Legislature(2007 - 2008)SENATE FINANCE 532
03/01/2007 09:00 AM Senate FINANCE
| Audio | Topic |
|---|---|
| Start | |
| Alaska Permanent Fund Corporation Presentation | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
| + | TELECONFERENCED | ||
MINUTES
SENATE FINANCE COMMITTEE
HOUSE FINANCE COMMITTEE
March 1, 2007
9:02 a.m.
CALL TO ORDER
Co-Chair Bert Stedman convened the meeting at approximately
9:02:22 AM.
PRESENT
Senator Lyman Hoffman, Co-Chair, Senate Finance Committee
Senator Bert Stedman, Co-Chair, Senate Finance Committee
Senator Charlie Huggins, Vice Chair, Senate Finance Committee
Senator Kim Elton
Senator Joe Thomas
Senator Fred Dyson
Senator Donny Olson
Representative Bill Stoltze, Vice Chair, House Finance Committee
Representative Mike Kelly
Representative Bill Thomas
Representative Harry Crawford
Representative Les Gara
Also Attending: CARL BRADY, Chair, Board of Directors, Alaska
Permanent Fund Corporation; MIKE BURNS, Executive Director,
Alaska Permanent Fund Corporation; MICHAEL O'LEARY CFA,
Executive Vice President, Callan Associates, Inc.
Attending via Teleconference: There were no teleconference
participants.
SUMMARY INFORMATION
^Alaska Permanent Fund Corporation Presentation
APFC Board of Directors
9:03:40 AM
Co-Chair Stedman introduced and stated the intent of the
presentation was to overview the value of the Alaska Permanent
Fund, dividend projections and expected rates of returns. The
2007 Permanent Fund dividend payments would likely be
approximately $1,000.
9:04:33 AM
CARL BRADY, Chair, Board of Directors, Alaska Permanent Fund
Corporation (APFC), informed that he was recently re-elected to
the position. He introduced other members of the Board, giving
background information on their experiences and qualifications.
9:06:57 AM
Mr. Brady announced that the year 2007 was the 30th anniversary
of the formation of the Alaska Permanent Fund.
9:07:40 AM
Mr. Brady stated that the contribution to the dividend program
was unknown at this time. The formula is complicated and could
not be predicted. He told of a business owner from Nome making
this same request arguing he needed to know the approximate
amount area residents would receive to allow him to adequately
order merchandise.
9:10:09 AM
Mr. Brady philosophized that the past is the past and the future
was unknown.
9:10:37 AM
Mr. Brady assured that the Fund investments were diversified and
would continue to become more diversified. Performance targets
would be met.
9:11:59 AM
MIKE BURNS, Executive Director, Alaska Permanent Fund
Corporation, had planned to report that the balance of the Fund
had reached $38 billion. However, events affecting the Chinese
investment market had implications on the worldwide market and
subsequently on the Alaska Permanent Fund.
Mr. Burns instead reported that the balance of the fund "closed"
at $37.3 billion on Tuesday. While this is a substantial loss
from "a dollar perspective", it was not the largest loss
incurred in a single day and although the events were
"dramatic", they were not unexpected. That the events happened
as quickly as they did was unexpected.
9:13:48 AM
Mr. Burns furthered that a "correction" such as occurred earlier
in the week was to be expected when investing in public and
private markets. The recent events would have no affect on the
Board's expectations for the Fund's performance.
9:14:37 AM
Mr. Burns outlined handout titled, "Alaska Permanent Fund
Corporation Fiscal Performance Summary" [copy on file], which
reads as follows.
For the fiscal year 2006:
· The Fund returned 11 percent, well ahead of our
benchmark of 10.5%
· For the first time the Fund reached $31, $32, $33, $34
and $35 billion in value.
· We earned $3.1 billion on investments, and received an
additional $601 million in mineral revenues.
· And we paid $689 million in dividends, ending the year
with a balance of $32.9 billion, a gain of almost $3
billion over FY 05.
For the first six months of fiscal 2007:
· The Fund returned 9.6%, and closed on December 31 with
an unaudited value of $36.4 billion.
· Statutory net income as of December 31 was $1.9
billion. Statutory net income was only $257 million
for FY 02, the year that falls out of the five-year
average, so we expect dividends will be higher this
fall.
· Performance since December was trending upward, and
the Permanent Fund closed $40 million short of $38
billion on Monday.
· Most of this strong performance is the result of gains
in both US and non-US stocks, and the markets have
held on to some of the gains made since December 31.
9:16:35 AM
MICHAEL O'LEARY CFA, Executive Vice President, Callan
Associates, Inc., gave a presentation titled, "House & Senate
Joint Finance Committee Economic & Capital Market Outlook" [copy
on file.]
9:17:12 AM
Mr. O'Leary noted that this presentation reflected five-year
capital projections and that "very little had changed" from the
prior year.
9:17:27 AM
Page 1
Economic Forecast: Contained Enthusiasm
· Growth remained robust in 2006, but economy is slowing
toward trend.
· Outlook for 2007 depends heavily on whether housing
stabilizes and the effects of the downturn are
contained.
· Consumers are spending all of their income, tax cuts
are over, and the savings rate is negative. Confidence
is high but vulnerable to shocks - housing, war,
economy.
· Decent job growth, improving real wages, and lower
gasoline prices will help support consumer spending.
· U.S. and China will continue to be the primary engines
of growth.
· Oil prices will slide - gradually - but with a new
floor of $50 ($60? $70?).
· Inflation will remain a low level threat; oil prices
are the wild card, labor costs represent the upside
risk.
· The Fed tightened to 5.25 and paused; the rate cuts
may still be up to a year away.
Mr. O'Leary reported that 2006 was a "record year" in the Fund's
performance. The growth had slowed somewhat to approximately
three percent, which was close to expectations.
9:21:12 AM
Page 2
Economy is Slowing After Three Strong Years - How Soft a
Landing?
[Bar graph showing Real GDP - annual percent change, for
the years 1990 through 2007 with a notation that the data
for 2007 is an estimate. Global Insight is cited as the
source of the information.]
Mr. O'Leary outlined the information, noting that performance
had been consistent with expectations.
