Legislature(2023 - 2024)SENATE FINANCE 532
03/10/2023 09:00 AM Senate FINANCE
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| Audio | Topic |
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| Start | |
| Presentation: Power Cost Equalization Endowment Fund Performance – Department of Revenue | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
| + | TELECONFERENCED |
SENATE FINANCE COMMITTEE
March 10, 2023
9:02 a.m.
9:02:16 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 David Wilson
MEMBERS ABSENT
Senator Kelly Merrick
ALSO PRESENT
Zachary Hannah, Chief Investment Officer, Treasury
Division, Department of Revenue.
SUMMARY
PRESENTATION: POWER COST EQUALIZATION ENDOWMENT FUND
PERFORMANCE DEPARTMENT OF REVENUE
Co-Chair Stedman discussed the agenda. He relayed that the
committee would hear a presentation dealing with the Power
Cost Equalization Fund, which affected many people around
the state. Topics would include the endowment, the
investment policy, cash flow, asset allocation, and market
performance.
^PRESENTATION: POWER COST EQUALIZATION ENDOWMENT FUND
PERFORMANCE DEPARTMENT OF REVENUE
9:03:27 AM
ZACHARY HANNAH, CHIEF INVESTMENT OFFICER, TREASURY
DIVISION, DEPARTMENT OF REVENUE, discussed his background.
It was his twentieth year as an investment officer for the
Treasury Division, and his third year as the Chief
Investment Officer (CIO). He discussed a PowerPoint
presentation entitled "Power Cost Equalization Fund:
Investment Policy, Performance, Downside Risk, and Spending
Volatility," (copy on file).
Mr. Hannah referenced slide 3, "Power Cost Equalization
Program Background, and noted that the program helped to
reduce high energy costs for close to 80,000 Alaskans in
approximately 200 communities. The Alaska Energy Authority
(AEA) administered the program, and the Department of
Revenue (DOR) managed the investments.
Mr. Hannah spoke to slide 4, "PCE: Cashflow," which showed
the PCE cash flowers over the previous 10-plus years
including earnings, withdrawals, balances, and other
information on the table. He noted that the totals over the
long term, including 2022, showed earnings of roughly 6.8
percent and well in excess of the 4.3 percent spending
rate. He cited that 2022 was notable for a downside
perspective, but prior 9 years were strongly positive with
an average of over 9 percent. He discussed 2022 and cited
that the decrease in fund balance was $191 million, through
a combination of investment losses and fund withdrawals.
Overall, $55 million had come from withdrawals, and $137
million from investment losses.
Mr. Hannah showed slide 5:
DOR/PCE Endowment Fund
Investment Policy and
Asset Allocation Process
Mr. Hannah turned to slide 6, "State Investment Policy and
Asset Allocation Process," and noted that the next several
pages covered an overview of the state investment policy
and asset allocation process that was used for the roughly
$8 billion in funds under the fiduciary control of DOR. He
explained that the division worked to design an investment
program for each fund that balanced investment objectives,
risk tolerance, and other attributes. Starting in December
2020, the state transitioned to a more transparent and
independent process for doing so.
He continued that currently state investments were covered
each quarter with the commissioner and an independent
investment advisory committee. He highlighted that
everything was subject to scrutiny and discussion,
including investment policy and asset allocation. The
meeting materials and summary were publicly available. The
process was in its third year and in some respects mirrored
that of the states retirement systems.
9:06:48 AM
Co-Chair Stedman asked to stop on slide 6 and discuss the
two charts.
Mr. Hannah explained that the top right-hand chart was a
scatter-gram of compound ten-year returns using Callans
current market assumptions for 2023. The range of returns
included cash through 100 percent bond portfolios and stock
portfolios in increments of 10 percent. He noted that the
top chart would be addressed in more detail in a later
slide. The bottom chart on the slide showed a range of risk
tolerances that were employed for various state funds.
Co-Chair Stedman observed that the PCE Endowment was listed
on the table on the bottom, followed by the Public School
Trust Fund and the Higher Education Fund. He asked Mr.
Hannah to address why the funds were classified at a higher
risk level than the PCE Fund and the difference.
Mr. Hannah described that all the funds on the table were
at the same high-risk profile as the PCE Fund. He noted
that he would address that the funds were at the highest
acceptable risk profile recommended for state funds, and
for a variety of reasons the funds had a time horizon that
allowed for taking on a certain amount of risk and an
ability to accept some amount of volatility.
