Legislature(2011 - 2012)SENATE FINANCE 532

02/25/2011 08:00 AM Senate FINANCE


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08:07:08 AM Start
08:07:21 AM Overview: Capital Markets and Permanent Fund Performance Review.
09:44:30 AM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ Capital Markets Outlook and Permanent Fund TELECONFERENCED
Performance Review by Michael O'Leary from
Callan Associates
+ Bills Previously Heard/Scheduled TELECONFERENCED
                 SENATE FINANCE COMMITTEE                                                                                       
                     February 25, 2011                                                                                          
                         8:07 a.m.                                                                                              
                                                                                                                                
                                                                                                                                
8:07:08 AM                                                                                                                    
                                                                                                                                
CALL TO ORDER                                                                                                                 
                                                                                                                                
Co-Chair  Stedman   called  the  Senate   Finance  Committee                                                                    
meeting to order at 8:07 a.m.                                                                                                   
                                                                                                                                
MEMBERS PRESENT                                                                                                               
                                                                                                                                
Senator Lyman Hoffman, Co-Chair                                                                                                 
Senator Bert Stedman, Co-Chair                                                                                                  
Senator Lesil McGuire, Vice-Chair                                                                                               
Senator Dennis Egan                                                                                                             
Senator Donny Olson                                                                                                             
Senator Joe Thomas                                                                                                              
                                                                                                                                
MEMBERS ABSENT                                                                                                                
                                                                                                                                
Senator Johnny Ellis                                                                                                            
                                                                                                                                
ALSO PRESENT                                                                                                                  
                                                                                                                                
Bill Moran, Chair, Alaska  Permanent Fund Corporation Board;                                                                    
Mike  Burns,  Executive   Director,  Alaska  Permanent  Fund                                                                    
Corporation,   Department  of   Revenue;  Michael   O'Leary,                                                                    
Executive Vice President, Callan Associates.                                                                                    
                                                                                                                                
SUMMARY                                                                                                                       
                                                                                                                                
^Overview:  Capital Markets  and Permanent  Fund Performance                                                                    
Review.                                                                                                                         
                                                                                                                                
8:07:21 AM                                                                                                                    
                                                                                                                                
Co-Chair  Stedman   introduced  the  chair  of   the  Alaska                                                                    
Permanent Corporation Board.                                                                                                    
                                                                                                                                
BILL MORAN,  CHAIR, ALASKA PERMANENT FUND  CORPORATION BOARD                                                                    
introduced  his cohorts.  He discussed  the  agenda for  the                                                                    
day.                                                                                                                            
                                                                                                                                
8:11:09 AM                                                                                                                    
                                                                                                                                
MIKE  BURNS,  EXECUTIVE   DIRECTOR,  ALASKA  PERMANENT  FUND                                                                    
CORPORATION, DEPARTMENT  OF REVENUE provided  a presentation                                                                    
titled: "Alaska  Permanent Fund Designed  for Sustainability                                                                    
(copy on file)."                                                                                                                
                                                                                                                                
Mr.  Burns  began with  Slide  2:  "FY2010 performance."  He                                                                    
explained the various markets.                                                                                                  
                                                                                                                                
     Total return        11.7%                                                                                                  
     Benchmark return    10.2%                                                                                                  
                                                                                                                                
     Ending balance      $33.3 billion                                                                                          
     Change from FY10    $ 3.4 billion                                                                                          
                                                                                                                                
     Dividend            $858 million                                                                                           
                                                                                                                                
Mr.  Burns  discussed Slide  3:  "FY  11 performance  as  of                                                                    
December 31."                                                                                                                   
                                                                                                                                
     Total return        14.5%                                                                                                  
     Benchmark return    16.6%                                                                                                  
                                                                                                                                
     Ending value        $38.4 billion                                                                                          
     Change from FY10    $ 5.1 billion                                                                                          
                                                                                                                                
8:14:34 AM                                                                                                                    
                                                                                                                                
Mr. Burns  discussed the  sources of the  fund as  listed on                                                                    
Slide 4:  "Renewable Resources." He explained  that Alaskans                                                                    
have  deposited $14.7  billion  into the  fund  to date.  He                                                                    
added that  $18.4 billion have  been paid out  in dividends.                                                                    
The current value of the fund  is $39 billion as of 2/24/11.                                                                    
He  concluded  that  the  fund  has  provided  a  successful                                                                    
socioeconomic experiment.                                                                                                       
                                                                                                                                
Slide 5:  "Fund Deposits." He noted  that the constitutional                                                                    
royalty deposits equal  $11.8 billion. Legislative transfers                                                                    
from  the general  fund (FY81  through FY  85) totaled  $2.7                                                                    
billion. Another  $2 million  were classified  as settlement                                                                    
deposits.                                                                                                                       
                                                                                                                                
