Legislature(2023 - 2024)SENATE FINANCE 532
02/16/2023 09:00 AM Senate FINANCE
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| Audio | Topic |
|---|---|
| Start | |
| Presentation: Callan - Capital Markets and Permanent Fund Sustainability | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
SENATE FINANCE COMMITTEE
February 16, 2023
9:02 a.m.
9:02:49 AM
CALL TO ORDER
Co-Chair Stedman called the Senate Finance Committee
meeting to order at 9:02 a.m.
MEMBERS PRESENT
Senator Lyman Hoffman, Co-Chair
Senator Donny Olson, Co-Chair
Senator Bert Stedman, Co-Chair
Senator Click Bishop
Senator Jesse Kiehl
Senator Kelly Merrick
Senator David Wilson
MEMBERS ABSENT
None
ALSO PRESENT
Gregory Allen, Chief Executive Officer, Chief Research
Officer, Callan; Steven Center, Senior Vice President,
Callan.
SUMMARY
PRESENTATION: CALLAN - CAPITAL MARKETS and PERMANENT FUND
SUSTAINABILITY
Co-Chair Stedman discussed the agenda. He highlighted that
Callan was a consulting firm that would advise on the
Permanent Fund. Additionally, Callan advised on pensions.
He noted that the committee members had reviewed the Power
Cost Equalization (PCE) Endowment, aspects of which could
be discussed. He thought the main focus of the meetings
discussion would be the Permanent Fund. He mentioned that
there had been committee discussion pertaining to the
prudent investor rule and the prudent man rule, which could
generate questions for the presenters.
^PRESENTATION: CALLAN - CAPITAL MARKETS and PERMANENT FUND
SUSTAINABILITY
9:05:32 AM
GREGORY ALLEN, CHIEF EXECUTIVE OFFICER, CHIEF RESEARCH
OFFICER, CALLAN, introduced himself and discussed his
background. He had been at the firm for almost 30 years,
and the firm was celebrating its 50th anniversary in 2023.
He had first worked with the Permanent Fund on a project
basis in 1989, and had been the general consultant for the
Permanent Fund for the previous decade. For the previous
twenty-plus years he had maintained a model of the fund
that helped in understanding the impact of asset allocation
on all of the funds financials. He considered that he had
a good mechanical understanding of the Permanent Fund,
which he thought could be useful to the committee during
the meeting.
9:06:32 AM
STEVEN CENTER, SENIOR VICE PRESIDENT, CALLAN, introduced
himself and discussed his background. He had been with
Callan for almost 13 years. He had worked in institutional
consulting for over 20 years. He had worked directly with
Mr. Allen on the Permanent Fund relationship for
approximately 8 years. He was also the co-consultant for
the Alaska Retirement Management (ARM) Board. He qualified
that while there was no ARM Board information included in
the presentation, he would be able to answer questions on
the topic.
Co-Chair Stedman thought there could be questions regarding
the stability of the Earnings Reserve Account (ERA) of the
Permanent Fund, as there was concern about the accounts
stability amongst the members. He mentioned roughly 90
percent of the fund being in illiquid securities.
9:08:10 AM
Mr. Allen showed a PowerPoint presentation entitled "Senate
and House Finance Committees - Alaska State Legislature -
Capital Market Outlook and Alaska Permanent Fund
Performance Update," (copy on file). He looked at slide 2,
"Outline":
?Callan's capital market projection process
?Current economic and capital market environment
?Summary of Callan's 2021 capital market projections
?Projected return and risk for APFC policy portfolio
?Alaska Permanent Fund
Recent Performance Review
?Concluding observations
Mr. Allen mentioned the use of capital market projections
in making decisions about the Permanent Fund.
Mr. Allen spoke to slide 3, "Callan Capital Market
Projection Process":
?Callan updates long term capital market projections
each year in January and uses them for the full year
with all clients for strategic planning purposes.
?Projections take into account long term relationships
balanced with current market conditions.
?Consensus expectations (central banks, economists,
asset managers, consultants, etc.) are carefully
considered as an integral part of the process.
?Each number return, risk, correlation for every
asset class must be individually defensible, and the
numbers collectively need to work together as a set to
generate reasonable portfolios during strategic
planning exercises.
?Projections change slowly over time and are not
designed to provide tactical insights.
?Process is executed by Callan's capital markets
research group and projections are peer reviewed by
Client Policy Review Committee as well as the hundreds
of the clients that use them every year.
?Process is battle proven it has evolved and improved,
but hasn't fundamentally changed over the last four
decades.
Mr. Allen highlighted that Callan had about 400 clients
that used the capital market projections, mostly large
institutional investors with over $1 billion in assets. He
noted that the projects were used for long-term planning.
Most of Callan's clients did a ten-year projection every
year and considered asset allocations every five years. He
discussed the work on developing projections and noted that
he oversaw the work of the committee of individuals that
made the final decisions on the numbers.
9:11:53 AM
Mr. Allen referenced slide 4, "Callan Capital Market
Projection Process":
Historical Rolling 10-year Return US Large Cap
Equity
? Historical 10-year return for US large cap has
averaged 10.5%.
? 2023 mid-point of projected range is 7.2%.
? Very few periods historically of negative 10-year
return for US equities.
? Current outlook is in lower third of historical
distribution, driven by relatively high valuations and
secular decline in equity risk premium.
Mr. Allen looked at the graph on the slide and noted that
the blue line was indicative of the return on the Standard
and Poor (S and P) 500, which was an equity index, for the
previous ten years. He noted that over ten-year periods,
returns were much smoother. He noted that there were a
couple of times shown on the graph where the ten-year
annualized returns were below zero, one in 1938 and one at
the end of 2008. He pointed out other ten-year periods with
annualized returns as high as 20 percent. He used the
example of the period ending 2021, in which the annualized
return on the S and P 500 over the previous ten years was
almost 17 percent.
