the global financial crisis
drawdown took about 360 trading days. The 2022 drawdown was
shown in green and lasted about 250 trading days through
December 31, 2022. The chart showed the drawdown in the
near-term was more in line with historical drawdowns in the
equity markets.
Mr. Center moved to slide 9 titled "U.S. Equity Market: Key
Metrics." The chart on the slide looked at forward price to
earnings (P/E) ratios for the S&P 500. He considered
whether the equity market was currently fairly valued
relative to historical trends. The forward P/E ratio was
reflected in blue compared to a range. The green lines on
the chart reflected the historical 25-year average, the +1
standard deviation, and the -1 standard deviation. He
highlighted that at the end of 2022, the S&P 500 was almost
exactly on top of its 25-year average (16.7x earnings
versus the historical 25-year average of 16.8x). Callan did
not believe there was a broad differentiation within the
U.S. equity market when it came to valuations; therefore,
the current market environment from a valuation standpoint
should not impact forward looking projections.
1:48:39 PM
Representative Ortiz asked for more detail on the phrase
"from a valuation standpoint."
Mr. Center answered that the price to earnings ratio
compared a stock's price relative to the underlying
earnings of that security. Historically, large cap stocks
within the U.S. traded at a P/E ratio of 16.8x. He
explained that the stock typically traded at about 16.8x
the earnings of the published forward earnings for a
security. He elaborated that sometimes there were
deviations from the average. He looked at the chart on
slide 8 and highlighted that between 2004 and 2012 the U.S.
stock market had been trading at a discount (lower than the
historical average). He explained it meant there was a
higher likelihood for increased equity returns from the
U.S. market. He stated it currently looked as if the stock
market was fairly valued. He added that when looking back
recently at 2019 and 2020, particularly as the COVID
"snapback" occurred, the U.S. equity market looked like it
may be overvalued.
Representative Galvin asked if Callan had done a lookback
at its projections to see about its accuracy over time. She
referenced Callan's projection of 7.2 percent return,
whereas the historical 20-year return was 10.8 percent [for
U.S. large cap equity shown on slide 5]. She observed that
Callan's projection was about 3.6 percent off [from the
historical average]. She thought perhaps the difference was
because Callan was being conservative or safe. She asked
for details.
Mr. Center replied that the information was not in the
presentation, but it could be provided. He relayed that
Callan conducted an analysis comparing its projections to
actual performance. He stated that Callan did not always
get the individual asset classes right over a 10-year
period; it was a difficult thing to get right. He
elaborated that Callan was very good at its goal of making
projections that looked similar to actual returns in a
portfolio. For example, when comparing the actual returns
of a 60/40 stock/bond portfolio with Callan's projected
returns, Callan looked very good. He stated that Callan's
ability to predict how the stock market would look over the
next 10 years was hit or miss, but no one was great at it.
1:52:45 PM
Representative Stapp looked at slide 8 related to valuation
measures. He asked if the evaluation of P/E ratios weighted
some of the companies that had been the biggest drivers of
equity market growth. He stated that many of the highest
market capitalization stocks were heavily weighted. He
wondered if it impacted the overall average. He used Tesla
as an example of a company with 58x earnings.
Mr. Center answered that a published P/E number for the S&P
500 excluded any stocks with negative earnings because a
negative number in the ratio messed up the calculation. The
P/E number was weighted by market capitalization;
therefore, larger stocks had a bigger impact on the number.
Co-Chair Johnson recognized Representative Cliff Groh in
the audience.
Mr. Center addressed slide 10 titled "Range of Projected
Equity Returns." The slide was the first of the slides in
the presentation illustrating projections for the Permanent
Fund. He underscored the illustrations included a range of
possible outcomes. The slide included Callan's projected
returns for public and private equity for the Permanent
Fund. He pointed to a chart on the slide and highlighted
the bar to the left reflected the Permanent Fund's public
equity portfolio. The number was higher than the 7.2
percent for U.S. equities only because the Permanent Fund
invested globally and held U.S. small cap equities;
therefore, the projection was 7.6 percent. He highlighted
the range reflecting a 10 percent chance the Permanent
Fund's public equity portfolio would perform positive 15.8
percent and a 10 percent chance it would return -0.16
percent over the next 10 years.
Mr. Center explained private equities on slide 10. He
detailed that some companies would prefer to remain
private. He elaborated that institutional investors like
the Permanent Fund could invest in the companies by
providing startup capital to gain shares and profit as a
company continued to grow over time and ultimately went
public or was sold to another firm. Private equity was
approximately 17 percent of the Permanent Fund's target
asset allocation. He detailed that private equity had
historically shown lower volatility because it was not
marked to market every second of the day like public
equity. He explained that private equity traded
sporadically, was valued on a quarterly basis, and was not
valued as rigorously and frequently as public stocks.
Callan's modelling used a larger volatility than public
stocks for private equity because there was a greater
possibility for potential loss if something were to go
wrong. Additionally, when Callan created model portfolios
from an asset allocation standpoint, if it did not dial up
the volatility in the asset classes, optimization programs
wanted to throw everything into private markets because it
looked like the place to be. He elaborated that performance
had been better compared to public markets because there
was a liquidity premium. Callan predicted about an 8.5
percent median return for private equity with a 10 percent
chance of a 21 percent return and a 10 percent chance of a
-3 percent return.