He explained  the difference  between the  investment income                                                                    
and outflow  on Slide 6:  "Inflow and outflow."  He informed                                                                    
that 1983 was the first year  of operation for the fund. The                                                                    
royalty  deposit in  1983 was  $421 million,  the accounting                                                                    
net   income  was   $471  million   and  the   dividend  was                                                                    
approximately  $64  million.  He   explained  that  in  1991                                                                    
dramatic  changes occurred.  The  pipeline  saw 665  million                                                                    
barrels of  oil in  1991 and  the price  was $25  per barrel                                                                    
with a  royalty deposit of  $435 million. He  mentioned that                                                                    
the accounting  net income was  $1 billion and  the dividend                                                                    
was $490 million.  He continued with the year  2000 when the                                                                    
royalty deposit was $311 million,  the accounting net income                                                                    
was $2  billion and  the dividend was  $1 billion.  In 2008,                                                                    
the permanent fund received the  greatest royalty deposit to                                                                    
date  and  coincidentally  paid the  highest  dividend.  The                                                                    
Trans-Alaska  pipeline  saw  258  million  barrels  of  oil;                                                                    
however,  prices  peaked at  $133  per  barrel. The  royalty                                                                    
deposit  in 2008  was $844  million and  the accounting  net                                                                    
income  was at  a $1.4  billion loss.  The dividend  was the                                                                    
largest ever at $1.3 billion.  He concluded that in 2010 the                                                                    
royalty deposit was $680 million,  the accounting net income                                                                    
was  $3.5 billion  and the  dividend was  $858 million.  The                                                                    
source  of the  committee  questions  included the  relative                                                                    
inflow. He informed that investment income drove the fund.                                                                      
                                                                                                                                
8:19:13 AM                                                                                                                    
                                                                                                                                
Mr. Burns discussed Slide 7:  "Risk Based Asset Allocation."                                                                    
He  explained that  interest rates  comprised 6  percent and                                                                    
existed for  times of  crisis, deflation,  and disinflation.                                                                    
The interest rates  provided a safe haven  asset from United                                                                    
States  (US)  treasury  bonds  and  non-US  sovereign  debt.                                                                    
Company exposure was  shown as the largest slice  in the pie                                                                    
chart  at  53  percent.  Investing  in  public  and  private                                                                    
companies  provided the  state  the  opportunity to  benefit                                                                    
from  growth  and  prosperity. The  company  exposure  group                                                                    
included   all  public   and  private   equities,  corporate                                                                    
investment  grade   and  high   yield  bonds.   Real  assets                                                                    
comprised another piece of the  pie at 18 percent. The asset                                                                    
group  was viewed  as protection  from  inflation risk.  The                                                                    
group  included   real  estate  tips  which   were  treasury                                                                    
inflation protected securities  and infrastructure. He added                                                                    
another  category  termed   "special  opportunities"  at  21                                                                    
percent.  The purpose  of the  allocation was  to allow  the                                                                    
permanent fund  to invest in special  opportunities and take                                                                    
advantage  of  dislocations  in   the  market.  The  special                                                                    
opportunities category  was viewed  as a limiter.  The final                                                                    
category  was cash  at 2  percent. The  cash allocation  was                                                                    
designed to  allow the  fund to build  up reserves  over the                                                                    
course of the year to meet the expected liabilities.                                                                            
                                                                                                                                
Mr. Burns  discussed Slide 8:  "Dollar Allocation  Limits by                                                                    
Risk Class  (1/31/2011)." The slide provided  a visual image                                                                    
of the fund's performance.  The slide illustrated the actual                                                                    
dollar allocation  to the risk grouping.  With the exception                                                                    
of  real assets,  all were  in the  green zone.  Values were                                                                    
required to be in the green  zone. When a measure moved into                                                                    
a yellow  zone, the Chief  Investment Officer and  Mr. Burns                                                                    
reviewed the situation  to take action within 90  days. If a                                                                    
value fell  into the  red zone, the  board must  be notified                                                                    
immediately to  rectify the situation within  30 days unless                                                                    
the  board  grants an  exemption.  The  bands were  designed                                                                    
specifically to  encourage communication.   When  bands move                                                                    
out of  the green zone, the  goal was to return  to green as                                                                    
quickly as is prudent.                                                                                                          
                                                                                                                                
8:25:08 AM                                                                                                                    
                                                                                                                                
Mr.  Burns   discussed  Slide   9:  "Tail   Risk:  Scenarios                                                                    
(1/32/2011)." The  graph illustrated the performance  of the                                                                    
portfolio  under  specific  conditions, including  the  2007                                                                    
through 2009  subprime mortgage  meltdown. He  mentioned the                                                                    
various scenarios presented.                                                                                                    
                                                                                                                                
Mr. Burns continued with Slide  10: "Tail Risk: Stress Tests                                                                    
(1/31/2011)." The  test included dividing the  portfolio and                                                                    
devising  various  tests. One  example  was  a test  of  the                                                                    
fund's  performance  if the  US  dollar  dropped 20  percent                                                                    
overnight. He mentioned the  various situations presented in                                                                    
the test. The test allowed  the corporation to gauge certain                                                                    
risks.                                                                                                                          
                                                                                                                                
Co-Chair Stedman  asked about the  stress test.  He wondered                                                                    
if the  various proposed risks were  individually triggered,                                                                    
particularly  the component  of global  equities. Mr.  Burns                                                                    
replied that the test illustrated  the measure of risk shown                                                                    
in  the  equity  portfolio.  He stressed  that  one  of  the                                                                    
proposed events would not occur singularly in reality.                                                                          
                                                                                                                                