Mr. Allen pointed out that Callan's projection for the S
and P 500 was the green line and was 7.2 percent for the
next ten years, which was a mid-point within a range
considering a standard deviation. He noted that the average
over the previous 100 years was 10.5 percent. Callan's
projection going forward was less than the average over the
previous 100 years.
9:13:54 AM
Mr. Allen turned to slide 5, "Callan Capital Market
Projection Process:
Historical Rolling 20-year Return US Large Cap
Equity
? Historical 20-year return for US large cap has
averaged 10.8%.
? 2023 mid-point of projection range is 7.2%.
? Very few periods historically where the 20- year
return was below 7.20% projection
? Longer time horizons reward equity risk takers with
more consistent positive returns.
? Worst 20-year period for S&P 500 since 1926 was
period ended 12/31/1950
(great depression, WW II).
Annualized Return 3.1%
(almost entirely dividends)
Mr. Allen noted that the chart on slide 5 was the same but
reflected rolling 20-year returns. He noted that there had
never been a 20-year period where there was zero return on
the S and P 500. He commented on the difficulty of
predicting short period stock performance.
Mr. Allen considered slide 6, which showed a graphical
representation of annual stock market returns by calendar
year, which offered another perspective on the market. The
tallest columns represented years where the return was
between zero and 10 percent. The column to the right was
the years between 10 and 20 percent. He pointed out that in
2008 and 2002, there was a -37 percent and -22 percent in a
ten-year period, which is why there was a below-zero ten-
year return. He pointed out highlighted columns that
reflected recent positive returns.
Mr. Allen displayed slide 7, which showed two linear graphs
addressing post-pandemic market performance. He noted that
there was a bad year in 2022, in which the markets lost
money and the Permanent Fund was reduced in size. The chart
showed performance since the beginning of the pandemic, and
the orange line showed the peak of return of the market
before the pandemic. He noted that even with the losses
from 2022, the markets were still well above pre-pandemic
levels. He cited that in 2022 the bond market also had its
worst year by more than three times the previously observed
worst year in the bond market. He summarized that markets
were above where they were before the pandemic.
9:16:25 AM
Mr. Allen highlighted slide 8, which addressed an equity
drawdown. He commented that the markets had declined but
were coming back in the first part of the current year. The
charts were to illustrate how long the market declines
typically lasted. He mentioned the "dot-com bubble" which
was shown in blue and was a long-lasting market decline
that persisted for 521 trading days. The teal line
represented the global financial crisis, which had
persisted for almost a year. He commented that the pandemic
downturn was the shortest bear market in history and
snapped back within 30 trading days. The green line showing
2022 was less like the pandemic and more like down markets
in the past. He noted that the data for the graph only went
through the end of December, after which time there had
been a rally in the equity markets.
Mr. Allen looked at slide 9, titled "U.S. Equity Market:
Key Metrics." He relayed that when doing projections, one
of the things Callan considered was whether the market was
fairly valued. The chart on the slide looked at forward
price to earnings (P/E) ratios for the S&P 500. He
explained that if the blue line was in the center of the
dotted lines, it signified that the market was about the
same as average over time. He shared the perspective that
going into 2022, the market was not over or undervalued and
one could expect relatively decent returns out of the
equity market for the following ten years.
Mr. Allen addressed slide 10, "Range of Protected Equity
Returns," which showed a bar graph. He highlighted that
when Callan was projecting returns, it projected a range.
The slide included Callan's projected returns for public
and private equity for the Permanent Fund. He pointed to a
chart on the slide and highlighted the bar to the left that
reflected the Permanent Fund's public equity portfolio,
with a range between the tenth percentile and the ninetieth
percentile. He highlighted the range reflecting a 10
percent chance the Permanent Fund's public equity portfolio
would perform positive 15.8 percent and a 10 percent chance
it would return -0.16 percent over the next 10 years. He
noted the midpoint of the range.
Mr. Allen addressed the fund's private equity portfolio and
noted that the Permanent Fund had close to a 20 percent
allocation to private equity, which was illiquid and had
been growing. The fund had added to the portfolio since it
had a higher than expected return but faced more risk on
the upside and downside than the public equity portfolio.
The graph illustrated the impact of risk and return, with a
higher midpoint but further spread outcomes.
9:19:56 AM
Senator Kiehl looked at the last bullet on slide 10, which
indicated that losses in public equities had largely not
been realized in private equity portfolios. He asked Mr.
Allen to elaborate on why he used the term realized.
Co-Chair Stedman asked Mr. Allen to define private equities
and how the value was calculated.
Mr. Allen explained that in public equity markets, the
price of companies changed micro-second by micro-second,
and it was possible to sell stock and get money out within
a three-day settlement. He continued that public markets
picked up on the smallest sensitivities and translated the
information to prices immediately. Private equities were
funds that invested in privately owned companies, in many
cases the fund would own an entire company or do a start-
up. The privately held companies could not be traded minute
by minute nor sold minute by minute. As a practical manner,
there was a lot of time spent on valuing private companies
when offering out more shares. On a daily basis, there was
not a need to value the company since it was not traded.
The net result was that private equity did not have the
same volatility as public equity markets.
Mr. Allen continued that when the prospects for an
individual company began to grow worse, it took some time
for the information to affect the price. He noted that
valuation was done not in individual transactions but
rather than guessing and only knowing the worth once an
asset was sold. In practice private equity markets did not
go down as much as public equities. He summarized that
public equity losses had all been realized, while private
equity impacts filtered slowly into valuations slowly as
transactions happened. He qualified that if all the private
equity in the Permanent Fund were to be sold tomorrow, it
would most likely be worth less than what was on the books.
9:23:33 AM
Co-Chair Stedman asked how the value of public equities was
assessed, and how often the value was restated for purposes
of the Permanent Funds financial statements.