Co-Chair Stedman asked if the funds were comingled.
Mr. Hannah answered that the funds were comingled at the
underlying investment level. When the funds were invested
in domestics stocks or fixed income, the funds were
comingled but were not comingled at the overall asset class
level and could have different asset allocations.
9:09:50 AM
Co-Chair Stedman asked if everything listed below and
including the PCE Endowment was comingled, or was the group
mixed in with the Constitutional Budget Reserve (CBR).
Mr. Hannah affirmed that all of the funds on the table
shared an underlying common group of investment building
blocks by asset class. He continued that all of the funds
above PCE Endowment (with the exception of General Fund and
Other Non-Segregated Investments (GeFONSI) and the
International Airport Fund) had different asset
allocations. Starting with the PCE Fund through the Higher
Education Fund, the funds had the same highest risk profile
asset allocation.
Co-Chair Stedman asked if the group had different
allocations amongst the group.
Mr. Hannah answered affirmatively and stated that the funds
used the same underlying building blocks, and most had
different asset allocations.
Co-Chair Hoffman recounted that the administration had
deemed the PCE Fund to be sweepable, and eventually it was
not determined so by the courts. He asked what other funds
on the table had been deemed sweepable.
Mr. Hannah relayed that the only other fund on the list of
the highest risk funds that was sweepable was the Higher
Education Fund.
Co-Chair Hoffman asked what action Mr. Hannahs office had
taken regarding investments when the funds had been deemed
as sweepable.
Mr. Hannah relayed that he had a slide that covered the
topic specifically.
9:12:18 AM
Mr. Hannah considered slide 7, "Asset Allocation and
explained that Callan was the investment consultant for
both the Alaska Retirement Management (ARM) Board and the
Alaska Permanent Fund Corporation (APFC). The department
also used Callans capital market assumptions. He noted
that the charts on the right-hand half of the slide
illustrated a couple of aspects that had influenced
investing over the previous 30 years. He described that in
1993 it was possible to have a fairly simple portfolio
composed of largely fixed income. Over time as interest
rates fell, fixed income was providing less return to
portfolios and required supplementing with increasing
levels of risk in the form of equities and other asset
classes.
Mr. Hannah made note of increasingly risky portfolios on
the graph from 2008 to 2022, as measured by the risk number
going up to an almost 17 percent in 2022. He observed a
curiosity in 2022, after a huge increase in interest rates
that had made a huge negative impact on returns with a
positive impact on forward expectations. To achieve the
nominal 7 percent return, it was necessary to hold less
equity risk assets.
Mr. Hannah noted that the chart on the bottom corner of the
slide had the forward risk and return including a 2022 line
and 2023 line. He noted that 2023 was a significant step up
because the expectation for fixed income returns was so
much higher, with a forward expectation for equities that
was modestly higher.
Co-Chair Stedman summarized that as interest rates went up,
bonds went down. He observed that bonds came under
significant downward pressure at the same time as the stock
market.
Mr. Hannah agreed.
9:16:02 AM
Mr. Hannah highlighted slide 8, "2023 Capital Market
Assumptions, and noted that each year DOR went through the
process of selectin asset classes for inclusion in state
portfolios. The asset classes currently being used were
shown in bold and italics and included a diverse set of
liquid public market investments. He noted that he used the
term liquid to refer to securities that were traded
daily. He noted that a characteristic of state portfolios
was the composition of strictly liquid securities.
Mr. Hannah noted that the bottom of the table showed items
not publicly traded that the state did not invest in,
including private equity and private real estate. The state
could not invest in most of the asset classes until late in
2020, when the United States Securities and Exchange
Commission (SEC) changed the definition of accredited
investor to include direct state funds. For a long time,
retirement funds had been considered an accredited
investor, and the APFC had a letter ruling from the SEC
that allowed it to invest in alternative assets.
Mr. Hannah explained that holdings that were direct
holdings of state governments could not invest in
unregistered securities like private market investments.
While it was possible starting in 2021, it was possible for
the state to directly invest in alternative investments,
the DOR did not recommend the practice. He qualified that
there was ultimately a liquidity mismatch between the
illiquidity of the investments compared with the annual
budgetary and policy changes that could take place with the
legislature and administration. He relayed that there was
some interest from the committee to compare the PCE Fund
asset allocation with that of the ARM Board and the APFC,
and noted that there was a comparison in the appendix of
the presentation. He summarized that the biggest difference
was the alternative investments, which altered the
liquidity profile and the character of the returns.