Co-Chair  Stedman asked  if the  global equity  exposure was                                                                    
tested regardless  of the other  holdings. Mr.  Burns stated                                                                    
that everything  would remain  the same.  He added  that the                                                                    
reaction to other  asset classes in this  type of simulation                                                                    
was complicated.                                                                                                                
                                                                                                                                
Co-Chair Stedman  asked about  the individual  components of                                                                    
risk as  shown in  the graph. Mr.  Burns explained  that the                                                                    
benchmark portfolio provided a comparison.                                                                                      
                                                                                                                                
8:29:37 AM                                                                                                                    
                                                                                                                                
Mr. Burns discussed Slide 11: "Peer Recognition."                                                                               
                                                                                                                                
    · aiCIO Industry Innovation Award                                                                                           
    · Public and private fund managers                                                                                          
         o Singapore Government Investment Corp                                                                                 
         o Norway Government Pension Fund                                                                                       
         o Mitsubishi UFJ Trust & Banking                                                                                       
         o Massachusetts PRIM                                                                                                   
         o California STRS                                                                                                      
         o University of California                                                                                             
                                                                                                                                
8:31:28 AM                                                                                                                    
                                                                                                                                
Co-Chair   Hoffman  wondered   about  the   board's  opinion                                                                    
regarding  oversight in  the legislative  review. Mr.  Burns                                                                    
responded that  the legislative or  administrative oversight                                                                    
was vital  to the  continued confidence  of the  citizens of                                                                    
Alaska. He expressed the challenge  of the state's resources                                                                    
and the  wisdom of the  decisions regarding the  spending of                                                                    
state  money. He  stressed  that the  permanent  fund was  a                                                                    
profit center for the state.  He commented that general fund                                                                    
money was  not used.  The oversight  of the  legislature was                                                                    
critical, although  separation from  the general  fund money                                                                    
among the opinion of the public was also essential.                                                                             
                                                                                                                                
8:33:45 AM                                                                                                                    
                                                                                                                                
Senator Thomas asked about Slide  5 and the realization that                                                                    
the settlement  deposits were so  small. He  understood that                                                                    
the receipts are based on  royalty deposits. He was informed                                                                    
that where lawsuits were concerned,  for every dollar spent,                                                                    
10 were collected.  He assumed the information  was based on                                                                    
production tax,  but expected a  similar discrepancy  on the                                                                    
royalties.  Mr.  Burns  responded  that the  fund  does  not                                                                    
benefit from a  tax settlement. An increase  in taxes lowers                                                                    
the royalty value.                                                                                                              
                                                                                                                                
Senator Thomas asked about the  timeframe for interest rates                                                                    
depicted on Slide  8. Mr. Burns responded  that the duration                                                                    
of the portfolio was approximately five years.                                                                                  
                                                                                                                                
Co-Chair  Stedman asked  for a  definition of  duration. Mr.                                                                    
Burns  responded  that  duration  was the  amount  that  the                                                                    
portfolio changes with a one  percent difference in interest                                                                    
rates.                                                                                                                          
                                                                                                                                
Co-Chair  Stedman   asked  about   the  adjustment   of  the                                                                    
benchmark  for the  asset  allocation.  Mr. Burns  responded                                                                    
that  the  corporation  measures  itself  against  its  peer                                                                    
group. The mandates for benchmarks had changed.                                                                                 
                                                                                                                                
8:37:55 AM                                                                                                                    
                                                                                                                                
MICHAEL   O'LEARY,   EXECUTIVE    VICE   PRESIDENT,   CALLAN                                                                    
ASSOCIATES,   presented  "2011   Economic  Environment   and                                                                    
Capital Markets Review (copy on  file)." He explained Callan                                                                    
Associates involvement in the permanent fund since 1989.                                                                        
                                                                                                                                
Mr. O'Leary  provided a brief  review of the  capital market                                                                    
outlook.  He provided  a description  of Slide  1: "Callan's                                                                    
Capital Market Projection Process."                                                                                             
                                                                                                                                
   · Evaluate the current environment and economic outlook                                                                      
    for the U.S. and other major industrial countries:                                                                          
        o Business cycles, relative growth, inflation.                                                                          
   · Examine the relationships between the economy and                                                                          
     asset class performance patterns.                                                                                          
   · Examine recent and long-run trends in asset class                                                                          
     performance.                                                                                                               
   · Apply market insight:                                                                                                      
        o Consultant   experience-Plan    Sponsor,   Manager                                                                    
          Search, Specialty                                                                                                     
        o Industry consensus                                                                                                    
        o Client Policy Review Committee                                                                                        
   · Test the projections for reasonable results.                                                                               
                                                                                                                                
8:41:17 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary described  Slide 2:  "Stock  Market Returns  by                                                                    
Calendar Year." The histogram  illustrated the calendar year                                                                    
performance for  the U.S.  stock market  over 200  years. He                                                                    
used the  histogram to demonstrate  the extreme  2008 market                                                                    
as well as the recovery in 2009 and 2010.                                                                                       
                                                                                                                                