1:57:49 PM
Mr. Center continued to speak to slide 10. He highlighted
that the public equity drawdown that occurred in 2022 had
not occurred in the private equity market. He expounded
that the S&P 500 had been down around 17 percent in 2022,
while most private equity investments were up slightly in
2022 thus far. He explained that December 31 valuations for
most private equity investments would not be known until
April; it took about four months to publish the valuations.
Also, companies liked to wait as long as possible to write
an investment down from a valuation standpoint.
Historically, when there had been equity market drawdowns,
the private equity market slowed, but not to the same
degree. Callan anticipated a bit of a slowdown in the
private equity marketplace in the next 10 years. He noted
that the difference between public equity and private
equity was higher in Callan's 2022 analysis than at
present. He noted the illiquidity premium had come in a bit
and it impacted private equity and private fixed income.
1:59:19 PM
Representative Hannan asked if there was data to show how
the Alaska portfolio of private equity was performing in
comparison to other private equity.
Mr. Center answered that Callan had the information, but it
was not included in the presentation. He stated that one of
Callan's most important jobs for the Permanent Fund (in
addition to asset allocation) was performance measurement.
Callan calculated the return for the Permanent Fund and
tracked its performance. He reported that the Permanent
Fund's private equity program had done very well. He
relayed that that APFC's CIO [Marcus] Frampton believed
Callan was underselling APFC's capabilities. He remarked
that Callan would typically agree. He elaborated that APFC
had a very mature private equity program and had been
investing in private equity for a long time. He stated that
four years earlier Callan created custom private equity
projections for APFC, but it had stopped doing it because
Callan did not do the work for ARMB, and it had created
substantial confusion. He noted Callan had stopped doing
the custom projections for all of its clients and used one
set of assumptions for all Callan clients. He stated that
the Permanent Fund's execution in the private equity space
was very strong, had done well over time, and was expected
to continue doing well over time relative to peers.
Representative Hannan asked about the performance of
Alaskan private equity within APFC's private equity
portfolio.
Mr. Center answered there was an instate investment
program, but it was very new. He explained that when new
private equity investments occurred, they were prone to the
J-curve. He elaborated that a J-curve referred to an
occurrence where an investment was made in private equity
and the investment's value went down initially followed by
a gradual increase over time. He explained that the instate
investment program was still in its infancy. He detailed
that the two managers had continued to raise and deploy
capital, but it was too early to tell how investments were
doing.
Representative Hannan asked when the turn [in the J-curve]
was generally expected in private equity.
Mr. Center replied it was typically at about three years.
2:03:00 PM
Mr. Center advanced to a chart showing the historical
return for fixed income on slide 11. He relayed that
equity, fixed income, and real estate were the three large
building blocks in most institutional portfolios (private
equity and private fixed income included). He looked at a
chart showing the rolling 10-year returns for the bond
market, specifically the Bloomberg aggregate index and
pointed out there was far less volatility than in the
equity markets. Bond performance was driven by yield. He
reported that over the past 100 years, the average 10-year
performance for the Bloomberg aggregate benchmark (for the
U.S. public bond market) was about 5.4 percent. Callan's
midpoint projection for the bond market over the next 10
years was 4.25 percent. He noted it was the largest jump as
far as changes year over year: Callan's projection for the
bond market in 2022 was 1.75 percent. He stated the
increase was pretty substantial for Callan as far as a
change in a single asset class. He would discuss the reason
for the revision in upcoming slides.
Mr. Center turned to slide 12 titled "Yield Curve Rose and
Inverted in Second Half of 2022." He explained that the
yield curve looked at what a lender would have to pay to
borrow over certain time periods. He reported that the
yield curve had moved dramatically in 2022. He pointed to
the dark blue line at the bottom of a chart on the right of
the slide reflecting the yield curve as of December 31,
2021. The slide showed a three-month T-bill, which he
described as overnight short-term cash that yielded 0.06
percent as of December 31, 2021. The 30-year treasury bond
yielded 1.9 percent. He stated that the Fed had raised
rates like "gangbusters" in 2022 at any possible chance.
Ultimately, by the end of the year, the Fed could control
the short end of the curve and had pushed the short end of
the curve way up. He explained that consequently, the
three-month T-bill yield increased to 4.4 percent as of
December 31, 2022. He underscored that cash was back and
yielding money. However, 30-year yields had not moved up as
much. The 10-year yield had increased from 1.5 percent to
3.8 percent and the 30-year had increased from 1.9 percent
to 3.97 percent.
Mr. Center continued to review slide 12. He explained that
the yield curve was inverted, meaning investors were
getting paid more to borrow at the short end than the long
end (there was a greater coupon at the short end of the
curve than at the long end). He addressed why it was a
concern. First, it was an anomaly. He clarified that the
standard yield curve was upper sloping. Typically, there
was higher compensation for longer risk investing. He
elaborated it was a sign the bond market thought the Fed
would have to slow at some point via stopping increases or
lowering rates. He relayed that inverted yield curves could
be a sign of recession. He informed committee members that
the last three recessions had all been preceded by inverted
yield curves. He emphasized that yield curve inversions did
not always result in a recession. He noted that the first
two quarters of 2022 saw negative gross domestic product
(GDP) growth, which were followed by two quarters of
positive GDP growth. He posed the question: are we
teetering on the edge of a recession? The answer was
uncertain, but it was a possibility.
