Legislature(1999 - 2000)
03/31/1999 09:12 AM Senate FIN
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
SENATE FINANCE COMMITTEE LOG NOTES 03/31/99 GENERAL SUBJECT(S): BALANCED BUDGET PRESENTATION Jim Kelly, Research & Liaison Officer Permanent Fund Corporation Department of Revenue The following overview was taken in log note format. Tapes and handouts will be on file with the Senate Finance Committee through the 21st Legislative Session, contact 465-2618. After the 21st Legislative session they will be available through the Legislative Library at 465-3808. Time Meeting Convened: 9:17 A.M. Tape(s): SFC-99 #75, Side A & Side B PRESENT: X Senator Parnell X Senator Adams X Senator Torgerson X Senator P. Kelly X Senator Donley X Senator Green X Senator Leman X Senator Phillips X Senator Wilken ALSO PRESENT: SENATOR KIM ELTON; JIM KELLY, Director of Communications, Permanent Fund Corporation, Department of Revenue; PETER BUSHRE, Chief Financial Officer, Permanent Fund Corporation, Department of Revenue; GREG ALLEN, Executive Vice President, Director of Operations, Callan & Associates. SPEAKER DISCUSSION CO-CHAIR PARNELL Convened the SFC meeting at 9:17 a.m. He commented that a key fiscal resource of Alaska is the Permanent Fund. The Alaska public needs to consider this in terms of building long range balanced budget plan. JIM KELLY Director of Communications Permanent Fund Corporation Department of Revenue Mr. Kelly introduced Peter Bushre, Chief Financial Officer, Permanent Fund Corporation and Greg Allen, Executive Vice President, Callan & Associates. Provided the Committee with a handout, which he would provide an overview of. The Permanent Fund Corporation does not get involved in making public policy choices. He addressed issues that relate to investment management and structure. He additionally asked to address the key assumptions that is used by the Permanent Fund Corporation and that they recommend that the Legislature take into consideration when developing the plans. In particular, the intent is to change the notion within the distribution of fund income, which is currently based on the percentage of fund income; the trustees have been looking at a formula based on market value of the total assets. Mr. Kelly noted that the mission of the Permanent Fund responsibility is to maximize the value of Alaska's oil revenues through prudent long term investment and investment of principle to produce income to benefit all current and future residents of Alaska. As a result of decisions made 20 years ago, the permanent fund has earned $20 billion dollars of income. That money has been divided between current and future generations-41% has been made available through the dividend program. Mr. Kelly suggested that the current procedures might not work as well in the future because: Increased volatility in the capital markets. It is the expectation that we will see lower returns in the future than have occurred in the past with increased risk. Another change in the world is the way that we account for the earning reserve in that account. The total to date of the earnings reserve is $6.3 billion dollars. The accounting rule now shows the unrealized portions and the realized portions of that income. That change causes an inconsistency the way that state law is written. He Kelly continued, the third major change is that the lines crossed last year. The 20 years of the Permanent Fund provided the benefit of all that oil. The financial assets were being built up. That has declines and the fund income will play a larger role. The future planning involves four objectives of the fund managers. 1) Maximize long term total returns; 2) Maximize annual spending distributions; 3) Preserve the real and the inflation value of the fund and preserve the purchasing power of the fund; and 4) Guarantee that the distributions are stable and predictable. He elaborated that the heart of the question is how much can be spent while still preserving the real value of the fund. The two driving factors that determine the rate of investment are 1) Capital market returns and 2) Asset allocations. The only thing that can be influenced is the asset allocation. He should slides, which addressed this concern. He pointed out that according to this calculation, GASB Income $66.8 billion would be earned over the next 20 years. Mr. Kelly explained fixed income, U.S. Equities, Non-U.S. equities, Real Estate and the Alaska CD's. Mr. Kelly explained the charts prepared by the Commissioner of Department of Revenue regarding how the fund works. He noted that the Alaska Permanent Fund has two parts, the principal and the income. The Legislature has inflation proofed each year and that money cannot be spent and he emphasized that no matter what decisions the Legislature makes this year in regards to the Permanent Fund, they may not use these funds Mr. Kelly continued, there are two kinds of income, i.e., realized income and unrealized income. Realized income is interest on the bonds and dividends on the stocks, cash flow on real estate; the unrealized gains is the appreciation that occurs. Under the terms of the State Constitution, all the money is available for appropriation. All the investments are invested in stocks, bonds and real estate. The money is co-mingled. SENATOR TORGERSON Asked the actual amount of cash in the fund. JIM KELLY Replied that there is $3 - $500 million dollars cash. $12 billion is a lot of money but not on the stock market it is not considered a large impact on the market however, to move it quickly would create some market impact. The State would lose some of the price we could get by trying to do it in a hurry. The preference is to move it slowly. CO-CHAIR PARNELL Requested clarification of how the dividend appropriation gets to the public. JIM KELLY Replied that in previous years, all the dividends came from selling bonds. In the last several years due to restructuring of the portfolio, there have been a lot of realized gains. The dividends paid last year came from selling stocks and bonds. The way that the investment professionals are working on it is that they make a plan and then figure out which place to