Mr.  O'Leary   detailed  Slide  3:  "The   Current  Economic                                                                    
Environment."                                                                                                                   
                                                                                                                                
   · Growth returned in the second half of 2009, but job                                                                        
     market struggles to revive well into 2011.                                                                                 
        o Unemployment remains above 9%.                                                                                        
        o Wealth has been hit, consumers de-levering,                                                                           
          savings are rebuilding.                                                                                               
        o QE II the "last" round of monetary stimulus.                                                                          
        o Tax compromise provides new fiscal stimulus in                                                                        
          2011-12.                                                                                                              
   · Steep recoveries usually follow steep recessions.                                                                          
  · However, recoveries after financial crises are slow.                                                                        
       o Financial stress has been greatly reduced…                                                                             
        o …but private credit is still contracting-banks                                                                        
          reluctant to lend, households and businesses                                                                          
          reluctant to borrow.                                                                                                  
   · Everyone expected growth to subside in 2010…                                                                               
        o Stimulus fades and the inventory cycle is                                                                             
          complete.                                                                                                             
        o Europe struggles with slow growth and sovereign                                                                       
          debt crisis.                                                                                                          
        o Emerging markets wait on our recovery.                                                                                
   · But the capital markets freaked out as projections                                                                         
     come true.                                                                                                                 
        o Equity hammered through Q3 2010, retail investors                                                                     
          fled risk, and bond inflows remained substantial.                                                                     
        o Interest rates headed even lower.                                                                                     
   · Q4 saw signs of economic stability, return of investor                                                                     
     confidence.                                                                                                                
   · Tax compromises will likely push 2011 GDP growth to 3                                                                      
     percent, a year ahead of expectations.                                                                                     
   · Federal government faces harsh budget realities.                                                                           
     Defense,   social   security,   Medicare/Medicaid   and                                                                    
     Interest dominate spending.                                                                                                
                                                                                                                                
8:45:39 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary  described Slide  4:  "Is  Rising Inflation  an                                                                    
Emerging  Threat?" He  spoke  about  governments across  the                                                                    
country  coping  with  budgetary  lows.  The  economy  began                                                                    
recovering in 2009  and continued through 2010,  but the job                                                                    
market remained  sluggish. He mentioned  unprecedented steps                                                                    
taken  to alter  the direction  of the  economy in  terms of                                                                    
monetary and  fiscal policy. The  tax compromise  reached in                                                                    
the fourth  quarter was another indication  of the perceived                                                                    
need for continued support of the economy.                                                                                      
                                                                                                                                
8:47:30 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary addressed Slide 5: "The Economy and the Capital                                                                     
Markets."                                                                                                                       
                                                                                                                                
      The economy was fully expected to meander through a                                                                       
      weak recovery, as the combination of recession,                                                                           
      financial crisis and deleveraging required time to                                                                        
      work through the system.GDP growth was expected to                                                                        
      slacken in 2011, but tax compromise may boost growth                                                                      
      to the long-term trend (3%).                                                                                              
   Inflation is in the headlines, but deflation remains                                                                         
      the real concern to the Fed. Inflationary pressures                                                                       
      stemming from Fed and Treasury actions are less of a                                                                      
      concern in the short to medium term.                                                                                      
     Double-dip is possible, but not the expected outcome.                                                                      
                                                                                                                                
     Callan's outlook: Inflation will likely drift higher,                                                                      
      but not immediately. Painfully low interest rates may                                                                     
      persist through 2011, but are expected to rise after                                                                      
      that, as the Fed eventually removes accommodation.                                                                        
     Historic nominal return averages will be hard to                                                                           
      achieve over the short, medium and even the longer                                                                        
      run.                                                                                                                      
     Stocks rallied in the fourth quarter of 2010 and                                                                           
      turned in a good year. However, prospects for above-                                                                      
      trend growth are weak; companies are strong enough to                                                                     
      attain trend profit growth, but not a lot more.                                                                           
     The housing market has yet to truly hit bottom,                                                                            
      despite mortgage rates at an all-time low. The                                                                            
      "shadow inventory" of homes yet to foreclose hangs                                                                        
      heavy over the market.                                                                                                    
     The chance that we could see another leg down on                                                                           
      housing is the greatest risk to the economy, and to a                                                                     
      deflationary spiral.                                                                                                      
   The dollar should face substantial downward pressure                                                                         
      as a result of U.S. policy. The problem, of course,                                                                       
      is what other currency can take the dollar's place?                                                                       
     The path to a rational set of long-term capital market                                                                     
      outcomes is likely through an ugly shorter term                                                                           
      period of rising interest rates, capital losses in                                                                        
      fixed income, and volatile equity markets.                                                                                
                                                                                                                                
8:48:47 AM                                                                                                                    
                                                                                                                                
Co-Chair Stedman asked about Slide  5 and the statement that                                                                    
historic  nominal  return  averages would  be  difficult  to                                                                    
achieve over the short, medium  and even the longer run. Mr.                                                                    
O'Leary  responded that  he wanted  to communicate  that the                                                                    
legislature  must  be  conservative  with  expectations.  He                                                                    
added that the issue was  driven by the outlook for interest                                                                    
rates.                                                                                                                          
                                                                                                                                