Mr. Allen replied that typically the Permanent Fund
received updates on the value of the funds on a quarterly
basis. Typically, the information arrived one quarter after
the quarter that the update included. He qualified that
there were typically long lags of time between the end of
the year and when it was known how much the private
holdings were worth. Additionally, if there were not
transactions, the values did not necessarily reflect a
potential loss if the asset was sold.
Mr. Center wanted to note that the use of the word
"realized" did not reflect a financial realized loss. He
pondered that recognized would be a better word to use in
the case of Senator Kiehl's question. He that realized
gains and losses trickled into the ERA, and he did not want
the term to be misinterpreted.
Co-Chair Stedman relayed that it was helpful during
presentations to see bugle charts on returns listed in
dollars. He thought once the percentages were shown in real
dollars, it was easier for the average person to understand
the magnitude of risk exposure. He thought most people in
the building had no clue of how much risk exposure was
present when viewing percentages.
Mr. Allen avowed to consider Co-Chair Stedman's comments
for his presentation the following year and noted that his
model for the Permanent Fund translated returns into
dollars.
Mr. Allen advanced to slide 11, "Callan Capital Market
Projection Process," and relayed that he wanted to discuss
fixed income. He cited a projection of 4.25 percent and
noted that the average return over the previous 100 years
was about 5.4 percent. He directed attention to the last
data point on the graph, which represented the end of 2022
and showed a return of 1.3 percent annualized for ten
years. He commented that it was the worst ten-year period
for bonds, and commented that it had been an epic ten-
year event in the bond market.
9:27:48 AM
Mr. Allen looked at slide 12, "Yield Curve Rose and
Inverted in Second Half of 2022," which he described as a
complex slide for anyone that was not in his business. He
looked at the line graph and addressed the blue line, which
was the yield curve at the end of 2021, and measured the
yield on bonds at different maturities. He discussed bond
returns over time and discussed the lack of yield. He
commented that when bond yields go up, bond prices go down;
and when bond yields went down, bond prices go up. The
orange line showed the end of 2022, when T-bills went from
earning zero to earning over 4 percent, while the 30-year
bond went from earning 2 to 4 percent. The immediate impact
was that the bond market lost about 12 percent.
Mr. Center continued to address slide 12. He commented that
the good news was that starting the new year showed over 4
percent yield for bonds, which made for a better future
outlook. There had not been good yield on bond portfolios
in about a decade, and there were opportunities for
investors to potentially take on a little less risk for a
greater return.
Co-Chair Stedman asked about the inverted yield curve for
December 31, 2022; and whether it should be paid attention
to.
Mr. Allen cited that Mr. Center had made the point the
previous day that all the recessions observed over the
previous 20 years had come on the heels of an inverted
yield curve. He noted that it was not clear that there was
a causal relationship, but suggested that an inverted yield
curve could be indicative of a slowing down in Gross
Domestic Product (GDP). He considered other factors of the
economy, such as the low unemployment rate. He opined that
the reason the curve was as inverted as was shown was an
artifact of how quickly the fed raised the short rates. He
thought there was an expectation that the fed would back
off and it would flatten out the curve. He did not think
Callan had the position that there would be a recession
because of the yield curve, but he thought it was important
to know that every recession observed for the previous 20
years was preceded by an inverted yield curve.
Co-Chair Stedman asked how many inverted yield curves had
occurred without a subsequent recession.
Mr. Center agreed to get back to the committee with the
information.
9:32:25 AM
Mr. Allen showed slide 13, "Credit Spreads Widened to Long
Term Average Levels," and discussed the importance of
credit spreads, which was the difference between the yield
on a corporate bond versus a treasury bond. He noted that
credit spreads had widened in 2022, and that usually when
the equity markets went down there was more yield spread
for buying a corporate bond. He felt spread was positive
for the future. He reiterated that it had been a been a
terrible year for bonds, but that there was an outlook for
better bond returns in the future.
Mr. Allen referenced slide 14, "Starting Yield Strongly
Predicts Forward Returns," and thought the chart showed
that if the yields were known at the beginning of the ten-
year period, there was a good idea of what the return would
be at the end of the ten years. The orange line depicted
the return at the end of the ten years, and the blue line
was the yield at the beginning of the ten years. He
commented that predicting bond returns was easier than for
stock returns.
Mr. Allen turned to slide 15, which showed a table of fixed
income forecasts. He had circled the aggregate index of
4.2, which represented the bond market in the United States
(U.S.) He noted that the Permanent Fund had more things in
its bond index (such as high yield, emerging market debt,
non-U.S. bonds) and had a slightly higher return
expectation. He cited a 2.5 percent increase in expected
return for bonds, which was a larger change than he had
previously seen. He emphasized that there had been
important repercussions.
9:34:27 AM
Mr. Allen displayed slide 17, "Highlights of 2023 Capital
Market Projections," and pointed out that there was a
slight rise in inflation expectations, as well as a rise in
public equity and bond expectations. He continued that
Callan projected a premium of expected returns in private
markets over public, with an expectations of private equity
at 8.5 percent, and public equity at 7.6. He noted that the
expected premium had come down, of the private markets over
public. He theorized that the change was partly because the
private markets had not fully absorbed the losses that the
public markets had, which would result in a lower spread
over the next ten years.
Mr. Allen highlighted slide 18, which showed a table of
return expectation that each of the asset classes employed
by the Permanent Fund. He highlighted that the circle at
the bottom signified Callans return expectation for the
total fund. The range of returns had a mid=point of 7.25
percent for the next 10 years. The expectation was up by
close to one percent from the previous year. The outlook
for the fixed income portfolio was 4.35 percent and the
outlook for equities was 7.6 percent, both of which were
better than the previous year. He considered that the state
was in many ways in a better position in the beginning of
2022 than in the beginning of 2021, if one did not consider
the amount of money the Permanent Fund lost over the course
of the year.
Co-Chair Stedman asked how the 5 percent yearly draw
affected the Permanent Fund portfolio.