2:07:36 PM
Mr. Center turned to slide 13 titled "Credit Spreads
Widened to Long-Term Average Levels: Widening of Credit
Spreads Aggravated Losses on Bonds in 2022." He defined a
credit spread as how much more an investor was compensated
for buying debt issued by a company versus debt issued by
the U.S. government. Typically an investor received a
higher coupon for investing in a corporate bond versus a
Treasury security. He explained that the Treasury security
was backed by the full faith and credit of the U.S.
government, whereas there was a possibility of default when
investing in a corporate bond. Tight spreads were a sign
the market was content with corporate earnings growth,
whereas widening spreads indicated the bond market was
concerned about the future. He reported that spreads had
been very tight. He expounded that following the global
financial crisis spreads had blown out in 2008 and blew out
a bit at the beginning of the COVID crisis in 2020, but
they had come back in again. During 2022 the spreads
started to tick up a bit, which was another sign that bond
prices could potentially be more volatile in the future.
Mr. Center looked at slide 14 titled "Starting Yield
Strongly Predicts Forward Returns." He stated that while
predicting equity returns could be difficult, predicting
returns for the U.S. bond market was less so. He explained
that the overall yield of the index was typically a very
good predictor of performance. The slide included a chart
titled "Bloomberg Aggregate Index Starting Yield vs. 10-
Year Forward Return." The blue line reflected the yield on
the Bloomberg aggregate benchmark for the last 30 years.
The orange line represented the 10-year forward return for
the benchmark from 1986 to 2022. He pointed to the far
right of the chart showing that the yield had jumped back
up. Based on the data, Callan was comfortable increasing
its expected return for fixed income over the next 10
years. Callan believed it made sense to increase its
projected return for fixed income dramatically over the
next 10 years.
2:10:51 PM
Mr. Center turned to a table on slide 15 titled "Fixed
Income Forecasts." The table looked at Callan's projections
for various parts of the U.S. and non-U.S. fixed income
markets for 2023 as outlined in the orange box on the
slide. He highlighted the 4.25 percent aggregate benchmark
projection compared to previous projections. He highlighted
that Callan had pretty dramatically increased its expected
fixed income returns for the next 10 years. He stated that
it was actually possible to get returns from fixed income
again, which was mostly driven by actions by the U.S. Fed
and the reactions from the U.S. bond market. He pointed out
that the Permanent Fund's bond portfolio was not strictly
U.S. based. The fund also invested outside the U.S., in
high yield bonds, and investment grade corporate
securities; therefore, the expected returns for the
Permanent Fund's portfolio was slightly higher than the
4.25 percent.
2:12:05 PM
Mr. Center moved to slide 16 showing a range of projected
public and private fixed income returns for the Permanent
Fund. Callan was projecting a median outcome of 4.35
percent for public fixed income with a 10 percent chance of
a return around 6 percent and a 10 percent chance of a
return around 2.6 percent. Private fixed income had been
around for about 15 years and there was the ability to lend
to corporations without going through a bank or publicly
traded security. He relayed that private fixed income could
be more volatile because it was a nonbinary outcome. He
elaborated that an investor either got their money back or
they were in court trying to recover their assets or take
control over an item they could sell. The investment could
be dangerous; therefore, the projected rate of return was
much broader. Callan projected a median outcome of about
6.9 percent with a 10 percent chance of returning about
12.4 percent and a 10 percent chance of returning about 1.7
percent.
2:13:31 PM
Representative Stapp asked if public fixed income included
money markets and CDs.
Mr. Center clarified that fixed income did not include CDs.
Fixed income was composed of bond investments including
treasuries, debt issued by companies such as Microsoft and
Ford, and debt issued by foreign countries.
Representative Stapp asked if the large shift in the
investment performance projection was driven by inflation
and interest rates.
Mr. Center answered it was almost entirely interest rate
driven. He explained that because the Fed had increased
interest rates and was issuing treasuries with higher
interest rates, it was driving the entire bond market to
have a higher yield. He highlighted that the Bloomberg
aggregate had been down 22 percent in 2022, which was the
worst year of the bond market. He explained that when
interest rates rose, bond prices decreased. He relayed that
every fixed income investor had seen their bond portfolio
lose value; however, all of the bonds would be "money good"
as they matured over the next 10 years. It was the reason
Callan had increased its fixed income expectation.
2:15:20 PM
Mr. Center looked at highlights of Callan's 2023 market
projections on slide 17. He reported that Callan's 10-year
inflation expectation had increased from 2.25 percent to
2.5 percent. The public equity mid-point for the Permanent
Fund's portfolio had increased from 6.85 percent (in 2022)
to 7.6 percent. The public fixed income mid-point
projection had increased from 2.2 percent to 4.35 percent.