Co-Chair Stedman asked about the ARM Board.
Mr. Hannah explained that the ARM Board were the pension
assets managed by DOR on behalf of the state.
Co-Chair Stedman asked if Mr. Hannah was comparing the
allocation relative to the allocation of the retirement
funds.
Mr. Hannah informed that the appendix had a comparison of
the PCE Fund to the ARM Boards and APFCs asset
allocation, which both included significant exposure to
alternative investments.
Co-Chair Stedman asked Mr. Hannah to refrain from using
acronyms when possible.
Mr. Hannah looked at slide 9, "PCE Investment Policy is
Based on Statute." The slide showed the investment policy
as adopted for the current fiscal year, which was an annual
process. The portfolio was designed to target the statutory
goals of prudently maximizing total return and considering
future purchasing power. He noted that the degree of asset
smoothing did impact spending goals. He mentioned a natural
tension between current spending and the preservation of
purchasing power.
9:21:00 AM
Mr. Hannah showed slide 10:
Performance Through December 31, 2022
Mr. Hannah advanced to slide 11, "Capital Market
Performance Update, which focused on 2022, which was a
challenging year. He noted that the chart on the right was
sometimes referred to as a periodic table of returns. The
chart rank ordered asset class returns from highest to
lowest for each time period. He considered 2022 and
observed that only cash had a positive return of 1.5
percent due to the impact of rising inflation and interest
rates. Broad market U.S. equities were down 19.2 percent.
He pointed out that the most unique aspect of the prior
year was that bonds were down materially at 13 percent. He
noted that the inset table on the left showed that any
simple combination of stocks and bonds performed horribly
in 2022.
He commented that on the far right, 2022 was broken into
two halves on the chart. He observed that the first half of
the year was almost universally bad, but the second half of
the year showed most equities had positive performance and
outperformed bonds.
Co-Chair Stedman asked if the asset mix shown on the left
had fairly common results or if it happened once in a time
period.
Mr. Hannah thought the results were a once-in-a-lifetime
event. He thought it had been since the 1800s since stocks
and bonds had co-performed so poorly. He identified the
unique set of circumstances from the Covid-19 period,
massive stimulus pushing bond yields down, followed by
starting with a low base and having to react to an
inflationary environment. He identified that one of the
advantages of bonds over equities was that as returns were
low during an interest rate reset, the ultimate expectation
would likely still be met in time whereas equities were
more volatile. While there was a sharp negative trend for
bonds the previous year, the upside was higher forward
expectations.
9:24:56 AM
Senator Bishop asked about the highest yielding bonds.
Mr. Hannah referenced the yield curve and discussed riskier
bonds that were a spread off of government owned bonds. He
noted that for risky bonds, there could be yields in the
high single digits or even double digits.
Co-Chair Stedman referenced Mr. Hannas discussion of bond
maturity. He asked if the bond portfolio was made of
individual bonds.
Mr. Hannah relayed that the bond portfolio was actively
managed with individual bonds.
Co-Chair Stedman asked if an actively managed bond
portfolio was different than a laddered approach to bond
portfolio management that one would hold to maturity.
Mr. Hannah affirmed that there was a difference, and the
portfolio was holding bonds at various levels of maturity.
He added that there was still a contractual commitment for
repayment of bonds, unlike for equities, that did allow for
bringing forward higher yields.
Co-Chair Stedman asked about the turnover rate of the bond
portfolio.
Mr. Hannah did not have the information at hand.
Co-Chair Stedman asked Mr. Hannah to provide the
information to the committee and give an estimate including
the previous two to three years.
Mr. Hannah looked at slide 12, "PCE Performance Through
December 31, 2022," which showed a table. He pointed out
that the performance for the one-year period and for most
periods had been modestly ahead of the funds benchmark.
He noted that 2022 clearly was a poor year from a total
return perspective overall. Most of the outperformance came
from fixed income asset classes, which were the most
actively managed as opposed to the equity asset classes
that were largely invested in stock market indices.
9:28:44 AM
Mr. Hannah showed slide 13, "PCE Performance Compared with
Prior Asset Allocations," which he thought was responsive
to Co-Chair Hoffman's earlier question. He wanted to
address the committees request to compare the funds
portfolio with prior asset allocations. He noted that there
had been a number of changes over the years including
legislative changes. He made note of three asset allocation
moves over the last few years. He had compared the actual
returns of the PCE Fund with the returns of three
portfolios as if there had been no additional asset
allocations. The change the previous year to prudent
investor resulted in better returns since it increased
equity risk. The original portfolio that targeted a 7
percent return had the worst performance in 2022 and had
the best performance over the full four-year period.