9:21:36 AM
Page 3
U.S. Economic Growth by Sector
[Spreadsheet listing Annual percent change for the
following components:
Real GDP
2002 1.6
2003 2.5
2004 3.9
2005 3.2
2006 303
Direction of Change: Moderating
Consumption
2002 2.7
2003 2.8
2004 3.9
2005 3.5
2006 3.2
Direction of Change: Moderating
Residential Investment
2002 4.8
2003 8.4
2004 9.9
2005 8.6
2006 -4.2
Direction of Change: Falling Sharply
Bus. Fixed Investment
2002 -9.2
2003 1.0
2004 5.9
2005 6.8
2006 7.5
Direction of Change: Surging
Federal Government
2002 7.0
2003 6.8
2004 4.3
2005 1.5
2006 1.9
Direction of Change: Winding Down
State & Local Govt.
2002 3.1
2003 0.2
2004 0.5
2005 0.5
2006 2.0
Direction of Change: Budget Pressures Easing
Exports
2002 -2.3
2003 1.3
2004 9.2
2005 6.8
2006 8.7
Direction of Change: Surging
Imports
2002 3.4
2003 4.1
2004 10.8
2005 6.1
2006 5.9
Direction of Change: Oil Prices]
Housing downturn reduced GDP growth in 3rd and 4th
quarters of 2006 by 1.2% through direct effect on
construction alone.
Mr. O'Leary overviewed this data. He pointed out that exports
were increasing and that imports were still affected by higher
oil prices.
9:22:21 AM
Page 4
Residential Construction Overbuilt
[Line graph demonstrating fluctuations of Residential Fixed
Investment - % of GDP for the years 1970 through 2005.
Global Insight is cited as the source of the information.]
Mr. O'Leary stated that this chart showed substantial growth in
residential investment followed by a significant downturn.
9:22:35 AM
Page 5
Housing Outlook: Hitting Bottom in 2007?
[Line graph demonstrating Millions of Units of Housing
Starts overlapped with Year-over-year percent change of
Median Existing Single-Family Home Price for the years 2001
through 2006. Global Insight is cited as the source of the
information.]
Mr. O'Leary remarked that the types of homes were changing and
the median price of homes was declining. Construction of new
homes had also declined.
Mr. O'Leary spoke to a recent news release stating that sales of
existing homes increased "sharply" in January 2007. This
information was learned at the same time information regarding
decreased new housing construction was released. Existing home
sales are "much more important" to the economy than new housing
"starts".
9:23:50 AM
Page 6
Housing Affordability Deteriorated as Interest Rates Rose
A higher index means homes are more affordable
[Line Graph providing detailed status of Affordability
Index for Existing Single-Family Homes for the years 1972
through 2005. Global Insight is cited as the source of this
data.]
Mr. O'Leary explained that the price of homes is not the only
factor in whether homes are affordable. Interest rates are also
important.
9:24:31 AM
Page 7
Mortgage Equity Withdrawal Fueled Consumer Spending
[Bar graph depicting the Percent of Disposable Income of
Net Equity Extraction for the years 1991 through 2005 and
the first three quarters of 2006. The source of this data
is cited as Federal Reserve - Kennedy/Greenspan data
updated as of December 2006.]
Mr. O'Leary reminded that during his presentation given one year
prior, he had emphasized the importance to consumer spending of
homeowners withdrawing equity in their homes. This was still
important but less so than last year. This practice had
diminished as housing prices "softened".
9:25:13 AM
Page 8
Personal Savings Rate Has Fallen Below Zero
[Line graph demonstrating Personal savings rate, percent of
disposable income for the years 1998 through 2006. The
following events and corresponding affect are pointed out:
9/11, Post 9/11 auto incentives, Microsoft dividend and
Katrina. Global Insight is cited as the source of the
data.]
Mr. O'Leary qualified this information excluded home values and
certain investments, such as 401k plans. The graph did however,
reflect general trends in which rate of savings is low.
9:25:42 AM
Page 9
However, Employment is Still Growing
[Bar graph showing Employment - percent change, annual
rate, for the years 1999 through 2006. Global Insight is
cited as the source of the data.]
Mr. O'Leary characterized this as a positive indication of the
economy. Employment was growing "at a pretty hefty rate" and
demonstrated "real average hourly earnings growth". The "marked
increase" had occurred recently. Previously, a "major source of
concern" was that the country had been "in economic recovery"
but wages had not increased.
9:26:24 AM
Page 10
Wage Growth is Finally Beating Inflation
[Line graph showing the Year-over-year percent change of
Real Average Hourly Earnings Growth, for the years 2000
through 2006. Global Insight is cited as the source of this
information.]
Mr. O'Leary explained that the consumer, "which is over two-
thirds of the economy, has propelled growth over recent years."
The expectation was that disposable income would grow "a little
bit more rapidly than consumption during '27."
9:27:00 AM
Page 11
Spending Has Outpaced Income Growth;
Some Rebuilding of Savings is Likely
[Bar graph showing Percent Growth of Consumption and
Disposable Income for the years 2003 through 2006 and
estimated figures for 2007. Global Insight is cited as the
source of this information.]
Mr. O'Leary explained this graph depicts "the share of national
income for employee compensation and economic profits". He
furthered, "Profits have done extraordinarily well," which has
"not gone unnoticed in Washington" D.C. Policy changes in
taxation on profits would not surprise him.
9:27:57 AM
Page 12
Productivity Growth Has Boosted Corporate Profits to Record
Levels
[Line graph demonstrating Percent of National Income of
Employee Compensation and Economic Profits for the years
1999 through 2006. Global Insight is cited as the source of
this information.]
Page 13
An Incredible Run for Corporate Profits;
Return to Earth?
[Bar graph showing Percent Change of Profits with IVA & CCA
for the years 1990 through 2005 and an estimated amount for
2006. Global Insight is cited as the source of this
information.]
Mr. O'Leary reported that corporate profits, with inventory
adjustments were almost 20 percent in 2006.
9:28:13 AM
Page 14
Manufacturing Capacity Utilization Reaching the Trigger
Point for Investment
1960-2002 average = 81.2
[Line graph demonstrating the percentage fluctuations for
the years 1970 though 2006. Global Insight is cited as the
source of this information.]
Mr. O'Leary shared that economists used to aver that 80 percent
capacity utilization required new capacity. This level of
capacity had finally been reached, which had helped support an
increase in business investment.