Mr.  O'Leary detailed  Slide 6:  "Starting asset  valuations                                                                    
dominant return expectations."                                                                                                  
                                                                                                                                
     Equity valuations, both domestic & international,                                                                          
      appear reasonable (not cheap but not expensive)                                                                           
     Analyst expectations already envision decent 2011 eps                                                                      
      growth                                                                                                                    
     Corporate balance sheets provide good flexibility                                                                          
     Developing countries are expected to enjoy strong                                                                          
      absolute growth which should offset soft demand in                                                                        
      much of the developed world                                                                                               
                                                                                                                                
     Interest rates are a different story.                                                                                      
     Even with low inflation real short-term interest rates                                                                     
      remain negative                                                                                                           
     Inflationary pressures could build (e.g. commodity                                                                         
      inflation, excess demand in emerging world)                                                                               
     Rates are so low across the curve that the "income                                                                         
      cushion" to rising rates is minimal (see Q4 2010 bond                                                                     
      returns for perspective)                                                                                                  
     Equity earnings yield versus Treasury or Corporate                                                                         
      bond yields look attractive but spread could be                                                                           
      narrowed quickly with a rise in rates.                                                                                    
   Our conclusion is that rates will rise and limit P/E                                                                         
      expansion opportunities                                                                                                   
                                                                                                                                
     Major theme is nominal returns for both stocks and                                                                         
     bonds will be positive but limited for the short-                                                                          
      intermediate term.                                                                                                        
                                                                                                                                
Mr. O'Leary described the graph  on Slide 7: "Equity Is More                                                                    
Reasonably  Priced."   He  explained   that  the   red  line                                                                    
represented the  long-run average.  The blue  line suggested                                                                    
that the price earnings ratio was at an average.                                                                                
                                                                                                                                
8:50:22 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  described the statistics on  Slide 8: "Absolute                                                                    
valuation measures  indicated that stocks  were "reasonably"                                                                    
valued." He  noted that  the price  earnings ratio  based on                                                                    
the most  recent fiscal year  earnings illustrated  mid teen                                                                    
levels, which historically were not considered excessive.                                                                       
                                                                                                                                
8:52:09 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary discussed Slide 9:  "Dividend yields are in line                                                                    
with recent experience  by not high." He  explained that the                                                                    
blue lines represented the S&P  500 earnings yield which was                                                                    
the  reciprocal  of  price  earnings  ratio.  With  a  price                                                                    
earnings ratio  of 20, a  dividend yield  of 5 was  seen. He                                                                    
added that  the red  line represented  the 10  year treasury                                                                    
yield which is  compared to the blue line.  The graph showed                                                                    
that stocks  were attractively priced  when compared  to ten                                                                    
year treasuries. He stated that  the difference was narrowed                                                                    
in various ways.                                                                                                                
                                                                                                                                
8:53:19 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary  jumped  to  Slide  12:  "Despite  Q4  Increase                                                                    
Current Yield is Exceptionally Low."  The investment for the                                                                    
bond market  allows for  a current  yield on  the investment                                                                    
grade bond market  or the Barclays aggregate. At  the end of                                                                    
2010, the  "yield to worst"  on that  index was less  than 3                                                                    
percent.                                                                                                                        
                                                                                                                                
Mr.  O'Leary   skipped  to   Slide  16:   "Decomposition  of                                                                    
Aggregate Bond Returns Note  Shrinking Income Component." He                                                                    
called  attention to  the low  income component.  He pointed                                                                    
out  that  the panel  in  the  upper right  illustrated  the                                                                    
interest  component,  while  the  panel in  the  lower  left                                                                    
detailed  the  price  change   component.  Prices  of  bonds                                                                    
increased when interest rates decreased  and prices of bonds                                                                    
decreased when interest rates increased.  He pointed out the                                                                    
low income  component in  the upper  right panel,  which was                                                                    
relative  to recent  history. He  opined  that low  interest                                                                    
rates present the source of  greatest concern with regard to                                                                    
the outlook.                                                                                                                    
                                                                                                                                
8:55:20 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  detailed Slide 13: "History  of Recent Interest                                                                    
Rate Hikes  1982-2010." He  pointed out  that the  blue line                                                                    
represented the federal funds rate.  The shaded areas on the                                                                    
page captured  periods where the  fed funds  rate increased.                                                                    
He  mentioned six  periods of  federal  tightening over  the                                                                    
past  28  years;  each  was unique  and  bond  returns  were                                                                    
positive in many ways.                                                                                                          
                                                                                                                                
Co-Chair   Stedman   supposed   that  the   graph   depicted                                                                    
substantial  interest rate  decreases  that might  slaughter                                                                    
the  bond market.  Mr. O'Leary  countered that  the positive                                                                    
returns were seen in the bond  market, but for less than the                                                                    
interest  earned.  The challenge  was  the  lack of  cushion                                                                    
against a rate hike. He did not anticipate a "slaughter."                                                                       
                                                                                                                                