Mr. Hannah thought the correct standard made good sense,
and forward asset allocations were subject to a very
transparent and independent review.
Mr. Hannah referenced Co-Chair Hoffman's question and noted
that the largest change that could be seen on the table was
the five percent target return shown on July 2020. There
was a de-risking that had occurred at the time. He
recounted a legislative change in 2017, that went from a
target of a 7 percent nominal return to a target down to a
minimum return of 4 percent. He relayed that DOR had
continued to invest towards a 6 to 7 percent return for a
number of years after the legislative change was made.
Mr. Hannah discussed the uncertain environment in July
2020, which is where he thought much concern with regard to
sweeping funds had come into consideration. He thought the
time horizon was the biggest determinate of how much risk a
fund could bear. There had been a view that there was a
risk that the time horizon for PCE was shortening, and the
decision had been made to take the risk down a bit and
focus on a 5 percent return.
Co-Chair Stedman asked if de-risking referenced building
the cash position or building short-term bond position.
Mr. Hannah explained that in the stock-bond column, the de-
risking was largely a shift from equities into bonds. There
was a small cash allocation that did not change.
Co-Chair Stedman asked about the time frame for bonds.
Mr. Hannah explained that the bonds were broad-market bonds
with a duration and maturity of 5 to 6 years.
Co-Chair Stedman asked about duration.
Mr. Hannah explained that duration was the amount of
interest rate sensitivity in a bond portfolio. He cited
that a bond portfolio with a duration of 6, with a 1
percent change in interest rate one could expect an
increase or decrease of 6 percent.
9:33:34 AM
Co-Chair Hoffman asked what DOR did when the administration
viewed the PCE Fund as sweepable. He asked where the funds
were moved and for how long. He thought most of the funds
that were swept were very small in comparison with $1
billion. He asked about the actions of DOR.
Mr. Hannah thought the table on slide 13 accurately showed
the trail of the PCE Fund. He thought there had been a
concern that the fund would be swept and would go into the
CBR. He understood that the fund was not swept. He thought
that the fund was de-risked because of concern that the
fund could be swept, which had the impact of potentially
shortening the investment horizon. The fund had not been
swept into the CBR.
Co-Chair Hoffman had been informed that the funds were
taken out of the asset allocations in getting ready to be
swept. He asked if it was Mr. Hannah's understanding or
knowledge that he was referring to.
Mr. Hannah relayed that it was his knowledge.
Co-Chair Hoffman asked if the funds were never taken out of
the asset allocations.
Mr. Hannah answered in the affirmative.
Co-Chair Stedman surmised that the funds were just
reallocated into a shorter time horizon. He asked about the
impetus for DOR to draw the conclusion that it should look
at the asset allocation for the PCE Fund and prepare for
liquidation.
Mr. Hannah relayed that he was not involved in some of the
discussions involving the change, and could not speak to
the specific impetus. He understood that the view that the
risk of the funds being swept was material enough to
decrease the risk of the funds.
Co-Chair Stedman asked where the information had come from,
and whether it was from the legislature or from a chain of
command in DOR.
Mr. Hannah reiterated that he had not been the CIO at the
time of the change and understood that all of the decisions
were made in discussions had happened at the department
with information provided by the collective group that led
to the decision.
Co-Chair Stedman asked about the collective group.
Mr. Hannah referenced the collective group of DOR. He
referenced the annual asset allocation process that the
department went through in 2020. The time horizon of every
fund was considered as part of the process. He understood
from going through documentation that for the PCE Fund,
there was a view that there was a risk that the fund might
have a shortened time horizon. The fund still had a fair
amount of investment risk and had a targeted 5 percent
return rather than a target of 6 to 7 percent previously.
9:38:33 AM
Co-Chair Stedman asked Mr. Hannah to provide information
regarding the dates of de-risking and the dates of
alteration of asset allocation.
Mr. Hannah relayed that typically when DOR made annual
asset allocation changes, the shift in risk happened fairly
quickly within the first several weeks of the fiscal year,
which was what he thought took place in this instance.
Co-Chair Stedman asked Mr. Hannah to get back to the
committee with the weeks the allocation de-risking took
place, as well as the weeks that it was unwound.
Mr. Hannah agreed to provide the information.