9:28:43 AM
Page 15
Capital Spending on Business Equipment is Still Growing
[Line graph showing fluctuations of $Billions on Unfilled
Orders (Nondefense capital goods excluding aircraft) for
the years 1998 through 2006. Global Insight is cited as the
source of this information.]
Mr. O'Leary pointed out that spending on business equipment had
increased substantially.
9:28:58 AM
Page 16
Non-Residential Construction is Taking the Lead
[Line graph demonstrating the (4-quarter percent change)
fluctuations of Real GDP, Equipment & software, and
Buildings for the years 1990 through 2006. Global Insight
is cited as the source of this information.]
Mr. O'Leary outlined this data.
9:29:32 AM
Page 17
Fed Will Have Room to Cut Interest Rates in 2007
[Line graph showing the percentage fluctuations of Federal
Funds and 10-Year Treasury Yield for the years 1999 through
2006. Global Insight is cited as the source of this
information.]
Mr. O'Leary commentated, "It's difficult to recall, but it just
was a few years ago, federal funds were at the one percent level
in '03 and early '04. They're now 5.25." Ten Year Treasury Rates
had increased "but no where near as much". Therefore, the
current situation was an "inverted yield curve - short rates are
higher than longer rates." Arguably, this had discouraged
investment and has been a predictor of every recession. However,
such inversions has occurred in the past with no recession
resulting. The amount of the current inversion was modest, but
still should be noted.
9:30:48 AM
Page 18
Federal Budget Deficit Has Actually Done Better Than
Expected
[Bar graph depicting deficit or surplus in Billions of
Dollars, Fiscal Years, for the years 1990 through 2006, and
projections for the years 2007 through 2010. Global Insight
is cited as the source of this information.]
Mr. O'Leary remarked that the impact of the aging baby boomer
population would become prominent. Federal revenue was greater
than anticipated and subsequently the budget deficit was less
than anticipated.
9:31:20 AM
Page 19
The U.S. Current Account Deficit: Peaking at Last?
[Bar graph depicting the Current Account Deficit and
Deficit as % of GDP in the Billions of Dollars for the
years 1970 through 2006 and projections for the years 2007
through 1020. Global Insight is cited as the source of this
information.]
Page 20
U.S. Export Growth Catches Up to World Trade Growth -
Falling Dollar Helps
[Bar graph showing Percent Change, Real Dollars for U.S.
Export Growth and World Import Growth (Excluding U.S.), for
the years 1991 through 2006 and a forecast for 2007. Global
Insight is cited as the source of this information.]
Mr. O'Leary characterized the Current Account Deficit as "huge"
but that it appeared to be "peaking as a percent of GDP "[gross
domestic product]. This was largely because export growth had
been "strong".
9:31:41 AM
Page 21
Inflation Risk Remains Modest
· Despite soaring energy and commodity prices, inflation
is contained. Outside energy, core inflation has moved
past the Fed's "comfort zone", but shows signs of
moderating.
· U.S. is the most susceptible to inflation among
industrialized economies - only one with above trend
growth.
· Consumer prices surged at times during 2005-06, but
came in at 2.5% for the year, down from the 3.4%
record in 2005.
· Strong productivity growth and modest wage inflation
keep prices in check.
· Oil prices in the $50-60s don't seem to mean as much
to the U.S. economy as once suspected - one of the
consequences of a service economy.
· Growth in Europe remains below trend and unemployment
rates are high. Japan is still shaking off the effects
of a decade of deflation.
· While U.S. capacity is stretched, large amounts of
spare capacity exist in other parts of the world.
China and other Asian countries continue to export
deflation.
Mr. O'Leary outlined this information.
9:32:16 AM
Page 22
Inflation Has Ticked Up…
Year-Over-Year Change in Consumer Prices
[Line graph showing the percentage fluctuations of CPI -
Core and CPI All Urban Cons, for the years 2001 through
2006. The current CIP - Core is specified as 2.57 percent
and the current CPI All Urban Cons is specified as 2.54
percent.]
Mr. O'Leary identified this page as "a comparatively short-term
picture of inflation, the rates of change." The tendency was to
focus on the core consumer price index (CPI).
9:32:40 AM
Page 23
… But Perspective is Necessary
Year-Over-Year Change in Consumer Prices
[Line graph containing the information depicted on the
previous page extended to include the years 1980 through
2006.]
Mr. O'Leary noted this page provided a longer term context. He
opined, "It's hard to believe that in the late '70s and early
'80s we were thinking about inflation rates in excess of 12
percent." The inflation rate had decreased substantially and
"while there's been a great deal of volatility, particularly on
a month-to-month basis and particularly when you look at the
series that includes energy and food" the rate had "stayed at
comparatively low levels.