Mr. Allen estimated that there was about a 4.75 percent
real rate of return. He commented that the fund was in a
better position than at the same time the previous year in
terms of the projection for making the draw. He mentioned
that a five percent draw was actually 5 percent of the
first five of the previous six years. As market values
generally trended upward, it signified that the effective
draw on current market value was less than five percent. He
reiterated that his estimate was that on average, the model
should result in a 4.7 percent draw of the current market
value. He relayed that Callan's view was that there was
about a 50 percent chance of making enough return to make
the draw, whereas last year there had been a less than 50
percent chance.
Co-Chair Stedman commented that there were not good odds.
9:38:03 AM
Senator Bishop thought the answer informed the committee
that it needed to keep more reserves in the Constitutional
Budget Reserve Fund (CBR).
Co-Chair Hoffman suggested that it was also possible to
lower the 5 percent draw. He recalled that Mr. Allen
mentioned advising other funds that were close to $1
billion. He asked why the state could not use similar
allocations for the Power Cost Equalization (PCE) Fund as
it did for the Permanent Fund to reduce costs and level out
the returns. He cited a $200 million loss in the PCE Fund
the previous year. He asked why education funds and other
long-horizon funds were not invested similarly or the same
as the Permanent Fund.
Mr. Allen relayed that the Permanent Fund with its $80
billion balance had a lot of resources at its disposal to
be able to invest in complex asset classes such as private
equity, private fixed income, and real estate. He continued
that the typical $1 million fund was managed by one or two
people and could not do the same things at the same scale
that the Permanent Fund could. He pondered if the Permanent
Fund could manage some of the other funds in the state to
take advantage of the scale of the fund and the expertise.
He commented that doing so in a separate $1 billion fund
was almost impossible.
Co-Chair Hoffman asked why the state was not utilizing the
Permanent Fund management for the other funds, and pointed
out that the practice was already done with the Alaska
Mental Health Trust Fund. He stated that Mr. Allens point
was well taken and thought the state should capitalize on
the expertise of the Permanent Fund and possibly
participate in it to potentially lower risk. He emphasized
that the PCE Fund was very important to rural Alaska and
expressed concern about the $200 million downturn on the $1
billion investment. He mentioned that Co-Chair Olson,
Senator Bishop, and himself represented communities that
benefitted from the PCE Fund because of high electrical
costs. He thought the committee should ponder Mr. Allens
point of trying to capitalize on the expertise that managed
the $80 billion fund.
9:42:21 AM
Co-Chair Stedman added that there was a portion of the
Permanent Fund that was comprised of Amerada Hess
settlement funds, which were co-mingled with the other
assets. He pondered a policy change that would allow for
the comingling of some of the other funds as mentioned by
Co-Chair Hoffman. He discussed having the other funds
managed by the Permanent Fund with the same allocation. He
thought the topic was something for the members to
consider.
Co-Chair Olson asked about the potential downsides of Co-
Chair Hoffman's concept of comingling the PCE Fund with the
Permanent Fund for investment purposes.
Mr. Allen qualified that he could not speak for the Alaska
Permanent Fund Corporation (APFC) and its willingness to
comingle and administer other funds. He cited that there
would be some administrative and accounting overhead to
account for separate funds and potential draws. He
mentioned that the Permanent Fund was not immune to losses
and had lost money in some years. He noted that part of the
portfolio involved private markets and therefore smoothed
the drawdowns. He reiterated that the Permanent Fund could
take illiquidity risk, which had the dual benefit of a
higher return and a smoother ride. He guessed that the PCE
Fund was mostly likely invested mostly in public markets,
and had gone down more than the Permanent Fund did in 2022.
In the long run he thought the Permanent Fund would
generate a higher return because of its ability to invest
in all the different asset classes in a very professional
way.
9:45:18 AM
Mr. Allen looked at slide 19, "The Return of Yield," which
showed a table that reinforced the point that there was
currently a bunch of yield that was not previously seen. He
noted that the orange bars showed the change in yield for
all the different alternatives.
Mr. Allen addressed slide 20, "Relationship Between
Expected Return and Volatility," which showed a chart that
he called a 'risk-return chart.' He noted that moving to
the right indicated more risk and moving upward on the
chart indicated more return. He explained that it was not
possible to get more return without taking more risk in the
capital markets. He pointed out that private equity was the
riskiest, with the greatest chance of the largest losses;
and cash was the safest. He emphasized the importance of
assuming risk in an efficient way, with as much return
possible per unit of risk. He referenced the benefit of the
size of the Permanent Fund as an asset structure and cited
that the fund outperformed in private and public equity as
well as in fixed income due to its skillful and efficient
handling of risk.
Co-Chair Olson referenced Mr. Allen's comment about cash
being more stable. He referenced the high rate of
inflation.
Mr. Allen relayed that with cash one rarely lost money, but
there was a risk of losing purchasing power if inflation
was high and the cash stayed at the same level. He conveyed
that cash did not earn enough to keep up with inflation. He
cited that the fund had to earn 7.25 percent in order to
cover the yearly draw and account for inflation, which
necessitated owning private equity and other risky items.
Co-Chair Olson considered cash versus precious metals. He
realized that the market was up and down but thought metals
might be more stable than cash.
9:48:44 AM
Mr. Allen relayed that the price of a precious metals
portfolio was pretty volatile and could go down as much as
15 percent to 20 percent in a year. He cited that there
were funds that did own commodities (like precious metals),
but usually used as an inflation hedge or diversifier, but
had to be held in combination with other asset classes due
to the volatility.
Mr. Allen advanced to slide 21, "Mixes Yielding 7% Expected
Returns Over Past 30+ Years," which showed four pie charts.