He noted that standard deviation on the bond portfolio had
increased from 3.75 percent to 4.2 percent. He referenced
the range of outcomes on the previous slide and explained
the increase in standard deviation meant the bar had gotten
a little bigger (the tails were a bit wider than they had
been previously). Callan's real estate projection remained
unchanged from the previous year. He reported that Callan's
projected premium for private equity and private fixed
income over public markets equity had declined because
Callan did not believe that private equity and private
fixed income had seen the same write downs as the public
markets experienced in 2022. Callan believed there were
more write downs to come at the end of 2022 going into
2023.
2:17:13 PM
Mr. Center turned to slide 18 titled "Capital Market
Projections: Summary of Callan's Long-Term Capital Market
Projections for APFC Asset Allocation Model (FY 2023-
2032)." A table on the slide illustrated the various
building blocks utilized for Callan's calculation
methodology to reach its projected return for the Permanent
Fund's portfolio using APFC's current target asset
allocation. He pointed to Callan's midpoint projected 10-
year return of 7.25 percent. The table included Callan's
projected returns for all of the building block asset
classes used by the Permanent Fund. He detailed that the
Permanent Fund a was mature and well diversified portfolio
invested in every area of the market. The projection had
been 6.65 percent in 2022 and had increased substantially,
primarily driven by increases in the public bond and public
equity projections.
Mr. Center addressed slide 19 titled "The Return of Yield."
He stated that yield did not only impact the bond market,
it also came from the equity market. He remarked that yield
had ticked up. He addressed how the increase had impacted
the Permanent Fund. The Permanent Fund had a two account
structure with the principal and earnings reserve account
(ERA). He detailed that the ERA was fed by statutory net
income and one of its key drivers was income generated by
investments in the portfolio. He explained that when yield
increased, the income generated by the investments
increased. The expectation was that interest generated by
bonds, dividends generated by stocks, and other income
generated by the investment portfolio would trend upward
over the next 10 years.
2:19:44 PM
Mr. Center turned to slide 20 titled "Relationship Between
Expected Return and Volatility." He addressed a chart
showing the capital market line, which looked at risk
versus return for the various asset classes utilized by the
Permanent Fund. The return was on the vertical axis (dots
higher on the chart had a higher expected return) and
expected volatility was on the horizontal axis. He detailed
that asset classes that charted to the right on the chart
were riskier than asset classes that chart to the left.
Cash appeared on the far left as the least risky, lowest
expected return asset class and private equity was at the
far top right. He stated relationship was necessary: higher
risk investments should pay more and lower risk investments
should pay less. He relayed it was exactly the case with
the various asset classes available to the Permanent Fund.
He pointed out the APFC portfolio plotted in the middle in
green. He stressed that some asset classes such as global
fixed income and commodities fell below the capital market
line. He stated the items could still be diversifying
investments within the concept of a broadly diversified
portfolio. It could still make sense to invest in the
strategies even though they may not offer the same reward
available for an investment with similar risk
characteristics. It did not take correlation into account.
2:21:30 PM
Mr. Center looked at slide 21 titled "Mixes Yielding 7%
Expected Returns Over Past 30+ Years." Callan had been
showing the pie charts for a couple of years as expected
returns ticked lower and lower over the past 15 years.
Callan had looked at its projections back to 1993 to see
what type of portfolio it would have recommended in order
to earn an expected return of 7 percent. He detailed that
they could create a portfolio that was 97 percent fixed
income and expect a 10-year return of 7 percent. In 2008
things were a bit more risky, but the fund looked like a
typical balanced fund with 50 percent in bonds and about 50
percent in public equities. By the time 2022 came around,
the portfolio could only have 4 percent in fixed income, 30
percent in private equity and real estate, and the
remainder in public equities in order to achieve a 7
percent return. To do so, the risk had tripled since 1993.
fixed income returns were "back" in 2023. He pointed to the
pie chart on the far right depicting Callan's capital
market expectations for 2023 and explained it was possible
to create a portfolio with a 7 percent expected return at a
much lower risk level than the previous year because the
2023 portfolio had about one-third invested in bonds. The
bond market was "back" when it came to the performance it
could generate.
2:23:39 PM
Mr. Center turned to slide 22 titled "Mixes Yielding 5%
Expected Real Returns Over Past 30+ Years." The reason for
the analysis was because the percent of market value (POMV)
draw on the Permanent Fund was about 5 percent. Therefore,
one of the long-term targets for performance of the
Permanent Fund was CPI + 5 percent. Under the scenario, the
asset allocation in 1993 had to be a bit more aggressive.
In 2022, the scenario showed an extremely aggressive
portfolio with no bonds. In 2023, the portfolio had about
15 percent invested in bonds.
2:24:50 PM
Mr. Center turned to slide 24 and discussed the APFC policy
mix. He planned to discuss APFC's asset allocation targets.
Additionally, he would discuss how the targets compared
versus peers. He explained that the Permanent Fund was
really a sovereign wealth fund and was compared to public
retirement systems and large endowment funds; it was not
perfectly like either but it had similar characteristics to
both.
Mr. Center moved to slide 25 titled "APFC FY 2023 Total
Fund Policy Target." The current APFC target asset
allocation was about 60 percent public markets split
between public equities, fixed income, and cash. The
remainder of the portfolio was invested in alternative
markets including private equity, real estate, private
infrastructure and credit, absolute return (hedge funds),
and risk parity. He noted risk parity was a 1 percent
target and APFC currently had $200 million invested (out of
$74 billion). He noted risk parity was on its way out of
the portfolio.