9:33:24 AM
Page 24
The Capital Markets - Context
Wild Ride for Investors Over the Last Seven Years
[Spreadsheet containing the following information
Broad U.S. Stock Market
Russell 3000
2000 -7.46
2001 -11.46
2002 -21.54
2003 31.06
2004 11.95
2005 6.12
2006 15.72
Average Annual Return
Five Years 2002-06 7.17
Ten Years 1997-06 8.64
Fifteen Years 1992-06 10.79
S&P Super Composite 1500
2000 -6.98
2001 -10.64
2002 -21.31
2003 29.59
2004 11.78
2005 5.66
2006 15.34
Average Annual Return
Five Years 2002-06 6.79
Ten Years 1997-06 8.83
Fifteen Years 1992-06 10.89
Large Cap U.S. Stocks
Russell 1000
2000 -7.79
2001 -12.45
2002 -21.65
2003 29.89
2004 11.40
2005 6.27
2006 15.46
Average Annual Return
Five Years 2002-06 6.82
Ten Years 1997-06 8.64
Fifteen Years 1992-06 10.80
S&P 500
2000 -9.10
2001 -11.88
2002 -22.10
2003 28.80
2004 10.88
2005 4.91
2006 15.79
Average Annual Return
Five Years 2002-06 6.19
Ten Years 1997-06 8.42
Fifteen Years 1992-06 10.64
Small Cap U.S. Stocks
Russell 2000
2000 -3.02
2001 2.49
2002 -20.48
2003 47.25
2004 18.33
2005 4.55
2006 18.37
Average Annual Return
Five Years 2002-06 11.39
Ten Years 1997-06 9.44
Fifteen Years 1992-06 11.47
S&P 600 Small Cap
2000 11.80
2001 6.54
2002 -14.63
2003 38.79
2004 22.65
2005 7.68
2006 15.11
Average Annual Return
Five Years 2002-06 12.49
Ten Years 1997-06 11.57
Fifteen Years 1992-06 13.24
Non-U.S. Stock Markets
EAFE ($US)
2000 -14.17
2001 -21.44
2002 -15.94
2003 38.59
2004 20.25
2005 13.54
2006 26.34
Average Annual Return
Five Years 2002-06 14.98
Ten Years 1997-06 7.71
Fifteen Years 1992-06 7.86
Fixed Income Markets
LB Aggregate
2000 11.63
2001 8.63
2002 10.26
2003 4.10
2004 4.33
2005 2.43
2006 4.33
Average Annual Return
Five Years 2002-06 5.06
Ten Years 1997-06 6.24
Fifteen Years 1992-06 6.50
Citi Non-US Bonds
2000 -2.63
2001 -3.54
2002 -21.99
2003 18.52
2004 12.14
2005 -9.21
2006 6.95
Average Annual Return
Five Years 2002-06 9.50
Ten Years 1997-06 4.70
Fifteen Years 1992-06 6.35
Cash Market
90-day T-bill
2000 6.18
2001 4.42
2002 1.78
2003 1.15
2004 1.33
2005 3.07
2006 4.85
Average Annual Return
Five Years 2002-06 2.43
Ten Years 1997-06 3.81
Fifteen Years 1992-06 4.00
Inflation
CPI-U*
2000 3.39
2001 1.55
2002 2.38
2003 1.88
2004 3.26
2005 3.42
2006 2.54
Average Annual Return
Five Years 2002-06 2.69
Ten Years 1997-06 2.43
Fifteen Years 1992-06 2.57
*Annual CPI-U data are measured as year-over-year change.]
Mr. O'Leary pointed out that 2000 through 2002 were the three
years of the bear market. He listed the investment categories.
Mr. O'Leary directed attention to the ten year average annual
return, which includes the "worst bear market since at least
'73-'74, and arguably since the 1930s." It also includes "a very
strong recovery subsequent to that bear market." He highlighted
some of the asset categories. This information is useful in
consideration of capital market projections.
9:35:03 AM
Page 30
2007 Capital Market Projections
[Spreadsheet containing the following information.
Asset Class: Equities
Broad Domestic Equity
Index: Russell 3000
Projected Annual Return-Real: 9.00%
Projected Annual Return-Nominal: 6.25%
Projected Standard Deviation (Risk): 16.90
Projected Yield: 2.10
2006 Projections: 9.00% 16.90
Large Cap
Index: S&P 500
Projected Annual Return-Real: 8.85%
Projected Annual Return-Nominal: 6.10%
Projected Standard Deviation (Risk): 16.40
Projected Yield: 2.20
2006 Projections: 8.85% 16.40
Small/Mid Cap
Index: Russell 2500
Projected Annual Return-Real: 9.85%
Projected Annual Return-Nominal: 7.10%
Projected Standard Deviation (Risk): 22.70
Projected Yield: 1.20
2006 Projections: 9.85% 22.70
International Equity
Index: MSCI EAFE
Projected Annual Return-Real: 9.20%
Projected Annual Return-Nominal: 6.45%
Projected Standard Deviation (Risk): 20.10
Projected Yield: 2.20
2006 Projections: 9.20% 20.10
Emerging Markets Equity
Index: MSCI EMF
Projected Annual Return-Real: 9.80%
Projected Annual Return-Nominal: 7.05%
Projected Standard Deviation (Risk): 32.90
Projected Yield: 0.00
2006 Projections: 9.80% 32.90
Asset Class: Fixed Income
Domestic Fixed
Index: LB Aggregate
Projected Annual Return-Real: 5.25%
Projected Annual Return-Nominal: 2.50%
Projected Standard Deviation (Risk): 4.50
Projected Yield: 5.25
2006 Projections: 5.00% 4.50
Defensive
Index: LB Gov't 1-3 Year
Projected Annual Return-Real: 4.25%
Projected Annual Return-Nominal: 1.50%
Projected Standard Deviation (Risk): 2.30
Projected Yield: 4.25
2006 Projections: 4.25% 2.30
TIPS
Index: LB TIPS
Projected Annual Return-Real: 4.90%
Projected Annual Return-Nominal: 2.15%
Projected Standard Deviation (Risk): 6.00
Projected Yield: 4.90
2006 Projections: 4.65% 6.00
High Yield
Index: SCFB High Yield
Projected Annual Return-Real: 7.00%
Projected Annual Return-Nominal: 4.25%
Projected Standard Deviation (Risk): 11.50
Projected Yield: 7.00
2006 Projections: 6.75% 11.40
Non US$ Fixed
Index: Citi Non-US Gov't
Projected Annual Return-Real: 5.15%
Projected Annual Return-Nominal: 2.40%
Projected Standard Deviation (Risk): 9.60
Projected Yield: 5.15
2006 Projections: 4.90% 9.60
Other
Real Estate
Index: Callan Real Estate
Projected Annual Return-Real: 7.60%
Projected Annual Return-Nominal: 4.85%
Projected Standard Deviation (Risk): 16.50
Projected Yield: 6.00
2006 Projections: 7.60% 16.50
Private Equity
Index: VE Post Venture Cap
Projected Annual Return-Real: 12.00%
Projected Annual Return-Nominal: 9.25%
Projected Standard Deviation (Risk): 34.00
Projected Yield: 0.00
2006 Projections: 12.00% 34.00
Absolute Return
Index: Callan Hedge FoF
Projected Annual Return-Real: 6.50%
Projected Annual Return-Nominal: 3.75%
Projected Standard Deviation (Risk): 9.70
Projected Yield: 0.00
2006 Projections: 6.50% 10.20
Cash Equivalents
Index: 90-Day T-Bill
Projected Annual Return-Real: 4.00%
Projected Annual Return-Nominal: 1.25%
Projected Standard Deviation (Risk): 0.80
Projected Yield: 4.00
2006 Projections: 4.00% 0.80
Inflation
Index: CPI-U
Projected Annual Return-Real: 2.75%
Projected Standard Deviation (Risk): 1.40
2006 Projections: 2.75% 1.40
Mr. O'Leary noted that the five year projections were unchanged
from the previous year.