Senator Wilson wondered who had been involved in the
decisions such as changing the target return.
Co-Chair Stedman asked Mr. Hannah to provide more
information pertaining to Senator Wilson's question. He
asked the broader question of how the department dealt with
asset allocation decisions. He thought the commissioner had
extensive powers and authority. He thought the commissioner
may or may not have counsel from others.
Mr. Hannah agreed to look into the matter and commented
that since he had been CIO there was a very independent
quarterly process that was transparent and was subject to
review. He specified that every change in asset allocation
was subject to a lot of scrutiny by independent experts.
Co-Chair Stedman relayed that the legislature had
encouraged every commissioner to have a process to fall
back on and reflect decision making. He mentioned past
incidents that had cost the state over $1 billion.
9:42:28 AM
Senator Bishop referenced Co-Chair Stedman's comments
regarding the timeline of when the funds would
theoretically be swept and changes in asset allocations. He
asked Mr. Hannah to provide information regarding any
resultant losses or gains that may have occurred.
Mr. Hanna relayed that the table on slide 13 attempted to
answer the question. He pointed out the actual PCE Fund
portfolio over one-, two-, and three-year periods. He
observed that the original 7 percent target fund had worse
performance over the one-year period, but better
performance over the three-year period. He commented on the
higher risk during the Covid-19 pandemic. If there was
higher risk during the period in the longer term, funds
tended to outperform. He thought that generally speaking, a
new asset allocation was put into effect fairly quickly. He
noted that it was probably a matter of days or as much as a
week or two and explained that a date of July would signify
the first week or two of the new fiscal year.
9:45:10 AM
Senator Bishop relayed that he would work with Co-Chair
Stedman about clarifying his question.
Co-Chair Stedman thought it might help to have more precise
information pertaining to the date of the change in asset
allocation.
Co-Chair Olson acknowledged that there were tumultuous
times when the PCE Fund was being discussed as sweepable.
He referenced Senator Bishop's question and about the net
outcome of the changes and liquidation of the fund.
Mr. Hannah agreed to get back to the committee with
numbers. He noted that the funds returns were on the
slide. He clarified that there was no liquidation that had
occurred, and that there was a decrease in risk that had
occurred. He characterized the change as not a full de-
risking but rather a move from a 6.5 percent expected
return down to a 5 percent expected return. He continued
that if the funds had moved down to the CBR, it would
decrease to a 1 percent expected return. He agreed to
provide additional information. He emphasized that the fund
was not liquidated but was modestly de-risked due to the
view that there was increased risk that the time horizon
might decrease.
Co-Chair Olson considered the fund in 2022 and the loss of
$200 million. He clarified that he had been asked how much
the PCE Fund had lost in the de-risking of the fund.
9:48:22 AM
Mr. Hannah displayed slide 14:
Asset Allocation,
Downside Risk, and
Spending Volatility
Mr. Hannah turned to slide 15, "The Risk and Return
Tradeoff," which addressed how the division thought about
risk. The table on the slide showed the prospective asset
allocation for the PCE Fund for FY 24. He highlighted that
the PCE Fund asset allocation in the middle of the chart.
The first set of bold numbers showed return statistics for
a 10-year forward period. The nominal or total expected
return was 6.8 percent, which was expected to remain steady
if the fund was in the same asset allocation. The real
return was 4.3 percent after being reduced by 2.5 percent
inflation. He cited that if the goal was to completely
inflation-proof the fund, the real return number would be
the forward expectation of how much the fund could expend
and be fully inflation-proofed.
Mr. Hannah continued to address the table on slide 15. He
pointed out that the last number in the section showed the
amount of inflation-proofing that it could be if the PCE
Fund spent at 5 percent. If spending was at 5 percent, the
earnings that remained in the portfolio would cover roughly
three quarters of expected inflation.
Mr. Hannah compared the portfolio to some alternatives,
which had been requested by committee members. He addressed
the right-most table, which showed six example portfolios
which ranged from no risk, 100 percent cash up through 100
percent in equities. Starting with the cash-only portfolio,
the expectation was a low nominal return of 2.7 percent and
real return of .2 percent. The cash-only portfolio gave no
ability to retain purchasing power in its risk-less
investment. He looked towards the right and observed that
at about the 60 percent equity area, the returns and
inflation projection started to look modestly acceptable.