Representative Tomaszewski asked if the Permanent Fund
corpus and ERA were invested together.
Mr. Center confirmed the two were invested together. He
elaborated that the ERA was for all intents and purposes an
accounting practice that was tracked, but it was not a
separate portfolio.
2:27:30 PM
Mr. Center moved to slides 26 and 27 compared APFC's asset
allocation relative to large public funds and large
endowment/foundations respectively. The slides included
charts depicting distributions of allocations to various
asset classes of the peer group. He used the public equity
bar on the far left of slide 26 as an example. He detailed
that the Permanent Fund had about 36 percent allocated to
public equities, whereas the median public retirement
system had about 46 percent allocated to public equities.
He elaborated that most public funds also had more in fixed
income. The Permanent Fund had more invested in private
equity, private credit, and absolute return and about
median in real estate. Most public retirement systems had
more invested in public equity and public bonds, primarily
because they needed more liquidity than the Permanent Fund.
He explained that a typical endowment did not have the same
payout structure as a typical retirement system
(particularly a public employees' retirement system).
Additionally, public funds needed to take on more risk to
try to earn more return because some states had very poor
funded status in their retirement systems and they needed
assets to grow to catch up with their overall liability
over time. The charts helped to explain return differences
relative to peers. He relayed that public employee
retirement systems were driven by public markets to a
higher degree. He highlighted that the bond market, U.S.
stock market, and non-U.S. stock market were all clobbered
in 2022, whereas the Permanent Fund looked great relative
to public employee retirement systems in 2022 because they
had much more allocated to public markets than the
Permanent Fund.
Mr. Center moved to the same analysis on slide 27 by
looking at large endowments and foundations. He flipped
back to slide 26 and pointed out the Permanent Fund was in
th
the 79 percentile for public equities versus public funds.
He moved back to slide 27 and highlighted that the
Permanent Fund had much more allocated to public equities
and public fixed income than large endowments and
foundations typically did. Some endowments had brought
their fixed income allocation down to 5 percent. He
explained they wanted to invest more in the private markets
where they thought they could get a better return and they
did not need to hold the bonds because they did not have
liquidity needs. The Permanent Fund was between the two
when looking at endowments and public funds. Over the past
decade, the Permanent Fund had looked more like an
endowment than a public employee retirement system. It had
invested in the private markets to a higher degree than
most public funds, but it still had a good amount invested
in the public markets (slightly less than 60 percent). He
stated that most endowments and foundations had about 55
percent invested in private markets, whereas the Permanent
Fund had about 41 percent given its current target asset
allocation.
2:31:27 PM
Mr. Center turned to slide 28 titled "APFC FY 2023 Total
Fund Policy Target." Based on the Permanent Fund's current
target and using Callan's capital market expectations,
Callan projected a 10-year expected median outcome of about
7.25 percent with a standard deviation of about 13.3
percent. Callan's expected inflation projection had
increased from 2.25 percent to 2.5 percent. Callan
projected an expected real return for the Permanent Fund of
about 4.75 percent over the next 10 years. He noted it was
an increase of about 55 basis points from Callan's 2022
projection.
Co-Chair Edgmon observed that Callan's standard deviation
was wider than before in the face of uncertainty around
possible global recession and increasing inflation.
However, Callan's rate of return projections over the next
10 years were more optimistic than the 6.25 percent
projection a couple of years back. He asked for a
reconciliation of all of the factors.
Mr. Center addressed the most important contributing
factors. First, the yield environment for fixed income had
improved dramatically. Second, valuations seem fair in the
public equity markets at present. Callan believed the death
of the institutional real estate market was greatly
overblown. He elaborated that even though the cost of
borrowing had increased, there was still a great deal of
demand for hotels, apartments, and industrial investments.
Callan believed the prospective outlook for the
institutional investment space had improved. He relayed
that over the past several years it had been very difficult
to construct a portfolio that would return 7 percent using
Callan's asset class projections; a return of that
magnitude meant taking on a great deal of risk. He stated
that Callan had received substantial pressure from its
clients to change its projections to increase the return
outlook, but it had not done so because the math behind it
was not there. Whereas now, the math was there. He relayed
that much of the shift was driven by the yield environment.
Co-Chair Edgmon stated that he had always equated a
sovereign wealth fund with an endowment. He understood
there was a difference between an endowment and a pension
fund. He referenced Mr. Center's earlier remarks about the
difference between endowments and pension plans and that
the Permanent Fund fell somewhere in the middle of the two.
Mr. Center explained the two comparisons related to the
evolution of the Permanent Fund over the past 15 years. He
detailed that 15 years ago the Permanent Fund had looked
more like a pension fund and had been almost 50 percent
bonds and 50 percent stocks. Since that time, the Permanent
Fund had become more like an endowment fund. He explained
there was a time approaching when Callan would stop
comparing the Permanent Fund with public funds. He
elaborated that because Callan had been working with APFC
for so long, it had the returns for approximately 30 years.