9:35:54 AM
Page 26
Domestic Fixed Income
Lehman Aggregate Index - Daily Yield to Worst from 1/1/01
to 12/31/06
[Line graph depicting the Yield to Maturity (%)
fluctuations between 3.0% and 6.5% for the odd-numbered
months between January 2001 and November 2006. Several
specific dates are highlighted.]
Mr. O'Leary deemed the Lehman Aggregate Index "a good measure of
the investment grade bond market." The final rate reported for
the year 2006, dated November 16, was 5.34 percent. He stated,
"As I've told you in the past, this is our basic building block
when we start making projections."
9:36:21 AM
Page 27
Domestic Fixed Income
Current Yield is a Strong Predictor of Returns
Lehman Aggregate Index 5 Year Returns vs. Lagged Yield to
Worst
[Line graph containing Five Year Return (%, Annualized) and
Yield to Worst (%, Lagged) between 2% and 22% of Five Year
Annualized Return (t) and Yield to Worst (t-5) for the
years 1981 through 2007 and projections of Yield to Worst
(t-5) for the years 2007 through 2012.]
Mr. O'Leary cautioned against "naively" assuming that the
current bond market yield would remain unchanged for the next
five years. This graph demonstrates the actual five-year return
for bonds and the Yield to Worst "and just pushes it ahead five
years." This methodology is "not perfect but it's a pretty good
predictor of bond market returns."
9:37:08 AM
Page 28
Equity Appears to be Reasonably Priced
Trailing P/E Approaching Long-Run Average
[Line graph showing the fluctuations of the Price to
Earnings Ratio for S&P 500 (1954-2006) superimposed on the
Long-Run Average of approximately 16 percent and a -2 Std.
Dev. and a +2 Std. Dev.
A notation reads: Trailing earnings as reported for the
fiscal year; includes negative earnings from 1998 onward.]
Mr. O'Leary noted that the five-year projection for nominal
stock returns was unchanged in large part because stocks do not
appear to be excessively valued. Stock values were "very close"
to the long term average. If a significant earning decline were
expected, stocks would not be undervalued.
9:38:00 AM
Page 29
Domestic Equity vs. Bond Yields
S&P 500 Earnings Yield vs. 10-Year Treasury Yield
[Line graph showing Yield (%) of S&P 500 Earnings Yield and
10-Year Treasury Yield for the years 1981 through 2006.]
Ratio of S&P 500 Earnings Yield and 10-Year Treasury Yield
[Line graph showing Yield Ratio for the years 1980 through
2006 with specific periods highlighted. Those include Peak
of interest rates and inflation in 1982; 1987 Market Crash;
Fed tardy in lowering interest rates in 1992 and 1993; Fed
raises interest rates to ward off inflation in 1995; Rising
rates, falling earnings in 1999 and 2000; and Stocks
Undervalued? Return to an old regime? in 2003 through
2006.]
Mr. O'Leary informed of another method to determine stock
valuations by comparing stocks to bonds. He told of a model
introduced by former Chair of the Federal Reserve Board, Alan
Greenspan, which "contrasted the earnings yield on the stock
market with the 10-year treasury". The graphs on this page
utilized that model.
Mr. O'Leary stated, "The earnings yield is the reciprocal of the
price earnings ratio." Therefore the earnings yield would be
five if the price earnings ratio was 20. A price earnings ratio
of 50 would result in an earnings yield of two. These graphs
illustrate that over the last two decades, stocks earnings yield
relative to the 10-year treasury "looks pretty attractive
today." He cautioned that this "gap could of course be closed"
with increasing interest rates or with earnings declining;
however, in comparison with high quality bonds, stocks "do not
look expensive".
9:39:35 AM
Page 31
Current Policy with 2007 Projections
Asset Mix Alternatives Optimization Set: 2007
[Spreadsheet containing the following information.
Portfolio Component: Large Cap
Max: 100%
Mix 1: 14%
Mix 2: 19%
Mix 3: 25%
APFC2006: 29%
Mix 4: 32%
Mix 5: 38%
Portfolio Component: Small/Mid Cap
Max: 100%
Mix 1: 4%
Mix 2: 5%
Mix 3: 7%
APFC2006: 5%
Mix 4: 8%
Mix 5: 10%
Portfolio Component: International Equity
Max: 100%
Mix 1: 6%
Mix 2: 9%
Mix 3: 12%
APFC2006: 16%
Mix 4: 15%
Mix 5: 19%
Portfolio Component: Emerging Markets Equity
Max: 100%
Mix 1: 1%
Mix 2: 1%
Mix 3: 2%
APFC2006: 3%
Mix 4: 2%
Mix 5: 3%
Portfolio Component: Domestic Fixed
Max: 100%
Mix 1: 59%
Mix 2: 48%
Mix 3: 36%
APFC2006: 25%
Mix 4: 24%
Mix 5: 12%
Portfolio Component: Non US Fixed
Max: 100%
Mix 1: 5%
Mix 2: 4%
Mix 3: 3%
APFC2006: 4%
Mix 4: 2%
Mix 5: 0%
Portfolio Component: Real Estate
Max: 100%
Mix 1: 5%
Mix 2: 6%
Mix 3: 7%
APFC2006: 10%
Mix 4: 9%
Mix 5: 10%
Portfolio Component: Absolute Return
Max: 4%
Mix 1: 4%
Mix 2: 4%
Mix 3: 4%
APFC2006: 4%
Mix 4: 4%
Mix 5: 4%
Portfolio Component: Private Equity
Max: 4%
Mix 1: 2%
Mix 2: 4%
Mix 3: 4%
APFC2006: 4%
Mix 4: 4%
Mix 5: 4%
Portfolio Component: Cash Equivalents
Max: 100%
Mix 1: 0%
Mix 2: 0%
Mix 3: 0%
APFC2006: 0%
Mix 4: 0%
Mix 5: 0%
Totals for the asset mixes are listed as follows:
Totals
Mix 1: 100%
Mix 2: 100%
Mix 3: 100%
APFC2006: 100%
Mix 4: 100%
Mix 5: 100%
Expected Return
Mix 1: 6.50%
Mix 2: 7.00%
Mix 3: 7.50%
APFC2006: 7.84%
Mix 4: 8.00%
Mix 5: 8.50%
Standard Deviation
Mix 1: 6.64%
Mix 2: 8.33%
Mix 3: 10.16%
APFC2006: 11.50%
Mix 4: 12.10%
Mix 5: 14.09%
Sharpe Ratio
Mix 1: 0.38%
Mix 2: 0.36%
Mix 3: 0.34%
APFC2006: 0.33%
Mix 4: 0.33%
Mix 5: 0.32%
A notation reads as follows:
Note that the APFC's implementation of domestic and
international equity is accomplished through both
global and domestic/international portfolios. The
current implementation plan has 14% allocated to
global portfolios funded through 7% reductions in both
international and domestic large cap.]