The charts showed what a portfolio would need to look like
to earn 7 percent using Callans capital market projections
at different times. He observed that in 1993, bond returns
were relatively high, and it would have been possible to
have a portfolio that was 97 percent bonds and 3 percent
equity, and there would have been a good chance of earning
7 percent over the following ten years. He discussed 2008,
when bond yields were lower, and it was necessary to add
international equities to earn the same 7 percent return.
He cited that at the beginning of 2022, one could only
afford to have 4 percent in bonds and still earn the 7
percent return. Because the yields had gone up so much in
one year, it was possible to have a 30-year portfolio in
bonds and earn the 7 percent.
9:50:54 AM
Senator Bishop asked if interest rates drove the bond
market up or down.
Mr. Allen answered affirmatively.
Mr. Allen spoke to slide 25, "APFC FY 2023 Total Fund
Policy Target," which showed a pie chart and the Permanent
Funds investment policy. The fund had 36 percent in public
equities, 20 percent was in public fixed income, and the
other 44 percent was in private markets. He described that
the Permanent Fund had been on a careful, well-executed
path from what was almost entirely public market securities
to now a 56-45 public private mix. He noted that private
equities was a complex asset class that generated a higher
return than public markets. Real estate and private credit
were other complex asset classes. The fund had gone down
the path as most of Callan's other large clients in taking
on more illiquidity in private markets and taking on more
complexity as a way to earn what was necessary for the 5
percent draw.
Mr. Allen thought it was an important point that Callan
still considered the Permanent Fund to have a balanced
portfolio. He mentioned that relative to other endowments
(with less in fixed income) it was a conservative
portfolio, although relative to public funds, the Permanent
Funds portfolio was riskier than average. He noted that
there were some forthcoming performance charts that would
bear out the assertion.
Mr. Allen appealed to the committee to consider any way to
not increase the annual draw from the ERA. He explained
that the bigger the draw, the more pressure on the
investment team to stretch the rate of return. He did not
think there was an asset allocation possible that could
cover a ten percent draw. He commented that even with the
current sophisticated asset allocation, there was still a
50 percent chance that the fund would not achieve the
desired rate of return. He emphasized that the more draw
that was required, the more pressure was put on the
investment team, the more risk, and the greater losses in
down markets.
Co-Chair Stedman thought Mr. Allen was indicating that the
more the legislature asked for (of the Permanent Fund
draw), the less likely they would get it.
9:54:34 AM
Co-Chair Stedman asked for more detail on the definitions
of absolute return and risk parity.
Mr. Allen explained that absolute return was more commonly
known as hedge funds, which indicated strategies where
funds were not invested to generate equity returns or fixed
income returns, but instead investments were used to
generate stable returns over time. The strategy was
sophisticated and involved leverage and derivatives, and
had relatively high fees. He summarized that the strategy
overall was relatively low risk, with a return expectation
somewhere between that of fixed income and equities.
Importantly, the hedge funds were not correlated with the
equity and bond markets. He cited that the Permanent Funds
absolute return portfolio was up by 6 percent the previous
year while its fixed income portfolio was down about 12
percent and its equity portfolio was down by approximately
17 percent.
Co-Chair Stedman understood that the method would involve
making money on a stock or shorting a stock and trying to
lock in a spread.
Mr. Allen agreed. He used the example of a typical trade
being bullish on Exxon stock and bearish on BP stock. He
discussed locking in differences between securities as
opposed to what was happening in the securities market as a
whole.
Co-Chair Stedman asked Mr. Allen to address risk parity.
Mr. Allen explained that risk parity was popularized in the
early 2000s, and was another way of investing in the public
markets. He explained that instead of having 80 percent of
risk in an equity bond portfolio, one used leverage to
increase the bond exposure to generate the same amount of
risk as the equities. The result was a more balanced
portfolio that generated a return similar to a stock/bond
portfolio. He noted that the risk parity was a very small
allocation at one percent and was one of the worse
performance parts of the portfolio in 2022.
9:57:59 AM
Mr. Allen referenced slide 26, "APFC FY Target versus Large
Public Funds," which showed a chart that plotted the
Permanent Funds target allocations in each asset category
in the context of public funds. He thought the information
was important in understanding the performance of the
Permanent Fund versus public funds. He cited that the first
bar represented the range of large public funds over $1
billion. He observed that the Permanent Fund had less
public equity and less private equity compared to public
funds.
Mr. Allen showed slide 27, which showed the same graph as
the previous slide, but for endowments. He argued that the
Permanent Fund was both a public fund and an endowment. The
fund was public money but not a pension fund. Endowments
were able to take more risk, had a longer time horizon, had
a smaller draw relative to the asset, and had very
different asset allocations. He noted that the Permanent
Funds asset allocation was the same for both the previous
and current graph, but observed that where the fund ranked
in the distribution was different.
Mr. Allen observed that as compared to other endowments,
the fund had one of the higher public equity allocations.
In private equity, the fund was below the median. On
average, endowments had more private markets and private
equity than the Permanent Fund, and less public funds. He
described the Permanent Fund as a "tweener." When showing
performance of the Permanent Fund for the board and staff,
Callan showed the fund against endowments and also against
public funds, as there were different results.
Co-Chair Stedman asked Mr. Allen to discuss different
ranges of payouts from endowment and foundations. He
wondered if other funds used a smoothing mechanism.
Mr. Allen thought it was important to note that there were
very few endowments that were as large as $80 billion. He
mentioned the Yale Endowment, which was not even close to
$80 million. He thought the typical endowment had a similar
formula for payout, with a smooth derivative of an average
market value over time. He considered that using five of
the first six years was a great formula that was good for
planning purposes. There were other endowments that used
corridors and changed with the rise and fall of the market.
The industry standard was some derivative of an average of
the previous three to five years of market value times a
percentage. The amount was usually between 4.5 and 5
percent.
10:01:58 AM
Co-Chair Stedman asked Mr. Allen to get back to the
committee to discuss the range of draws and the numbers
included in the range. He mentioned the 50/50 chance of
achieving the desired draw from the Permanent Fund and
thought many would prefer better odds.