He relayed that when comparing the Permanent Fund to
endowments over 20 years, the Permanent Fund did not look
great because 10 years back it had significantly more bonds
than most endowments and foundations. Unfortunately, the
data on sovereign wealth funds was extremely difficult to
gather; there were some U.S. based sovereign wealth funds
and land trusts, but larger sovereign wealth funds were
located outside of the U.S. He stated that sovereign wealth
funds did not like to divulge their investments; therefore,
trying to get track records to create peer group
performance or to show comparative asset allocations was
impossible. Under the circumstances, Callan had decided
that large endowments were the best comparison for the
Permanent Fund.
2:37:07 PM
Co-Chair Edgmon remarked on the tremendous amount of good
information provided by Mr. Center. He asked what the asset
allocation chart would have looked like five to 10 years
back for the Permanent Fund. He assumed the public fixed
income would have been lower than 20 percent.
Mr. Center clarified the public fixed income allocation had
actually been a bit larger in the timeframe mentioned by
Co-Chair Edgmon. He provided the information looking five
years back because he had been working with the Permanent
Fund for eight years. He explained that the Permanent Fund
was a battleship and steering a battleship took time. He
explained that Mr. Frampton, the APFC CIO had a plan for
how he wanted the asset allocation to change over the next
three years. He explained the plan included changes such as
moving 1 percent from one asset class to another (moves of
1 and 2 percent). He estimated that about three years back
fixed income had been about 23 percent, the real estate
allocation had been higher than its present level, private
infrastructure had been lower, and public equity had been a
bit higher. There had not been substantial changes from
five years ago.
Co-Chair Edgmon highlighted that the POMV draw had only
been in place for five years. He noted the first three
years had a 5.25 percent draw and years four and five had a
5 percent draw. He wondered how it would be incorporated
into the asset allocation decisions made by trustees.
Mr. Center highlighted Callan's expected real return of
4.75 percent at the bottom of slide 28. He clarified that
the 5 percent POMV draw was not 5 percent of the current
value of the Permanent Fund. He explained that the POMV
draw calculation was 5 percent of the average of the first
five of the previous six years. He detailed the calculation
was a smoothing mechanism used by most endowments to create
a predictable, stable draw amount out of the fund over
time. He elaborated that the calculation enabled visibility
into what the draw would be ahead of time. He noted that
the next draw amount was known because the last number used
in the calculation was June 30, 2021. The next draw was
approximately $3.6 billion. He relayed that in an upward
trending market a 5 percent draw calculated with the
smoothing mechanism equated to about 4.7 percent of the
current market value. He stated that upcoming slides would
show Callan's projection showing the likelihood of hitting
a 5 percent real return in addition to the likelihood of
hitting a 4.7 percent real return, which Callan found to be
more illustrative of a sustained 5 percent draw using the
current smoothing mechanism.
Co-Chair Edgmon found the topic fascinating. He shared that
he had been on the committee in 2016 when it had done a
couple of weeks of the iterative analysis. The information
had been incredibly enlightening and simultaneously
paralyzing in terms of its magnitude.
Mr. Center relayed that [a chart on] slide 30 looked at the
range of projected returns for the current asset allocation
mix as shown in the bar to the far left. All of the other
bars on the chart were the various arrangements for the
various asset classes utilized in the Permanent Fund. The
median outcome for the Permanent Fund was about 7.25
percent and the probability of hitting 7.5 percent (5
percent real) was about 47.7 percent. The likelihood of
hitting 7.1 percent, which Callan identified as the actual
return goal (4.6 percent plus the inflation target), was
about 51.4 percent. He highlighted that the figure had been
below 50 percent the previous year. He noted there had been
a lower inflation projection in 2022. He relayed that
missing the 4.6 percent real return did not mean there was
no draw whatsoever; it was not a binary outcome. He
explained it meant there would be hope that perhaps the
next year the Permanent Fund would have a slightly higher
return. He elaborated that capital markets were not smooth
by nature and some fluctuation of returns over time should
be expected.
2:43:53 PM
Representative Josephson stated that the previous year in
May the legislature had been close to taking a 7 percent
draw from the ERA. He asked how the legislature should
weigh the value in showing discipline and not taking more
than 5 percent. He had seen the number for the present
value of the ERA range from $5 billion to $17 billion. He
listed various variables such as the need to inflation
proof, large deposits electively made to the corpus by the
legislature, and a projected draw. He asked how to measure
whether it was acceptable to do a 7 percent draw when in
need notwithstanding the projected 4.75 percent return.
Mr. Center clarified that he had not stated they could draw
less than 5 percent. Callan believed the 5 percent draw was
sustainable and he commended the legislature for not being
tempted to exceed that amount. He advised it should take
significant attention before more than a 5 percent draw was
taken from the Permanent Fund. Callan did not want to be
political about the Permanent Fund or its mechanics. He
understood the APFC had put forward some resolutions about
constitutionalizing the elimination of the two account
structure and inserting the 5 percent POMV draw in writing
as currently calculated. Callan believed the 5 percent POMV
draw was sustainable for the long-term and that it would
meet the needs for inflation proofing the corpus,
guaranteeing intergenerational equity for current and
future Alaskans, and the elimination of the two account
structure removed the slim possibility of the ERA becoming
depleted and eliminating the draw source from the Permanent
Fund. One of the potential concerns with the ERA was that
it looked like a piggy bank. He estimated the current ERA
balance at around $13 billion prior to inflation proofing
and POMV draw. He explained the temptation could be there
to draw more than 5 percent. He would hope that
constitutionalizing a sustainable 5 percent draw would help
minimize that possibility.