Mr. O'Leary posed the question of "what does all this mean." He
responded that the assumptions were input to an "optimizer" to
develop efficient portfolios. The Permanent Fund existing policy
had been included as a point of reference. Utilizing the new
capital market assumptions, a return of 7.84 percent was
expected. This contrasted with the 7.77 percent return
projection developed utilizing the previous year's assumptions.
9:40:29 AM
Page 32
Efficient Frontier Graph
[Line graph comparing Projected Return to Projected Risk
with APFC2006 specified at approximately 7.8 percent. A
notation reads as follows.
Current policy is essentially on the efficient
frontier. Note that this efficient frontier was
developed using constraints in allocation both for
private equity & absolute return strategies.]
Mr. O'Leary asserted that the Alaska Permanent Fund policy was
"right on the efficient frontier".
9:41:01 AM
Co-Chair Stedman, referring to the information on Page 31, spoke
to the correlation between the Alaska Permanent Fund and the
Public Employee Retirement System (PERS) and the Teacher
Retirement System (TRS) trust, with regard to the portfolios,
long term returns and targets. He requested additional
explanation of the "matrix", specifically to the 2006 target
return of 7.84 percent for the Permanent Fund. He also asked how
the target could be increased to nine or ten percent and the
risk associated with such a change. He suggested this could be
considered for the retirement trust.
9:42:13 AM
Mr. O'Leary gave the following response.
First let me be sure that everybody understands this table
and then I'll get to the question.
What we said to the computer, was "We want the lowest risk
portfolios between 6.5 percent and 8.5 percent; and we want
to look at basically five, so that there are meaningful
differences." Then we added in the Permanent Fund.
"Large Cap" refers to large cap US Equities. "Small to Mid
Cap" refers to small to mid-cap domestic equities.
International Equities; Emerging Markets Equity; Domestic
Fixed; Non US Fixed income; Real Estate, Absolute Return;
Private Equity, and Cash. Those are the asset categories
that were considered.
We constrained Absolute Return to four percent. We said you
can't use more than four percent in absolute return. That's
hedge funds - [indiscernible] funds and Private Equity. The
reason that those were constrained is it's very difficult
for a fund of this size to get a lot invested. The
Permanent Fund has been moving to get invested in private
equity for several years, and has a plan - has made
commitments, but the money hasn't actually been drawn down.
Those were practical limitations.
9:44:00 AM
Mr. O'Leary directed attention to Page 30, instructing the
Committee to "scan down this list of projected returns", and
continued.
You can see that the highest projected return is 12 percent
for Private Equity. So theoretically one could have a
portfolio of a hundred percent private equity and hope to
earn 12 percent. It would clearly be imprudent, nobody's
suggesting that.
Mr. O'Leary returned to Page 31 and pointed out that the Mix 5
scenario would have an expected rate of return of 8.5 percent.
The percentages of "Standard Deviation" increased for each asset
category listed. The Mix 5 scenario contained only 12 percent of
Domestic Fixed and no international fixed income.
Mr. O'Leary continued:
So it's basically 88 percent in equity-linked investments.
Real estate equity is equity. Absolute return is hopefully
more bond-like in volatility, but is taking aggressive
positions. The rest of the portfolio would largely be in
publicly traded equity - domestic and international large
and small.
Pragmatically, I guess where I'm going Mr. Chairman, is to
say, I think you can get up and plan such as the retirement
board, have targets near the eight percent level, in
today's environment, if you agree that inflation is going
to be 2.75 or that order of magnitude.
9:46:16 AM
Mr. O'Leary cautioned, "It's tough to get much higher than 5.25
percent real return."
9:46:33 AM
Mr. O'Leary spoke of treasury protected inflation securities
(TIPS) as follows.
TIPS today … has no credit risk -obviously, there's nothing
[of] higher quality - treasury obligation. But they have an
implicit real return of just a little bit over two percent.
The real return from the highest investment grade bonds is
somewhere south of three percent.
Mr. O'Leary concluded:
The more of your portfolio that you have in investment
grade bonds the more difficult it is to achieve a real
return on the total portfolio in excess of five percent.
9:47:19 AM
Co-Chair Stedman surmised that increasing the target rate of
return from eight percent to ten to twelve percent would
substantially increase volatility, which was reflected as a
standard deviation.
9:47:50 AM
Mr. O'Leary affirmed. He explained standard deviation, utilizing
Mix 4 as an illustration.
The middle of a distribution of possible outcomes is eight
percent with that policy. A standard deviation of 12-1 says
that in a year that policy might produce between plus 20.1
percent or a negative return of 4.1 percent. That's one
standard deviation. Two standard deviations in a one-year
period double that number.
That's the range; huge increase in volatility. I'm going to
put it in context. The bear market that we were in was more
than a two standard deviation event. So those things do
happen. They don't happen, fortunately frequently, but they
do happen.
An investor who has a super aggressive strategy, that is
almost 100 percent equity, is taking on the volatility. If
they can stay the course and don't need the money, they may
be much better off in the long run. But they have to live
through the shorter run.
9:49:30 AM
Co-Chair Hoffman attempted to correlate the presentations of Mr.
Burns and Mr. O'Leary. Mr. Burn's presentation stated that the
Fund returned 11 percent in 2006, which was "well ahead" of the
benchmark of 10.5 percent. Co-Chair Hoffman asked if this was
the expected return cited in Mr. O'Leary's presentation as well.
9:49:50 AM
Mr. O'Leary answered it was.
9:49:54 AM
Co-Chair Hoffman shared that when he first began his service in
the Alaska State Legislature, the balance of the Permanent Fund
was $8 billion. The Fund would soon exceed $40 billion, and at a
seven or eight percent rate of return the Fund would exceed $50
billion shortly. Given the five-fold increase of the Fund from
$8 billion to $40 billion, he predicted the Fund balance could
someday be in excess of $200 billion.