Mr. Allen commented that there would be a much better
chance of achieving a 3 percent draw.
Co-Chair Stedman agreed but thought the state would not be
able to meet its obligations with a 3 percent draw.
Senator Wilson had thought the Permanent Fund was not
invested in so much private equity due to public use of
funds and transparency. He asked Mr. Allen to address the
topic.
Mr. Allen relayed that there were many upsides and
downsides with private equity. He highlighted that it was
not possible to get the level of transparency with private
equity as it was with pubic equity. He commented that the
Federal Trade Commission (FTC) had made a bigger burden
each year on public companies to be more transparent and
more fair about information getting to markets. Private
companies were not subject to the same level of scrutiny be
regulators, and a lot of managers of private companies felt
that it was an important competitive advantage to not be as
transparent. He summarized that one gave up transparency
into the operations of the underlying companies when
investing in private equity.
Mr. Allen highlighted slide 28, "APFC FY 2023 Total Fund
Policy Target," which showed a pie chart entitled APFC
Total Fund Target and listed the projected return and
standard deviation for the Permanent Fund. He summarized
that the slide translated the funds policy mix into return
and risk. He cited that while the expected return was 7.25
percent, there was a 13.3 percent standard deviation. The
expected real return was 4.75 percent, which was just above
what was viewed as the long-term draw that resulted from
the formula.
Co-Chair Stedman referenced information the Permanent Fund
put together on historical returns, and expectations if the
fund hit a return of 7.25 percent. He asked if Callan put
together the data for the Permanent Fund.
Mr. Allen affirmed that Callan provided the Permanent Fund
a range of expected returns including the total return and
the statutory return, which was the statutory net income
divided by the value.
Co-Chair Stedman asked if the information was available on
the historical data sheets on the Alaska Permanent Fund
Corporation (APFC) website.
Mr. Allen affirmed that the information was listed on a
projection sheet.
10:05:37 AM
Mr. Allen looked at slide 29, "Constrained Efficient
Frontier Analysis 40% Private Assets," and discussed
efficiency of the Permanent Fund portfolio, in terms of
whether the fund was generating the maximum return for the
amount of risk being taken. He mentioned a tool called the
'Efficient Frontier,' which was illustrated by a graph on
the slide. He highlighted that the blue line represented
various investment mixes from conservative to more
aggressive. He noted that each mix on the line generated
the highest return possible per unit of risk.
Mr. Allen continued to address the graph on slide 29 and
pointed out a green triangle below the blue line that
represented a 75-25 equity-fixed portfolio. He discussed
the spread between the green triangle and the orange
triangle above the blue line, which in Callans view was
due to the use of asset classes like real estate, private
equity, private credit, and absolute return. The classes
were all diversifiers that allowed for a little more return
for the same amount of risk as public markets. He
summarized that the Permanent Fund portfolio was efficient.
Mr. Allen addressed slide 30, "Range of Projected Returns,"
which showed the range of expected ten-year returns looking
forward. He cited that there was a 10 percent chance that
the fund could generate a 13 percent annual return over the
next 10 years. Callan also thought there was a 10 percent
chance the return could be as low as 1.7 percent. He
pondered that the chance of the return being over 7.5
percent was only 48 percent. Considering the previous five
years, there was about a 51 percent chance of making the
7.5 percent return.
Co-Chair Stedman discussed an analogy of rolling dice and
losing in half the scenarios.
Mr. Allen thought it was important to put "losing" in
context. In most scenarios, "losing" would mean the state
would not be able to make the whole draw. He thought it
might be a good time to address the ERA.
Co-Chair Stedman reminded that he had prepared the
presenters to anticipate the topic of the PCE Fund,
diversification, ERA sensitivity and meeting the obligation
to the citizens. He did not think the topic of state
finances had permeated the building as it should.
10:09:33 AM
Mr. Allen wanted to address the subject of a pure endowment
before addressing the ERA. He described that in a pure
endowment there was spending rather than focus on putting
money in the principal and never touching it again. In an
endowment there was not a two-account structure, and the
purchasing power of the principal would erode. He thought
the 50 percent chance that the returns would cover the draw
was good enough for most endowments. He continued that the
Permanent Funds two-account system was fairly unique, by
which there was an endowment model for spending, but a
historical construct of the ERA and inflation-proofing. He
cited that there was an absolute limit of when if the ERA
went to zero, the payout went to zero. When the ERA got
smaller as a portion of the fund, it was closer to hitting
the cliff," where the draw might be missed entirely.
Mr. Allen recalled the time in 1998 when the year started
with zero in the ERA. He thought the two-account system had
the nuclear option effect. He recalled that the previous
year there was a pretty big ERA balance, but when the
downward market in 2022 wiped out some of the unrealized
gains in the account. He qualified that the ERA was
sensitive to how much was moved into the principal, and how
much was paid out.
10:13:14 AM
Mr. Allen continued that the ERA was also sensitive to
market activity. The account had to be replenished via
income from bonds or by selling securities at a realized
gain, both of which were volatile. In the current year,
Callan had expected realized income to be around $4.5
billion. Through December 31, the amount was only coming in
at about half of what was expected. The numbers were all
explainable, but statutory net income was volatile and
could not be absolutely controlled. He thought for the
previous three years the system had been fine because of
the large ERA balance.
Mr. Allen mentioned the high inflation rate of the previous
year, and noted that when applied to the principal it
resulted in an approximately $4 billion inflation-proofing
appropriation for the end of the fiscal year. He thought
the Permanent Fund was in good shape as an endowment, but
that the ERA was fragile and had the potential to wipe out
the draw if it was reduced to zero. He understood the
dynamic that when the ERA was too big, discipline was
needed; while at the same time if the ERA was too small it
would bring the draw to zero. He thought the ideal
situation would be to get rid of the two-account system and
put the draw into the constitution. He did not know if the
solution was possible. He mentioned a second solution of
keeping the ERA as big as possible and not bringing the
debt scenario into play.