2:49:05 PM
Representative Josephson referenced the 2.5 percent rate of
inflation used by Callan. He noted that the Office of
Management and Budget (OMB) was using a 10-year outlook at
1.5 percent. He asked if Callan would advise the House
Finance Committee to look at a rate of 2.5 percent if it
were to devise its own 10-year outlook.
Mr. Center agreed. He stated that Callan had come under
fire for 2.25 percent being too low the past year.
Co-Chair Edgmon believed the 10-year plan needed to be
tightened up to be less politicized and more accurately
reflect the information from Callan. He spoke about the
need to educate legislators on the topics under discussion
in the current meeting. He stated that financial risk did
not equal political risk. There were many policymakers
making decisions based on political calculations that did
not affix themselves to any sense of reality vis-a-vis
professional advisors and professional long-term outlook
provided to APFC. He believed more education in the
building was needed. He really appreciated the information
in the presentation.
2:51:45 PM
Mr. Center shared that the remainder of the presentation
focused on performance of the Permanent Fund compared to
its benchmark and peer groups as of December 31, 2022.
Representative Hannan referred to Mr. Center's use of the
term industrial real estate and asked if it was synonymous
with commercial real estate.
Mr. Center answered that industrial real estate included
things like warehouses. He relayed that the bright spot in
real estate over the past 18 months had been warehouses and
industrial space versus retail, office, and apartments.
Representative Hannan surmised that industrial was a type
of commercial real estate.
Mr. Center agreed.
Representative Hannan stated that over the past couple of
years she had heard the Permanent Fund had made substantial
money in its real estate allocation by investing in the
real estate crash in residential real estate portfolios.
She stated that the fund had profited because there had
been a substantial rebound in the sector. She wondered if
Callan advised APFC on the allocation within the real
estate portfolio (e.g., one-third industrial, one-third
other commercial, and one-third residential).
Mr. Center answered that the Permanent Fund had a separate
real estate consultant and Callan did not advise APFC on
real estate.
2:54:16 PM
Representative Ortiz asked about the term sustainable. He
asked if it meant the fund would maintain its current value
adjusted for inflation or increase in value above
inflation.
Mr. Center answered that Callan believed the 5 percent POMV
draw as currently calculated should enable the fund to keep
pace with inflation over time. He stated it could exceed
[inflation] and grow in value. He clarified that Callan
believed the current draw was sustainable and would not
have a negative impact on the real value of the Permanent
Fund.
Representative Ortiz asked if the likely outcome would be
to maintain the current value rather than increase.
Mr. Center answered affirmatively. He pointed to the chart
on slide 31 and relayed that the median outcome was keeping
pace with the 5 percent draw as currently calculated plus
inflation.
2:55:53 PM
Mr. Center turned to slide 34 and discussed the APFC total
fund historical returns. He relayed that the Permanent Fund
had been performing very well. He noted it was hard to use
that descriptor when the fund was down 6.4 percent over the
last year; however, Callan compared the Permanent Fund's
performance with two targets. The first was the total fund
target made up of a composite of publicly available
benchmarks (shown at the bottom of the slide) that match
the way the Permanent Fund was investing its portfolio over
time. Callan believed it was the most applicable
performance measure for the Permanent Fund to see how
benchmarks were implementing relative to its target asset
allocation. The Permanent Fund returned -6.4 percent over
the past 12 months compared to the total fund benchmark
return of -9.15 percent. The second benchmark was CPI + 5
percent. He stated it was easy to look at the returns and
question why the Permanent Fund had not kept pace with CPI
+ 5 percent over the past year. He underscored that if he
could get CPI + 5 percent, he would put all of his money
into it all day, every day. He stated it was an
aspirational long-term goal. He advised the focus should be
on how the Permanent Fund had performed relative to CPI + 5
percent over the last five to 20 years.
Mr. Center highlighted that over all time periods, the
Permanent Fund was ahead of its performance benchmark and
pretty handily ahead of its performance benchmark on a net-
of-fee basis. He noted the slide depicted returns after all
management fees. The Permanent Fund was also ahead of its
target over the last 10 years by 1 percent and ahead of the
CPI + 5 percent target over the last 10 and 20 years.
Performance of individual asset classes was not included on
the slide. He stated that the asset classes had all been
doing well. The APFC team had been doing a great job
investing the portfolio. He added that the Permanent Fund's
public equity portfolio was one of the best performing
public equity strategies in Callan's entire database.
2:58:51 PM
Mr. Center moved to a chart showing the APFC total fund
cumulative return versus CPI + 5 percent on slide 35. The
CPI + 5 percent was represented by the orange line and the
Permanent Fund was reflected by the dark blue line. He
reported that on a cumulative basis over the past 20 years
the Permanent Fund had outpaced CPI + 5 percent. The
Permanent Fund had experienced far more volatility and some
drawdowns, particularly during the global financial crisis
of 2007/2008. Additionally, there was another dip at the
outset of the COVID pandemic and in 2022.