take the money from, whichever place makes the most sense. Mr. Kelly continued to explain the priority for use of fund income. The AS 37.13.140 & 145 provides the priority for the payment of dividends and inflation proofing. He acknowledged that there are two permanent fund dividend calculations, the lesser of two things, i.e., the 1/2 of 21% of the sum of five years realized earnings or 1/2 of what is available in the earnings reserve account. He provided an example of how that works. CO-CHAIR PARNELL Suggested that if step 2 were not in play, there would be a new definition of the earnings reserve account. He asked how that would be accounted for. JIM KELLY Stated that would be subject to interpretation. It is unclear but according to general accepted accounting principles, the "big" earnings reserve account must be taken into consideration. He explained that when including the unrealized income, a whole new level of volatility becomes introduced. He did not foresee the $6 billion being touched. CO-CHAIR PARNELL Noted that the accounting principles have changed the statutory interpretation. PETER BUSHRE Chief Financial Officer Alaska Permanent Fund Corporation Department of Revenue Explained that State law currently defines the earnings reserve account and limits it to just realized earnings. He stressed that we cannot interpret State law to include the new accounting standards. He added that this would need to be clarified by the change to State law. SENATOR TORGERSON Which one would take precedence? PETER BUSHRE Replied that currently, when it comes to giving the dividends, by law, they are limited what is written. JIM KELLY Explained further, that by the first calculation, there would be no problem. However, with the second calculation the questions arise and do need clarification. He requested further guidance from the Legislature regarding that concern. SENATOR PHILLIPS Asked if the Permanent Fund would be making the recommendation to the Legislature or to the LB&A committee. He asked for further explanation of the 21% previously referred to. JIM KELLY Replied that it the State would not want to have a dividend based on what was made in every given year. The Legislature created a "smoothing" mechanism five-year average. He added that the 21% is like a five-year average, a small change that the Legislature made in 1986 to increase it. SENATOR P. KELLY Questioned the statement that the unrealized earnings were gone. JIM KELLY Explained that when market goes up, unrealized gains go up and when the market goes down, the unrealized gains go down. He added that Step 2 was a hypothetical possibility. Mr. Kelly spoke to how inflation proofing works. We inflation proof only the principal by taking the average of the monthly consumer price index (CPIU) for each of the two previous calendar years, note the change and multiply that rate of change by the times of the principle balance on the last day of the fiscal year. SENATOR WILKEN Pointed out that some people say that the State is double inflation proofing. JIM KELLY Commented that inflation proofing is a public policy decision. It done with the notion guaranteeing that the money in the principal is there. If inflation proofing is not done and the market goes away, everything goes then. Mr. Kelly advised that they would like to address a long-term situation of capturing the total return to use to pay for the inflation proofing. That would be a percentage of market value based on distribution. Mr. Kelly pointed out that the Corporation always follows the statutes regarding the correct measures to take to inflation proofing. He stated that distribution of income based on the percentage of market value has been address since Hugh Malone was on the board of the Permanent Fund. Various groups have proposed the distribution of fund income for many years. Mr. Kelly read from the State of New Mexico Investment Council-1998 Annual Report. That State changed their constitution now having a new distribution and payout. They are based on a percentage of market value. The advantages from a market value-based distribution are 1) It provides more predictability and stability in the annual distributions; 2) It disconnects investment decisions from short-term spending considerations; and 3) The spending provision becomes part of long-term investment strategy rather than tactical response to market cycles. Mr. Kelly referred to the handout booklet, "The Role of the Permanent Fund in Alaska's Future". He noted that it was a nice collection of the people's voice and recommendations. Mr. Kelly concluded his presentation and introduced Mr. Greg Allen of Callan and Associates. GREG ALLEN Executive Vice President Director of Operations Callan and Associates Stated that Callan & Associates works with large pools of money mostly pension funds. The Strategic Planning Group at Callan provides financial planning for large bodies or pools of assets. The work of that group is to allow the stewards of assets through the building of models to understand the potential investments on the future of assets. He stated that two years ago, Michael O'Leary without anticipating the current situation, asked him to build a model of the permanent fund to help the State of Alaska to make necessary decisions on rebalancing and asset allocation. The model was called the Alaska Permanent Fund Simulation Model (Mother of Models, All or MOMA) Fundamental objective in building the model was to create a tool that would allow us to understand the potential impacts of any policy change. It is important to understand the impact on the fund value, the earnings reserve balance, the distributed income, and inflation proofing across a complete range of possible capital market outcomes. Those are the four fundamental measures determining the health of the fund. The distributed income (the dividend) is very important to the people of Alaska. He added that inflation proofing is important because without it, the dividend could erode. The model shows what happens if the market drops. The fund value, base-medial results show the costs vs. market value of the assets. He explained this graph in the handout. Mr. Allen