Co-Chair Stedman relayed that the previous year the
committee had pondered another transfer from the ERA to the
corpus. The year previous to that the committee had made an
additional $4 billion transfer, and the year previous had
made a transfer of $4.9 billion. He offered the context of
the two checks in the committee room. The previous year,
the committee had decided not to do the transfer as the
committee felt there was too much risk exposure to the ERA
with the downdraft in the market that seemed to be
continuing, as well as a war starting in Europe. He
considered that many legislators did not want to liquidate
the fund, but rather save it for future generations. He
emphasized the critical nature of the ERA and the need to
inflation-proof the fund, as well as keeping a balance of
the two needs.
10:18:31 AM
Senator Wilson wondered if Callan had run the numbers to
keep the state in the 75th percentile of likelihood of
keeping a healthy ERA balance.
Mr. Allen relayed that he had run a model and offered a
caveat that he only had data through from December 31
through June 30. It appeared that even if the legislature
made the $4 billion appropriation required by the formula,
there was less than a five percent probability that over
the next three years it would impede the draw. If the model
was extended ten years, there was about a ten percent
chance. He thought the real risk to the Permanent Fund,
with the current ERA balance, was not one bad year but
rather a number of years in a row with low returns. He
viewed that the state was in a relatively healthy position
given the current $13 billion in the ERA.
Mr. Allen qualified that as long as statutory net income
kept up with the draw plus inflation-proofing, the account
would stay in the same place. He reiterated that the only
way to replenish the ERA was through statutory net income.
He summarized that the ERA balance could stay healthy if
the state was able to generate $4.5 billion $5 billion in
statutory net income without any extreme inflation.
10:21:26 AM
Co-Chair Stedman recalled that two years previously the
state's statutory net income was $7.8 billion or $7.9
billion, after earnings of about $5 billion, which were
both related to real estate sales. He thought the real
estate sales after a long holding period could skew the
numbers.
Mr. Allen explained that the income from bonds, dividends
from stocks, and rents on real estate were relatively
stable even with rates going up. The volatile piece of the
income was the realized gains. He mentioned sales of some
big real estate properties with giant gains. He described
that private equity companies had been sending cash back to
the Permanent Fund at an amazing clip in 2019. Between the
real estate sales, private equity returns, and some
rebalancing, the state had some very high years of
statutory net income that had contributed to a much higher
reserve balance than historically seen. The same type of
activity was not present in the current year, which
explained the statutory net income running at $1 billion.
Senator Bishop asked if what Mr. Allen described was
indicative of higher interest rates.
Mr. Allen relayed that higher interest rates would be
helpful in creating more statutory net income going
forward, but because the Permanent Fund was only 20 percent
in bonds, it would only affect that part of the portfolio.
The extra $500 million in income would help, but the fund
needed to realize gains from sales to achieve the previous
levels.
Senator Bishop clarified that he had been referring to the
higher interest rates on some of the equities for real
estate investments, and whether it went down due to higher
interest rates.
Mr. Allen relayed that there was some relation in what
Senator Bishop described. He qualified that when interest
rates went up quickly, stock prices went down and private
equities could not go sell companies in the market.
10:25:16 AM
Co-Chair Hoffman referenced the deposits to the Permanent
Fund symbolized by the two large checks in the committee
room. He pondered that the legislature had pre-paid for
inflation. He asked if it was the same case for the second
appropriation.
Mr. Allen pondered whether the call funding inflation-
proofing or just a special appropriation. He did not know
specifically how the legislature thought about the
appropriations, but when adding the amounts, he thought the
appropriations were a little ahead of keeping up with
inflation.
Co-Chair Hoffman clarified that when the legislature had
made the appropriations, for the next couple of years there
was money to spend because the inflation proofing was pre-
paid.
Mr. Allen thought Co-Chair Hoffman had a reasonable way of
looking at the matter.
Co-Chair Stedman recalled that when the appropriation was
done for $4.9 billion of inflation proofing, it was
discussed as a new concept in the building. He mentioned
the second appropriation of $4 billion and thought the
value of the transfer had been recognized by many
legislators. Co-Chair Stedman emphasized that the
fundamental discussion was amongst senior members. He
referenced expenditure of savings that had shocked himself
and others. He discussed the importance of building
reserves and using another mechanism to disallow spending
down the funds.
Co-Chair Stedman continued his remarks. He explained that
he was trying to come up with another mechanism versus just
building the ERA to an unlimited amount, because there was
concern that the funds were an easy spending target. He
mentioned that the reason the appropriation did not happen
the previous year was due to the risk.
10:30:29 AM
Co-Chair Hoffman thought Co-Chair Stedman's point was well
taken. He wanted to make the point that putting aside $10
billion did not originate from the administration or the
Permanent Fund Board, but rather from the Senate Finance
table. He asserted that the protection of the Permanent
Fund to enable it to grow over $80 billion was a result of
the commitment of the members in the Senate Finance
Committee.
Co-Chair Stedman mentioned that everyone had voted for the
budget that included the appropriations. He mentioned the
political winds of the time.
Senator Merrick thought it sounded as though Mr. Allen was
advocating for moving away from the ERA model. She asked if
there was a downside to moving to more of a one-account
endowment model.
Mr. Allen explained that if the state was to move to an
audit model, yet have draws on an ad hoc basis, it would be
worse than the current model. He thought an endowment model
with a constitutionally set draw was a good option.
Co-Chair Stedman relayed that there had been serious
discussion of a ten percent draw two years in a row. He
shared that some members had been alarmed at the
proposition.
Mr. Allen wanted to remark on the legislature not doing
inflation-proofing in 2022. He commented that the inflation
going into the year had been low, and the inflation-
proofing appropriation would have been small and did not
put the fund too far behind.