8:58:36 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary described  Slide 14:  "Rate  Hike Summary."  He                                                                    
explained that  the graph  endeavored to  illustrate through                                                                    
symbols the  shape of the  yield curve. The yield  curve was                                                                    
positively sloped  and short term  interest rates  were much                                                                    
lower than long term  interest rates. In other environments,                                                                    
the yield curve was flat.                                                                                                       
                                                                                                                                
9:00:30 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary  continued with Slide  17: "2011  Capital Market                                                                    
Expectations-Traditional  Asset  Categories."  He  explained                                                                    
that   the  table   represented  different   return  numbers                                                                    
including the  projected arithmetic return and  the five and                                                                    
ten year geometric mean returns.  The standard deviation was                                                                    
a measure of volatility of  return. The greater the standard                                                                    
deviation, the  greater the  difference between  the average                                                                    
return and  the compound  return. He  quoted the  adage that                                                                    
"if you  go down 50 percent  you must come back  100 percent                                                                    
to be even."                                                                                                                    
                                                                                                                                
Co-Chair  Stedman  asked  if the  return  expectations  were                                                                    
similar to  those seen by  the Alaska  Retirement Management                                                                    
Board (ARMB). Mr.  O'Leary answered yes. He  stated that the                                                                    
return expectations  were updated annually and  the ARMB had                                                                    
seen  the  expectations  and   would  evaluate  their  asset                                                                    
allocation   considering  various   combinations  of   asset                                                                    
classes. The  same projections were  used for  the permanent                                                                    
fund. The building blocks were identical.                                                                                       
                                                                                                                                
Mr.  O'Leary  described  Slide   18:  "2011  Capital  Market                                                                    
Expectations-Traditional   Asset   Categories."  The   slide                                                                    
provided  an  illustration of  a  segment  of the  efficient                                                                    
frontier including six different  mixes. He called attention                                                                    
to  the projected  arithmetic  return  line showing  limited                                                                    
bond exposure.                                                                                                                  
                                                                                                                                
Mr.  O'Leary continued  with Slide  19:  "APFC Policy  Index                                                                    
Projections."                                                                                                                   
                                                                                                                                
Mr. O'Leary  backed up to Slide  18: "Illustrative Efficient                                                                    
Mixes-  Traditional  Characterization."  He noted  that  the                                                                    
volatility of the  mix was high. A mix was  not suggested to                                                                    
most institutional investors.                                                                                                   
                                                                                                                                
Mr. O'Leary returned to Slide  19 and explained the focus on                                                                    
global  corporate   securities  and  domestic   equity.  The                                                                    
permanent fund  grouped international and  domestic equities                                                                    
into  global  equities.  The global  government  bonds  were                                                                    
hedged to measure the interest rate sensitivity.                                                                                
                                                                                                                                
9:04:49 AM                                                                                                                    
                                                                                                                                
Co-Chair  Stedman asked  about the  ARMB and  permanent fund                                                                    
comparisons  as seen  on Slide  20:  "Current Policy  versus                                                                    
Efficient Frontier."  He struggled with the  targeted return                                                                    
of 8.25 percent, which he  deemed too high. He recalled that                                                                    
the ARMB planned  to lower the target to 8  percent. He also                                                                    
struggled  with the  perceived  risk  exposure. He  wondered                                                                    
about  the  appearance  of  a   more  risky  and  aggressive                                                                    
portfolio  in the  retirement system.  He believed  that the                                                                    
permanent fund  should be  able to take  more risk  than the                                                                    
retirement funds. He  added that the permanent  fund was not                                                                    
required  to   meet  the   liability  obligation   that  the                                                                    
retirement  fund  must.  Mr.  O'Leary  responded  that  many                                                                    
complex  elements were  involved.  The 8.25  percent was  an                                                                    
actuarial   earnings  assumption.   The  actuary   developed                                                                    
consistent  sets  of  expectations.  A  key  driver  of  the                                                                    
liability was  an expectation about future  inflation, which                                                                    
was  the  actuarial  expectation   with  respect  to  salary                                                                    
growth.                                                                                                                         
                                                                                                                                
9:09:18 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary stated  that a pension system  was investing for                                                                    
forty  plus  years and  the  contributions  affected by  the                                                                    
actuary's expectation of future  salary increases were 20-40                                                                    
years.                                                                                                                          
                                                                                                                                
Co-Chair  Stedman commented  that  the committee  had a  low                                                                    
comfort  level  with the  targets  of  8.25 percent  in  the                                                                    
retirement  system.   Mr.  O'Leary   added  that   both  the                                                                    
permanent  dividend  fund  and  the  retirement  funds  both                                                                    
pursued a 5  percent long term real return  target. He noted                                                                    
that the target might be achievable in the future.                                                                              
                                                                                                                                
Co-Chair  Stedman  agreed, but  added  that  the short  term                                                                    
might bankrupt the state. Mr. O'Leary concurred.                                                                                
                                                                                                                                
Mr.  O'Leary pointed  out that  the ARMB  projected standard                                                                    
deviation  was higher  than  the permanent  fund  in the  13                                                                    
percent range. He  noted that ARMB had  a greater commitment                                                                    
to private markets.                                                                                                             
                                                                                                                                