pointed out that the reserve account indicates the base-case median results. Mr. Allen spoke to the distributed income, the amount of money paid out of the fund each year. TAPE CHANGE 99-75 B Tape Change, SFC 99-75, Side B GREG ALLEN Mr. Allen commented that the fee for FY99 is projected to be $1.1 billion dollars. He pointed to the inflation proofing line, which drops significantly in 1999. It is projected to be 3% in the year 2000 and thereafter. Mr. Allen noted that this is a medium case projected outcome. He explained the risk vs. return, median case, zero risk. When there is no risk, there is no volatility in behavior. Unfortunately, the world market has risk. The equity market returns introduce risk, which is the pattern most likely to happen in the future. Fund value, scenario in the handout #28, which introduces risk. The reserve account drops to zero in 2002 and 2003 as a result of low returns, which is distributed income. Mr. Allen said that the heart of issue is if you want to inflation proof and protect principle, and that is a fundamental priority, in a volatile world, you can only pay out of earnings reserve account. This is inflation proofing to the principal. When there is not enough money in the earnings reserve account to both inflation proof and pay distributed income, the fund has created a deficit account twice in past. Mr. Allen referred to this as a demo model. He noted that shows one possibly scenario, however, the model will create many scenarios, 300 in fact. Looking at fund value in earnings reserve account, we will see that sometimes it is up and sometimes it is down. Underlying the concern is all the various types of annualized risk vs. return for the next 20 years. Callan and Associates keeps track each year of all 300 scenarios of the distributed income and fund value as it relates to this model. The chart illustrates the probability of the range of distributed income in each of the years. Mr. Allen applied the model and compared the status quo to three variations on a market- value-based distribution rule. He referenced the capital market assumptions and explained the range of potential outcomes. Mr. Allen explained that all scenarios he has developed were realistic and that each one has a "probability" associated with it. He continued, his job was to look at the future of the fund, not changing the distribution roles analyzing three scenarios distributing income based on market value as opposed to based on income. In the base case it is assumed that there would be no appropriation except for the dividend. They would assume that the fund remains vested at 48% equity, income distribution and inflation proofing are status quo. That was compared to a case that differed in one way. The distributed income formula is 4.5% on a five-year average market value. Rather than transmitting inflation proofing back into principle each year, it would be left in the earnings reserve account. In the last case scenario, the State would go to a 5.5% distribution rate, but in order to do that and not drain the fund down, the equity allocation would be boost 60%. Mr. Allen noted that for every 1/2% of market value you may want to distribute, the equity allocation needs to be increased by 10%. Mr. Allen briefly reviewed the "Fund Value" graphs. The fund is currently paying out an amount that is consistent with a 4.5% payout rate. From the perspective of the value of the fund, whether you keep the money in the earnings reserve account or whether you leave it in the principle is immaterial. SENATOR PHILLIPS Asked if using these assumptions, would it be possible to create a graph backward from 1999. GREG ALLEN Responded that he had not did that for more than five years. Mr. Allen explained that he has spent a lot of time "fine-tuning" this model to make sure it is accurate and that last year's prediction came within 12 cents of actual dividend. Mr. Allen provided an overview of the distributed income graph. He noted that the market value of the fund is far less volatile than the earnings of the fund. A percentage of the market value formula is generally much smoother than the income formula. He emphasized that is important information. Mr. Allen illustrated the worst case scenarios on graph. In the worst case, in 2003 the fund value would amount to $23 billion dollars. In the best case, the fund value would amount to $37 billion dollars. From the value of the fund standpoint, all the plans are relatively indifferent from one another. He believed that the most interesting part was the range of distributed income graph under the base case. This would take a decision to keep the inflation-proofing component in the earnings reserve balance and not appropriate it back to principle every year. It would also take not making extra appropriations each year. SENATOR PHILLIPS Asked what extra appropriations would entail. GREG ALLEN Explained that would be anything beyond the dividend. Mr. Allen added that any movement out of the earnings reserve account would be considered an appropriation. There is more volatility in the future payout stream. He noted that with a 5.5% payout, there would be much more volatility even with the money kept in the earnings reserve. Mr. Allen summarized the key findings. The permanent fund, under the current structure, can support its three objectives. 1) Preserving principle; 2) Distributing the income; and 3) Protecting the purchasing power of the fund. By considering a market based distribution roll, the State could improve the stability of that payout. To distribute higher levels of distributed income would require greater allocations to higher-return, higher- risk assets (i.e. equities.) He pointed out that distributing income in excess of sustainable levels would create potential shortfalls in future distributions due to the funds requirement to preserve principal. JIM KELLY Made his final comments to the SFC Committee. He noted that he would be happy to review the proposed model from Callan & Associates if requested. CO-CHAIR PARNELL ADJOURNMENT The meeting adjourned at 10:35 A.M. SFC-99 (9) 3/31/99 a.m.
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