Co-Chair Stedman relayed that the calculations would be
done and brought to the committee by the Legislative
Finance Division when the budget cycle began.
10:34:12 AM
Mr. Center advanced to slide 34, "APFC Total Fund
Historical Returns," which showed a bar graph. He
referenced his presentation to the Permanent Fund Board the
previous day. He noted that Callan compared the funds
performance on an ongoing basis against a couple different
benchmarks, including the total fund target. He explained
that the total fund target was a blend of the various
benchmarks that were representative of the strategies used
by the Permanent Fund, and was considered by Callan to be
the best benchmark of the fund. He cited that the previous
year the fund returned negative 6.37 percent, which was
ahead of its total fund target of down by 9.15 percent.
Mr. Center continued that Callan also compared the
Permanent Fund to the Consumer Prince Index (CPI) plus 5
percent objective and recommended looking at the comparison
over long periods. He cited that over the last year CPI
plus 5 was up 11.47 percent. He considered the last 3 to 5
to 7 years and noted that the Permanent Funds performance
was ahead of its total fund target over all the trailing
time periods, but got closer to the CPI plus 5 goal the
further out in time. Looking out 10 to 20 years, the fund
had exceeded the CPI plus 5 goal.
Mr. Center explained that over the long term, the
investment team at APFC had done a very admirable job of
implementing their investment strategy.
Mr. Center addressed slide 35, "APFC Total Fund Cumulative
Return vs CPI + 5%," which showed a line chart as a visual
representation of the long-term goal. The orange line
showed inflation plus 5 percent, while the blue line showed
the Permanent Funds performance over time, with a time
span of 20 years ending December 31. While it had
volatility over time, the fund outperformed CPI plus 5
percent. He observed that there were periods of downturn,
which lined up with the global financial crisis in 2007-
2008, and the Covid-19 snapback in 2020.
10:37:40 AM
Mr. Center spoke to slide 36, "APFC Total Fund Ranking
versus Large Public Funds," and noted that slide 36 and
slide 37 compared the Permanent Fund to the peer groups
of large public funds (retirement plans), which was one of
two large groups that Callan compared the fund to. He
observed that in the near term, over the last year, the
fund vastly outperformed most retirement plans, because
most U.S.-based public funds had a higher allocation to the
public equity market, which was the worst performing space
during 2022. Over longer time periods, the Permanent Fund
also compared very favorably to other public funds,
primarily due to the funds use of private assets, which
tended to be higher than most U.S.-based public retirement
systems. He mentioned that most U.S.-based public
retirement systems had higher payouts than the Permanent
Fund, and as a result needed to have higher liquidity.
Co-Chair Stedman asked about pension plans with higher
liquidity and asked how risk tolerances were connected to
projected returns.
Mr. Center explained that risk tolerances among U.S.-based
public retirement systems varied widely. He continued that
a lot of the variation had to do with funded status, and
the states ability to fund the pension plan. For some
states, pension plans were very well funded and resultantly
did not have as high of a risk appetite. Some states had
unfunded liability in the pension plans and tended to take
on a higher degree of risk in hopes of earning enough
returns on assets to pull up the funded status. He went on
that overall risk appetite had to do with funded status
rather than overall outflow. The outflow had a bigger
impact on the need for liquidity. There were a lot of
different forces at play for public retirement plans
relative to a typical endowment fund focused on a steady
payout.
Mr. Center looked at slide 37, "APFC Total Fund Ranking
versus Large Public Funds," which was the same as the
previous slide but looked at performance relative to large
endowment funds. He commented that over the last 10 years,
the Permanent Funds asset allocation had looked more like
an endowment than a public retirement system. He considered
the twenty-year bar on the far right of the graph, and
observed that the Permanent Fund had far more in fixed
income and public equities than most endowments and
foundations. He continued that for the previous 1-year, 5-
year, and 10-year comparison, the fund looked more like an
average endowment fund and ranked in the median for
performance.
10:41:31 AM
Mr. Allen moved to slide 38, "Concluding Observations":
?Total Fund has outperformed performance benchmark
over most short-term and longterm periods ended
December 31, 2022.
?Total Fund has underperformed the long-term
performance objective of CPI +5% over short-term
periods, but modestly outperformed over long-term
periods.
?Total Fund performance has been competitive with that
of large public pension funds and large endowments and
foundations over most time periods ended December 31,
2022.
?Asset allocation of Total Fund looked more like that
of a large public fund up until about 5 years ago.
?Asset allocation of Total Fund has evolved to look
more like a large endowment and should perform
increasingly in line with that universe over time.
Mr. Allen summarized that from Callan's perspective, the
permanent Fund had done extremely well and had beat every
benchmark in almost every asset category in a one-year,
three-year, five-year and longer time horizon. He thought
it was important to recognize that the staff at APFC had
done a good job throughout a great deal of turnover. He
thought APFC had not taken excess risk. He thought that
equity portfolios were one of the best performing around.
He affirmed that asset allocation was important, but
additionally having a capable staff to address matters over
time was important.
Co-Chair Hoffman inquired about past recommendations by the
APFC Board.
Mr. Allen was reticent to speak to the actions of the
board. He noted that the board had made resolutions
supporting the POMV model.
Co-Chair Hoffman asked about recommendations to combine the
ERA and the Permanent Fund.
Co-Chair Stedman asked Mr. Center and Mr. Allen to get back
to the committee with any additional information. He
suggested that the APFC could respond regarding any
resolutions and the timetable.
Co-Chair Stedman thanked the presenters.
Co-Chair Stedman discussed the agenda for the following
Monday, at which time the committee would consider the
governor's budget amendments.
ADJOURNMENT
10:46:59 AM
The meeting was adjourned at 10:46 a.m.
| Document Name | Date/Time | Subjects |
|---|---|---|
| 021623 Callan Presentation - Senate and House Finance Committees.pdf |
SFIN 2/16/2023 9:00:00 AM |