9:12:29 AM                                                                                                                    
                                                                                                                                
Mr.  O'Leary explained  that projections  must be  developed                                                                    
for private  equity and  direct real  estate. He  noted that                                                                    
Callan  Associates always  used  high risk  levels for  both                                                                    
categories because they were equity investments.                                                                                
                                                                                                                                
Co-Chair Stedman asked about a  chart with asset allocations                                                                    
for ARMB and the permanent  fund to allow for comparison. He                                                                    
wondered how similar the standard deviation might be.                                                                           
                                                                                                                                
9:14:34 AM                                                                                                                    
                                                                                                                                
Mr. O'Leary suggested  viewing Mix 4 and Mix 5  on Slide 18.                                                                    
He stated that ARMB would exist between the two.                                                                                
                                                                                                                                
Co-Chair  Stedman  proposed  discussion about  the  targeted                                                                    
return of the allocation.                                                                                                       
                                                                                                                                
Mr. O'Leary  responded that the  discount rates used  in the                                                                    
public  pension  arena have  declined  and  existed at  7.75                                                                    
percent and 8 percent.                                                                                                          
                                                                                                                                
9:16:24 AM                                                                                                                    
                                                                                                                                
Co-Chair Hoffman asked about the  actual rate of return over                                                                    
the last ten years.                                                                                                             
                                                                                                                                
Mr.  O'Leary  replied that  the  cumulative  return for  the                                                                    
permanent fund over ten years  was 526 and the benchmark was                                                                    
519. The ten  year period included the dot  com meltdown and                                                                    
the  more recent  recession.  The ten  year  return for  the                                                                    
pension systems  using preliminary  real estate  numbers for                                                                    
calendar year 2010, were 445.                                                                                                   
                                                                                                                                
Co-Chair Hoffman asked the monetary  values of the differing                                                                    
numbers.                                                                                                                        
                                                                                                                                
Mr.  O'Leary  did not  know.  He  offered to  calculate  the                                                                    
numbers later for  the committee. He stated  that the Public                                                                    
Employees  Retirement System  (PERS) had  a return  of 12.44                                                                    
percent and  Teachers' Retirement  System (TRS) a  return of                                                                    
12.54 percent.  The two year  annualized returns  were 12.87                                                                    
and 12.97 percent respectively.                                                                                                 
                                                                                                                                
9:19:34 AM                                                                                                                    
                                                                                                                                
Co-Chair Stedman  commented the permanent fund  would have a                                                                    
higher  risk exposure  and higher  rate of  return than  the                                                                    
retirement portfolio  with its  liability stream  and finite                                                                    
life.                                                                                                                           
                                                                                                                                
Mr.  O'Leary responded  with Slide  22:  "Expected Range  of                                                                    
Returns 1,  5, and 10  years." He pointed out  the challenge                                                                    
for the board and the state,  given the nature of the closed                                                                    
pension system. The  policy would change toward  one of more                                                                    
conservative investment. The change  might occur at a higher                                                                    
level of interest rates.                                                                                                        
                                                                                                                                
9:22:44 AM                                                                                                                    
                                                                                                                                
Co-Chair  Stedman commented  that upcoming  liability stream                                                                    
payments would  be $3  billion per year.  He noted  that the                                                                    
legislature  struggled   to  devise  a  plan   to  meet  the                                                                    
payments.   The  issue   required   resolution,  since   the                                                                    
liability was spreading.                                                                                                        
                                                                                                                                
Mr.  O'Leary  agreed.  He  stated  that  the  "dirty  little                                                                    
secret" about  private pension funds was  that an investment                                                                    
in government  bonds would yield an  investment earning rate                                                                    
of less than 5 percent.                                                                                                         
                                                                                                                                
Co-Chair  Stedman   stressed  the  importance   of  balanced                                                                    
investment.                                                                                                                     
                                                                                                                                
9:25:02 AM                                                                                                                    
                                                                                                                                
Senator Egan  requested definitions  for the terms  real and                                                                    
long term rates of return.                                                                                                      
                                                                                                                                
Mr.  O'Leary   responded  that  real  rate   of  return  was                                                                    
communicated  in  constant  dollars without  inflation.  The                                                                    
presumption was that a real  rate of return was earned while                                                                    
maintaining  the  value  in nominal  terms.  He  noted  that                                                                    
publicly traded equities ranged between 5.5 and 8 percent.                                                                      
                                                                                                                                
9:26:48 AM                                                                                                                    
                                                                                                                                
Co-Chair Hoffman  asked about  the the  real rate  of return                                                                    
for the permanent fund's portfolio for the last ten years.                                                                      
                                                                                                                                
Mr. O'Leary  responded that the  Consumer Price  Index (CPI)                                                                    
plus five, over  ten years was 735. He pointed  out that 735                                                                    
was the rate of return required  to achieve a 5 percent real                                                                    
rate of return. The actual nominal return was 526.                                                                              
                                                                                                                                
Co-Chair  Stedman asked  for  the real  rate  of return  and                                                                    
nominal rate of return.                                                                                                         
                                                                                                                                