Mr. Center looked at APFC's performance relative to large
public funds on slide 36. He highlighted that the Permanent
Fund had less allocated to public equities than most public
funds, which had benefitted the Permanent Fund relative to
other public retirement systems in the past year. He stated
th
that even being down 6.4 percent, the fund was in the 9
percentile relative to public retirement systems. The
Permanent Fund was in the top quartile relative to other
large public retirement systems in the past three, five,
and 10 years. Much of the difference was driven by the
asset allocation decision.
3:00:24 PM
Mr. Center moved to slide 37 and reviewed APFC's
performance relative to endowments and foundations. He
stated that the Permanent Fund looked a bit more like an
endowment, particularly over the most recent 10-year
periods. He highlighted that the Permanent Fund was
performing near median and in line with what would be
expected for an average endowment fund over the three,
five, and 10-year periods. He pointed to the bar on the far
right side of the chart and noted it looked like the
st
Permanent Fund was in the 71 percentile over the last 20
years relative to endowments and foundations. He explained
that in the early 2000s the Permanent Fund had not been
invested like most endowments and foundations; it had more
invested in the public markets, which was a relative
negative from a performance standpoint. He did not want
legislators to be alarmed by the rank. Callan found the
last year and last three, five, and 10 years to be more
indicative of how the fund was currently being invested
from a peer group standpoint.
Mr. Center provided concluding observations on slide 38. He
stated that the Permanent Fund had performed incredibly
well relative to its benchmark over the near and long-term
periods. The fund had outperformed the CPI + 5 percent
target over the long term. The fund had been very
competitive compared to large public pension funds and
looked more like an endowment fund from a performance
standpoint.
Representative Coulombe referred to Mr. Center's statement
that the Permanent Fund was operating more like an
endowment fund. She observed that it sounded like it was
better than operating like a retirement fund. She asked why
it was better to operate more like an endowment fund. She
considered if it was because the risk was lower and there
was more stability.
Mr. Center answered that public retirement funds and
endowments and foundations took on risk in order to earn
returns. He detailed that an endowment and foundation could
typically take on more illiquidity risk via investing more
in the private markets. He elaborated that private markets
tended to have a slightly higher return over time. Most
public employee retirement systems could not invest as much
in private equity, private debt, real estate, and hedge
funds because of their liquidity needs. Given that the
payout for most endowments and foundations was in the 4.5
to 5 percent range over time, they could take on more of
the illiquidity risk. The Permanent Fund had been able to
migrate towards that model, particularly over the last 12
to 15 years.
Representative Coulombe stated her understanding that a
retirement fund had to have more liquidity built in,
meaning they had to invest more in public equity. She
referenced Mr. Center's statement that public retirement
funds tended to lean towards high risk to make up the
difference quickly because they were underfunded. She asked
if the scenario reflected that a fund was being poorly run
or the nature of the way retirement funds operated.
3:04:43 PM
Mr. Center answered it was the nature of the beast. He
elaborated that one of the ways public retirement systems
in states that had been deficient in funding their
liability over the long-term could potentially dig
themselves out was by taking on additional risk in their
portfolio. He stated it was typically done by investing in
stocks and stock-based hedge funds, which could be
extremely dangerous.
Representative Tomaszewski referenced retirement funds. He
asked if Callan had ever given a diagnosis between the
state's retirement system and the Permanent Fund.
Mr. Center answered that he was the co-consultant for ARMB.
He addressed the risk and return characteristics for the
Alaska retirement system. He stated that while the
retirement system came about it in a slightly different
way, it had more allocated to public equities and about the
same allocated to fixed income as the Permanent Fund. The
risk and return characteristics were fairly similar. He had
been told he would be invited back to talk to the committee
about the state's retirement funds.
Representative Tomaszewski was interested in a comparison.
He was interested in the cost of managing the retirement
system versus the Permanent Fund. He asked if it would be
possible to combine the funds and whether it would be a
smart move or not.
Mr. Center answered that some work had been done on the
possibility of combining the investment teams prior to
COVID. He believed it had hit some kind of dead end. He
clarified that the funds were implemented in a very
different way. The Permanent Fund was invested like an
endowment fund that accounted for the annual draw and could
take on additional levels and degrees of risk. The funds
also had some similarities. He elaborated that all of the
fixed income in the Permanent Fund was managed in-house and
the majority of the fixed income in the retirement system
was managed internally by the Department of Revenue. The
in-house expertise saved a substantial amount of money.
Both funds invested externally with private equity managers
to different degrees. Additionally, both funds had robust
real estate portfolio. He detailed that the Permanent Fund
invested directly in real estate assets by purchasing
individual buildings, whereas the retirement system
invested in real estate funds.
Co-Chair Johnson thanked Mr. Center for his presentation.
She reviewed the schedule for the following day.
ADJOURNMENT
3:09:04 PM
The meeting was adjourned at 3:09 p.m.
| Document Name | Date/Time | Subjects |
|---|---|---|
| Callan Presentation - APFC - HFIN 021623.pdf |
HFIN 2/16/2023 1:30:00 PM |