9:51:13 AM
Mr. O'Leary characterized this as "the magic of compounding."
9:51:15 AM
Co-Chair Hoffman asked whether the Fund's Board of Directors had
contemplated how large the Fund should grow and the point in
which the "philosophy" of inflation proofing should be changed.
Inflation proofing would "take larger and larger chunks of the
Fund" as the balance of the Fund increases. He asked the point
that the Legislature would begin utilizing a portion of the
earnings of the Fund for purposes other than inflation proofing
the principal of the Fund and payment of dividends.
9:52:06 AM
Mr. Burns told of a Board of Directors retreat held August 2006
that included staff and Mr. O'Leary. The questions of whether
the size of the Fund was reaching an amount in which "we're
going to have to think substantially differently about how we do
things, why we do things" and whether "size just in and of
itself going to change things" were posed. The conclusion was
reached that no changes were necessary until the Fund balance
was $60 to $70 billion.
Mr. Burns admitted, "There's a point out there where you start
doing things and you have different constraints." He gave an
example as follows.
The huge plans in the country: Cal PERS. In private equity,
for them to take a meaningful piece of a private company,
gets to be such a large number that they have things that
they have to register with the SEC [federal Securities and
Exchange Commission] as an insider and as an investor over
a certain threshold.
Mr. Burns assured that the Alaska Permanent Fund was "a long way
from those types of constraints." Therefore, the methodology
currently employed to manage the Fund would remain the same. A
point would be reached "when you're a different type of fund",
but that was "a ways away."
9:54:07 AM
Co-Chair Hoffman, noting that the Fund balance increased by $10
billion in less than 13 months' time, surmised that at a growth
rate of 8.5 percent, the Fund would reach $60 to $70 billion in
a short period.
9:54:31 AM
Mr. O'Leary addressed this as follows.
Number one, I want to underscore, everybody's attitude - we
all recognize that this Body [the Legislature] determines
what happens with the earnings of the Fund. There's no
question with regard to that.
The rates of return enjoyed over the last three years -
four years, of market recovery have been well above the
long term average.
Mr. O'Leary displayed Page 24 and continued.
I wanted to draw your attention to the 15-year return for
bonds - investment grade bonds: 6 1/2 percent per year.
That was a significant part of the return enjoyed by the
Permanent Fund. Because interest rates are so much lower
today, we have great confidence in saying "You're not gonna
see 6 1/2 percent from bonds. We think 5.25 is optimistic."
The same can be said for almost every major asset category.
You're all aware of how well real estate has done as an
asset class. Our expectation for real estate going forward
is 7.6 percent. For stocks, it's only nine percent.
So as we look ahead, we are not extrapolating the returns
of the last 15 years, nor are we extrapolating the returns
of the bounce-back from this horrendous bear market that we
saw from 2000 to '02.
9:56:43 AM
Mr. Burns added for clarification that his earlier testimony
stating that the Fund's performance was "ahead of our benchmark"
of 10.5 percent, was not speaking to "the 7.8 percent that goes
into the asset allocation." He stated that once the 7.8 percent
was determined as the "proper asset allocation", "then we go to
the benchmarks that are driven" by the information contained on
Page 22. He explained the benchmark and its relation to asset
allocation as follows.
If we're going to have 12 percent that's going to be tied
to the Russell 3000, do we do better than that? That
becomes the benchmark. How does that compare with the
cumulative benchmarks that are driven by the asset
allocation? … They're different levels.
9:57:32 AM
Mr. O'Leary further noted, "The 7.84 is using the asset class
projections. It is the target index going forward based on these
estimates. "
9:57:41 AM
Mr. Burns concluded his explanation that the benchmark
represented "how we performed against the rest of the world this
year."
9:57:49 AM
Co-Chair Stedman, relating to Co-Chair Hoffman's assertion,
pointed out that the Fund balance was approximately $26.5
billion in the year 2000 compared to the present day balance of
approximately $37 billion. Co-Chair Stedman commented as
follows.
At some point, there's got to be a policy discussion within
the State, as we fuel this economic engine, of how are we
going to deal with inflation proofing and how are we going
to deal with any structural changes from a strategy
standpoint at this table dealing with our budgets. We're
going to be over about a billion dollars in 2015 just
inflation proof. So that discussion is I guess is coming
attractions. I think that's some of the points that Senator
Hoffman was bringing up. This economic engine we have
called the Permanent Fund, is most likely the fastest
growing economic entity we have in the State. This is a
huge driver.
9:58:59 AM
Mr. Burns advised that the Board of Director's task was to
provide the Legislature with as many options as possible with
regard to use of the earnings of the Permanent Fund. The intent
was for the Fund to be as successful as possible to give the
Legislature many choices.
9:59:14 AM
Senator Thomas asked what factors are utilized as benchmarks.
9:59:27 AM
Mr. O'Leary listed the S&P 500 and "the Russell family" as
benchmarks used for domestic equity; the Leman Aggregate Bond
Index was used for investment grade bonds; the NCREIF Index,
which is a measure of institutional grade direct private real
estate, was used as a benchmark for real estate; "an appropriate
REIT index" was used for "REITs"; Public Equity Markets were
used "as a proxy" for private equity; a "specific target rate,
[indiscernible] London Interbank Rate plus four percent" was
utilized as a benchmark for the absolute return managers; and a
high yield bond index was used for high yield.
10:00:30 AM
Senator Thomas referenced the testimony stating that the Fund
performance exceeded its benchmark by one-half of a percent, and
asked if the witnesses had a chart to indicate "where that
difference came from - how well you were doing in a particular
asset class."
10:00:51 AM
Mr. O'Leary answered that the detail was not included in the
presentation; however, the information provided to the Fund
managers on a quarterly basis and could be shared with the
Committee.
10:01:04 AM
Co-Chair Stedman requested that the presentation to the Board on
the performance "breakdown" of the previous quarter be forwarded
to the Committee.
Mr. Burns agreed to provide the information.
10:01:27 AM
Co-Chair Stedman returned to testimony provided earlier in the
presentation regarding difficulty in calculating the dividend
amount. He expressed concern that the public could perceive that
the dividend calculation was so complex as to only be
discernible by the "Wizard of Oz". He requested an explanation
of how the dividend was currently calculated, excluding mention
of how the Board would like the calculation method to be
changed.