Further towards the 80 to 100 percent equity portfolios,
there was less diversification, and the division viewed the
portfolios as testing the bounds of prudence. He
highlighted that DOR positioned the portfolio at the
roughly 70 percent equity level, which should provide for
adequate earnings. The level preserved reasonable
purchasing power and had manageable volatility, and had a
prudent risk posture from an institutional perspective.
9:52:03 AM
Mr. Hannah continued to speak to slide 15 and addressed
downside risk. He noted that all of the investments came at
potential cost. He summarized that low levels of risk were
unlikely to produce acceptable earnings, and high levels of
risk added potential uncertainty and downside losses. The
last section at the bottom of the table showed risk
statistics. He explained that the standard way of
discussing risk was as a standard deviation of returns,
which he found a bit opaque. He had included some
downside statistical risk measures that addressed estimates
of potential loss. He cited the 10 percent probable return
over one year of negative 15.4 percent, which was an
expected loss once in ten years. Since it was a 10-year
forecast, it was the return that one might expect in one of
the next ten years. He pointed out that somewhat
coincidentally, the estimate was close to the actual loss
from the previous year.
Mr. Hannah addressed the 5 percent downside return over
three-year periods of negative 8.2 percent, which he
thought was a downside case worth considering for planning,
since the PCE Fund did have a 3-year smoothing period. If
the PCE Fund had a 5-year smoothing period, the number
would further be reduced to negative 4.8 percent. He
discussed smoothing over time and the lessening of loss
over longer smoothing periods.
9:54:24 AM
Co-Chair Stedman asked Mr. Hannah to discuss inflation
expectations over the next decade, and to address other
information he had seen in the investment world regarding
inflation expectations.
Mr. Hannah informed that the department used Callan's
capital market assumptions, which were independent and had
a robust process. He cited that Callans expectations for
10-year forward inflation was 2.5 percent, and market
inputs were providing roughly the same figure. He mentioned
break-evens for inflation protected bonds, which were also
in the 2.5 percent bonds. He mentioned the tug-of-war
between inflation and growth.
Co-Chair Stedman understood that the department used
information from Callan, where the committee also received
oil price information that it benchmarked against other
indices around the world. He asked about the payout rate of
the portfolio under the expectations and wondered about the
level of the draw.
Mr. Hannah offered that his perspective on the spending
rate was colored by the expected real return. He cited that
a 4.3 percent rate for a portfolio like the PCE Fund was
where the Treasury Division was comfortable. With spending
at the real return level, there would be a forward
expectation of complete inflation proofing. He highlighted
that the statute did not say complete inflation proofing,
but referred to future purchasing power. If there was
spending beyond 4.3 percent, there should be an expectation
of cutting into forward purchasing power. Spending 5
percent still allowed for inflation proofing at a three-
quarters level. If the goal was to completely inflation-
proof, then the recommendation was to expect to spend at
about 4.3 percent, which was what PCE Fund had expended
historically. The real return from the capital market
assumptions being the same amount as the spending was a
coincidence.
9:58:16 AM
Mr. Hannah considered slide 16, "Hypothetical Historical
Drawdowns of a 70% Stock / 30% Bond Portfolio," which
showed another way to triangulate downside risk. He
explained that the chart compared three- and five-year
smoothing for a 70-30 bond portfolio similar to the PCE
Fund over the past forty-plus years. The chart used actual
stock market data. The dotted line showed rolling annual
returns. He pointed out extreme volatility. The blue line
showed three-year smoothing of annual returns, which
reduced volatility considerably. With five-year smoothing
(shown by the red line) there was incremental additional
volatility reduction.
Mr. Hannah pointed out that the inset table showed that the
three-year periods were very similar, but the historical
market had been more volatile over one-year periods and
less volatile over five-year periods. He thought the
statistical forward measures penciled out fairly well with
what the market had looked like historically from a
downside perspective. He pointed out that the shaded region
represented the prior two market drawdowns and recoveries.
As expected, three-year smoothing was more reactive. He
summarized that as one went through market turmoil, three-
year smoothing would go down more quickly and go up more
quickly, while five-year smoothing averaged the amount out
further.
10:00:49 AM
Mr. Hannah displayed slide 17, "Spending Volatility
Reduction with Smoothing - History," which showed two
graphs that looked at three- and five-year smoothing over
the recent history of asset levels for the PCE Fund. He
observed that that over the period both had been close, but
the three-year smoothing would always be higher from a
combination of generally rising markets and the PCE Funds
spending profile. He noted that the lines had basically
converged at the end of the year with 2022s losses, and
there was expectation that the lines would cross over.