Mr. O'Leary  responded that the  nominal return was  526 for                                                                    
ten years.                                                                                                                      
                                                                                                                                
Co-Chair Hoffman  added that the  real rate of return  was a                                                                    
little over two percent.                                                                                                        
                                                                                                                                
Co-Chair Stedman  invited Mr. O'Leary to  testify for future                                                                    
ARMB and PFD presentations.                                                                                                     
                                                                                                                                
9:29:47 AM                                                                                                                    
                                                                                                                                
Co-Chair  Hoffman asked  about  the 18  months ending  April                                                                    
2009  when  the fund  lost  in  excess  of $13  billion.  He                                                                    
wondered about  actions taken  by the  board to  address the                                                                    
loss.                                                                                                                           
                                                                                                                                
Mr. Burns responded that the  board rebalanced into the weak                                                                    
equity market.  He added the  adoption of a robust  focus on                                                                    
risk  management  and assessment.  He  focused  on the  risk                                                                    
management and learned many lessons.                                                                                            
                                                                                                                                
Mr.  O'Leary informed  the committee  about  changes in  the                                                                    
industry to build investment  programs with ample liquidity.                                                                    
He agreed that  an explicit liquidity plan  was necessary to                                                                    
meet the  annual dividend. He  noted that the  interest rate                                                                    
was restricted to highly  liquid government obligations that                                                                    
were not  subject to  the types  of spread-widening  seen in                                                                    
the broader  investment grade bond market.  He advocated for                                                                    
greater attention  to potential liquidity needs.  He pointed                                                                    
out that  all funds considered altering  their strategies in                                                                    
pursuit of  less volatility within  the equity  component of                                                                    
their programs.                                                                                                                 
                                                                                                                                
9:34:19 AM                                                                                                                    
                                                                                                                                
Co-Chair   Stedman  mentioned   the  Constitutional   Budget                                                                    
Reserve (CBR)  and Statutory Budget Reserve  (SBR). He noted                                                                    
the substantial savings in the  accounts and the discussions                                                                    
regarding  the management  of the  assets. He  advocated for                                                                    
building  a  separate  savings   portfolio  to  protect  the                                                                    
permanent   fund.  He   mentioned  concerns   regarding  the                                                                    
management style of the Department of Revenue (DOR).                                                                            
                                                                                                                                
9:37:46 AM                                                                                                                    
                                                                                                                                
Co-Chair Stedman  asked about  the relationship  with Callan                                                                    
Associates Inc. and the DOR regarding the CBR and SBR.                                                                          
                                                                                                                                
Mr.   O'Leary  responded   that  he   had  no   relationship                                                                    
pertaining to the  CBR or the SBR. He  understood that staff                                                                    
could   utilize  the   Callan  Associates'   capital  market                                                                    
projections.  Callan  Associates  had  no  participation  in                                                                    
discussions regarding  the investment policy for  the CBR or                                                                    
SBR.                                                                                                                            
                                                                                                                                
Co-Chair  Stedman  added that  the  questions  asked of  Mr.                                                                    
O'Leary were  no surprise. He requested  a letter clarifying                                                                    
the  relationship  between  Callan Associates  and  DOR.  He                                                                    
mentioned discussions between the  finance co-chairs and the                                                                    
governor's office regarding the  management of the funds. He                                                                    
hoped  for  a  concise  plan. He  stressed  Alaska's  strong                                                                    
fiscal position  during rough  times in  other parts  of the                                                                    
country.                                                                                                                        
                                                                                                                                
9:41:25 AM                                                                                                                    
                                                                                                                                
Senator McGuire  asked about funds within  funds managed for                                                                    
other jurisdictions or companies regarding energy.                                                                              
                                                                                                                                
Mr.  O'Leary recalled  deliberation about  energy issues  in                                                                    
the  legislature. He  stated that  many major  funds had  an                                                                    
explicit allocation  to energy  related strategy as  part of                                                                    
their investment program.                                                                                                       
                                                                                                                                
Co-Chair Stedman  clarified the  question. He asked  about a                                                                    
spin-off of revenue or a percent of market value.                                                                               
                                                                                                                                
Mr. Burns  replied that he  managed the mental  health trust                                                                    
fund  money within  the permanent  fund. He  added that  the                                                                    
sub-fund concept was utilized. The asset allocation and                                                                         
investment goals remained similar.                                                                                              
                                                                                                                                
9:43:50 AM                                                                                                                    
                                                                                                                                
Co-Chair Stedman commented that the issue required                                                                              
resolution by April 2012.                                                                                                       
                                                                                                                                
9:44:30 AM                                                                                                                    
                                                                                                                                
ADJOURNMENT                                                                                                                   
                                                                                                                                
The meeting was adjourned at 9:44 AM.                                                                                           

Document Name Date/Time Subjects
2011 02 25 Callan Associates 2011 Economic Environment and Capital Markets Review.pdf SFIN 2/25/2011 8:00:00 AM
Permanent Fund Performance Review
2011 02 25 _ APFC Designed for Sustainability.pdf SFIN 2/25/2011 8:00:00 AM
Permanent Fund Performance Review