10:01:53 AM
Mr. Burns explained, "The basic number is all driven by realized
income."
Co-Chair Stedman interjected to request a definition of realized
income.
Mr. Burns assured he would provide such and continued as
follows.
When the Fund was first created - and it made a lot of
sense at that time because the Fund at creation was only a
bond portfolio. You realize income from a bond portfolio
for accounting purposes in two ways. You collect your
interest or you sell the bond at a profit. Those both are
classic accounting realized income.
For a broader portfolio, such as ours, realized income is
rents that we receive, it's dividends, it's interest, [and
it's] capital gains when we receive them. What it does not
include is unrealized gains. That would be a piece of real
estate we buy for $75 million and it becomes worth [$]90.
There's no realized income in that. We do recognize it for
performance but we don't for the dividend formula.
There is a five year trailing average. There's a five year
history of realized income. Basically half of that goes
into the dividend formula each year. Why that's changing so
dramatically right now, as we talked about, the bear
markets that were falling off, the number that falls out of
the formula, what will become the sixth year, was $257
million. In the first half of this year our realized income
was $1.9 billion. What that will be the next six months is
hard to say but the number will be dramatically different
than $257 million. Next year the number that falls out of
the formula is $355 million. I think without any capital
gains being realized, we have probably a 60 - I can't tell
you the run rate - but just from dividends, interest and
rents, we have a run rate substantially higher than that.
Every time you make a change in the portfolio you're
selling something to put something in another place and
what you sell realizes income. Actually just paying the
dividend itself - and we have to come up with $700-800
million to pay the dividend - we're selling things that
hopefully creates profit. The realized income is generated
in that way.
I would add that we do not manage the Fund with an eye
towards realized income. We track it, we keep track of it,
but we don't make investment decisions based on realizing
income. We make investment decisions based on what is best
for the Fund's total return.
10:05:00 AM
Co-Chair Stedman clarified that unless the financial markets
"turn really really sour" substantial increases in dividend
amounts would occur for the next "couple years".
Mr. Burns affirmed.
10:05:22 AM
Co-Chair Stedman inquired about the 50 cent impact on the
dividend amounts as a result of data that was lost and
subsequently had to be reentered into the computer system.
10:05:42 AM
Mr. Burns deferred to the Department of Revenue, as the
Permanent Fund Corporation has no involvement in the
administration of dividend payments.
10:06:25 AM
Co-Chair Stedman commented that the issue was not significant,
but should be publicized.
10:06:33 AM
Senator Huggins directed attention to the Inflation figures
contained on Page 24. He asked the impact of deflation,
specifically as a result of the events of the past week, and
generally to the risk factor. He theorized that inflation could
be managed by that deflation "could be our greatest nightmare."
10:07:23 AM
Mr. O'Leary defined deflation as destruction of wealth, which is
"exceedingly bad for financial markets." He continued as
follows.
I generalize by saying there are only two types of
investments. You can lend somebody money or you can be an
owner. Being an owner in a deflationary environment tends
to be bad. Being a lender, if the lender doesn't go
bankrupt, is good.
If you really felt that deflation were a significant risk,
the best investment strategy would be to own long term
government bonds. That's part of a diversification
strategy. That's one of the roles that bonds fulfill in a
diversified portfolio. If you saw signs of that coming, you
might accept a lower real return to try to protect your
store of value.
10:08:40 AM
Co-Chair Hoffman expressed appreciation to the Board of
Directors on behalf of all Alaskans for its hard work and
dedication.
10:09:17 AM
Senator Thomas asked if the Asset Mix Alternatives Optimization
Set, as shown for the year 2007 on Page 31, was undertaken every
year or whether the portfolio components of the Fund were
generally the same as shown for APFC2006.
10:09:46 AM
Mr. O'Leary replied that Callan Associates reviews the asset
allocation each year and would update the Board with the latest
information later in the day. Each year, the Board adopts an
asset allocation policy. The Board is mindful of the changes in
relative value between stocks and bonds and other asset
categories, and "are constantly considering ways to try to
improve the return and risk characteristics of the policy."
Mr. O'Leary reminded that the Legislature recently provided
"enhanced flexibility" to the Permanent Fund, which resulted in
the addition of asset categories, such as absolute return and
private equity. He commented, "Those, in my view are still in
the ramp-up stage and five or ten years from now, I'd fully
expect them to take a larger role in the portfolio." The total
equity position has increased over the last ten years "by quite
a bit."
10:11:12 AM
Mr. Burns told of a change to the manner in which domestic
allocation and international allocation to equities are
reflected. These no longer included global managers, which has
been made a specific allocation. This change did not effect
operations.
10:12:29 AM
Senator Elton, noting that the rate of return has been "far
outpacing" the rate of inflation, surmised that the balance of
the Fund would reach $60 to $70 billion. He specifically wanted
to know of the planning currently underway to implement the
management changes that would be required of the larger Fund
balance.
10:13:24 AM
Mr. Burns responded that the current status of the Fund "is the
size to be able to access the very best talent in the world." He
furthered, "That's our challenge to make sure we're getting the
best talent. So we are in that upper tier already and we will
continue to be in that upper tier." He acknowledged that
challenges could arise as the size of the Fund increases, but
that "a change in thought" would be more appropriate than a
change in management.
10:14:15 AM
Mr. O'Leary agreed with Mr. Burns. Mr. O'Leary informed that the
State of Washington held over $58 billion in investments for its
retirement system. For 20 years that state "makes extensive use
of what others perceive to be liquid markets and real estate
operating companies and private equity." However, time is
required to build infrastructure to support that type of
investment program. He shared, "That's the type of change that I
would envision" for the future of the Alaska Permanent Fund.
10:14:57 AM
Representative Mike Kelly referenced earlier testimony that
unrealized gains were not reflected in the calculation of the
dividends. He asked if "any sideboards" on unrealized losses
were considered with the transition of Fund investments into
riskier ventures.
10:15:23 AM
Mr. Burns answered that unrealized loses were considered part of
the principal of the Fund under the ruling of an attorney
general opinion.
ADJOURNMENT
Co-Chair Bert Stedman adjourned the meeting at 10:15:35 AM
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