Mr. Hannah commented that PCE spending was based on average
balances, that were affected both by investment returns and
spending almost in equal measure. He continued that over a
three-year period, it was expected that spending evenly at
5 percent per year lowered the average value of the fund by
7.5 percent. In a downside case that resulted in a 3-year 5
percent probable loss of 8.2 percent, the total reduction
in the three-year average would be roughly 16 percent when
combined with spending. He offered the context that if the
downside scenario was put upon the FY 24 budget, the fund
would be reduced to $46 million by FY 27.
10:02:41 AM
Mr. Hannah highlighted slide 18, "Prospective Spending with
Smoothing Median Forward Case," which illustrated a
forward baseline case for the PCE Fund. The two charts
showed what asset levels and spending could look like over
the following decade, with three- and five-year smoothing,
if the PCE Fund hit baseline case with a median return of
6.8 percent. He observed that the lower chart showed that
the three-year smoothing would bottom out with a roughly 13
percent reduction from the peak at $48 million.
Mr. Hannah noted that five-year smoothing was the most oft-
used method for a fund like the PCE Fund, as it would
better cushion the blow of possible decline in assets. He
cited that often there was some form of volatility
reduction through smoothing or other measures, and often
some form of spending control if it appeared necessary.
Co-Chair Stedman considered historic highs for the fund and
thought that the view looked forward a decade.
Mr. Hannah agreed.
Co-Chair Stedman asked if shortening the time horizon would
require an equity infusion or a riskier portfolio.
Mr. Hannah added, or a market correction beyond these
baseline estimates. He explained that the slide showed a
baseline smooth projection forward. He commented on the
possibility for a quicker rebound, and discussed the math
for an asset base to support preferred spending.
10:06:00 AM
Mr. Hannah looked at slide 19, "Conclusion and Summary
Observations." He reminded that there was a comparison of
the PCE Fund to the ARM Board and APFC if the committee
wanted to discuss it.
Mr. Hannah advanced to slide 22, "PCE Statutory Investment
Powers and Duties," which had been in response to some
questions from the committee and Co-Chair Stedman. He
referenced the Prudent Person Rule versus the Prudent
Investor Rule, and relayed that the current standard was
the Prudent Investor Rule. He explained that the care in
which the fiduciary of the funds needed to treat them was
the care that a Prudent Investor would treat like funds in
like circumstances as if they were their own. The concept
built on a body of work including the prior Prudent Person
Standard. He discussed the history of the standards, which
had started in the 1800s.
10:09:59 AM
Co-Chair Hoffman asked how the Prudent Investor Rule
translated to the highest risk funds as shown on slide 6.
Mr. Hannah relayed that a prudent investor, looking at a
set of circumstances that the department looked at with
respect to the funds, would reach largely the same
conclusions given the same facts for the funds. If one
combined goals of maximizing returns, some inflation
proofing, and the need to support a reasonably high level
of expenditure, a prudent investor would come to the same
conclusion that the department did in developing the same
relative risk profile.
Mr. Hannah relayed that the second paragraph of slide 22
outlined the investment powers and duties of the DOR
commissioner had with respect to the funds that were under
fiduciary control. Some of the items were the same as a
definition of the Prudent Investor. He thought there was an
important clarification in statute to exercise duty in the
sole financial best interest of the beneficiaries. He
thought the clarification came into play, particularly with
respect to DORs investment of the pension systems.
Co-Chair Stedman asked who the beneficiaries of the PCE
Fund were.
Mr. Hannah answered, "Many residents of the state."
10:12:45 AM
Mr. Hannah spoke to slide 23, Asset Allocation Comparison
PCE, ARMB, and APFC," which was a summary comparison. He
noted that the PCE Fund did not have any alternative
investments like private equity and private real estate. He
noted that the PCE Fund column only had public equity and
fixed income assets. The ARM Board had 36 percent in
alternative investments, and the APFC had 42 percent in
alternative investments. He noted that new asset
allocations had not been made for all the groups, and the
market assumptions were from the previous year.
Mr. Hannah noted that the second table illustrated a
hypothetical scenario in which the PCE Fund was adjusted to
the risk level of the ARM Board. He compared a 6 percent
expected return for the PCE Fund adjusted to a 13.9 risk,
versus a 6.3 percent return for the ARM Board.
Mr. Hannah considered administrative or legislative changes
that occurred annually with portfolios, and thought it was
difficult to invest in alternative investments with
liquidity profiles that could stretch beyond five years. He
discussed the perception of public portfolio investments,
and the options provided by liquidity. He noted that the
ARM Board and APFC had long time horizons and had a lot of
control of governance risk. He thought the groups had made
sensible decisions in terms of investments.
10:17:45 AM
AT EASE
10:17:56 AM
RECONVENED
Mr. Hannah commented that particularly at points of market
inflection, it made it difficult to compare public market
portfolios with portfolios that had significant exposure to
alternative investments. He continued that anytime there
had been a crisis or significant drawdown and rebound, one
would see that alternative investments lagged public market
investments considerably, even though they were tightly
linked. He explained that over time, the valuations would
work themselves out. He thought the most difficult time to
compare returns and draw conclusions was during times of
market inflection. He thought for a portfolio like the PCE
with 100 percent public market investments would likely
strongly outperform portfolios that had a lot of
alternative investments.
10:19:53 AM
Senator Wilson wondered if DOR also used Callan and other
standardized aspects that the APFC and ARM Board used. He
pondered DOR in competition with staff at APFC. He asked
about investment decisions that had lacked transparency. He
estimated that DOR had about 27 investment officers and
managed about $8 billion, while APFC had about 32 staff and
managed about $77 billion. He pondered shifting some long-
term investments to APFC and employing fewer investment
officers to manage accounts such as the SBR, CBR, and the
General Fund and Other Non-Segregated Investments (GeFONSI)
accounts. He mentioned issues at DOR such as staff and
administration changes every four to eight years. He
thought it could be more cost-effective for the state to
make a shift.
Co-Chair Stedman asked if Senator Wilson was making a
comment or asking a question.
Senator Wilson relayed that he had seen some questionable
accounting practices with DOR. He thought it seemed more
efficient and effective to downsize DORs investment
officers.
Co-Chair Stedman did not think there was a question of
accounting, but rather the decisions coming from the top.
He mentioned a question earlier regarding reallocation that
had not come from investment officers but rather somewhere
upward in the chain of command.
Mr. Hannah relayed that DOR had 15 investment officers, and
estimated that it was roughly half the size of APFC. He
thought the departments cost structure was quite a bit
lower and thought DORs performance was excellent. He
clarified that the $8 billion (mentioned by Senator Wilson)
was only the assets under the fiduciary control of the
commissioner of DOR. The department managed roughly $50
billion in total, which was largely retirement assets and
was how he spent most of his time. He commented on the
complexity of the systems. He cited that there were 14
retirement funds. He did not expect consolidation would
result in cost savings, and he thought there was far less
duplication of resources than people might expect.
10:24:11 AM
Co-Chair Hoffman asked to go back to slide 4, and consider
June 2021, which appeared like it was an outstanding year
with earnings of $150 million. He thought the Permanent
Fund had over 6 percent higher earnings for the same
period. He asked how much potential earnings the state
could the PCE Fund have because the department was
anticipating the sweep.
Mr. Hannah discussed the returns of the PCE Fund and the
Permanent Fund during the period in question. He clarified
that the state could not own alternative investments prior
to 2021. He noted that alternative investment portfolios
took much time to build.
Co-Chair Hoffman clarified that his question was about the
anticipation of the sweep of the PCE Fund, and asked if
there were decisions made by DOR that precluded the fund
from earning investments.
Mr. Hannah reiterated that there was a slide in the deck
that showed the returns expressed in percentage. He relayed
that he would provide the comparisons in numbers.
Co-Chair Stedman asked Mr. Hannah to be expeditious. He
cited concern, directed at politics rather than portfolio
managers, that politics had been pushed into management of
the portfolio. He wanted to gather information on the
timing and when meetings and discussions had taken place.
He did not want the situation replicated.
Mr. Hannah was happy to provide the additional information.
He reiterated that since he had been CIO there was a new
process that was very transparent and well vetted.
Co-Chair Stedman recognized that the department did not
look forward to discussing political winds in the
department. He expressed the desire to keep politics out of
the management of the three funds. He thanked Mr. Hannah
for his testimony.
Co-Chair Stedman discussed the agenda for the next meeting
the following week.
ADJOURNMENT
10:29:15 AM
The meeting was adjourned at 10:29 a.m.
| Document Name | Date/Time | Subjects |
|---|---|---|
| 031023 DOR-PCE-Senate Finance-March-2023.pdf |
SFIN 3/10/2023 9:00:00 AM |