HOUSE BILL NO. 18 "An Act making a special appropriation from the earnings reserve account to the principal of the permanent fund; and providing for an effective date." REPRESENTATIVE RAMONA BARNES noted that she has only offered two bills in her legislative career. She read from her sponsor statement: I am offering House Bill 18 to ensure an alternative approach is available to the ongoing debate over the Permanent Fund and the use of its earnings. As the title suggests, HB 18 would make a special, one- time appropriation from the Earnings Reserve to the corpus of the Permanent Fund. The appropriation would include the existing balance of the Earnings Reserve on June 30,1999. As the bill's sponsor, I ask the Finance Committee to amend the effective date in HB 18. I believe placing the existing balance of the earnings reserve into the corpus of the Fund would serve the dual purpose of further protecting the funds and ensuring the growth of the Permanent Fund. Representative Barnes added that she received additional information that needed to be considered by the House Finance Committee. She observed that if the whole earnings of the Permanent Fund were put into the corpus of the fund that it could lead to the reduction or elimination of the dividend. She asked the Committee to take action to protect the dividend. Co-Chair Mulder observed that members were provided with a proposed committee substitute, work draft, 1-LS0163\D, Cramer, 3/20/00 (copy on file). The committee substitute would lower the appropriation to $250 million dollars. He agreed with Representative Barnes that if there were a deposit of the unappropriated balance that there is a real likelihood that there could be insufficient funds remaining in a protracted downward market to pay the dividend. BOB STORER, EXECUTIVE DIRECTOR, ALASKA PERMANENT FUND CORPORATION, DEPARTMENT OF REVENUE observed that the Corporation contracted with Callan Associates Incorporated for a sophisticated model to evaluate a number of asset allocations and decisions including the volatility of any given year. He provided members with a handout titled "Volatility Model, Move Realized Earnings Reserve to Principal at the end of FY00" (copy on file). Mr. Storer reviewed assumptions used in the modeling provided to the Committee in the handout. Actual investment results were used through December 31, 1999. He explained that expected median returns for the next 5 years were developed in each asset class. The risk associated with each asset class is also reviewed. The statutory formula for the dividend and the current limitations of the Earnings Reserve Account were used. The model was based on the Department of Revenue's fall 1999 estimates for new income. The model was based on the transfer of the realized earnings reserve into the principal at the end of fiscal year 2000. Mr. Storer reviewed current asset allocation as contained on page 3 of the handout: Cash Equivalents 0% Domestic Bonds 35% Active Large Cap Domestic Equities 17% Passive Large Cap Domestic Equities 13% Small Cap Domestic Equity 7% International Equity 16% Real Estate 10% International Bonds 2% Mr. Storer reviewed the market assumptions as contained on page 4 of the handout: Inflation over the next 5 years - 3.25% Median expected return - 6.7 % U.S. Equity market of large companies - 8.9% U.S. Equity market of small companies - 10.40% International Equities - 9.75% Real Estate - 8.3% International Bonds - 6.5% Mr. Storer noted that the standard deviation on domestic bonds would be 5.5%. Two-thirds of the time the median would be expected at plus or minus 5.5 percent. Returns between 12.2 and 1.2 percent would be expected two-thirds of the time. Vice Chair Bunde pointed out that the expected return could be twice as much or twice as little. Mr. Storer agreed and gave further examples of the range of returns. Mr. Storer reviewed page 5 of the handout: range of ending market value. At the end of 1999 the Fund was $25.132 billion dollars. The median expected at the end of the year 2000 is $27,216 billion dollars. At the end of the year 2003, the median of $32,453 billion dollars is expected. At the 75th pecentile in the year 2003, the Fund would be $27,633. He noted that there is a 10 percent chance that the Fund would be worth $25,246 billion dollars in the year 2003 if there were a prolonged bear market. Co-Chair Mulder clarified that the range of ending market value includes the total fund assets. Mr. Storer reviewed the range of principle balance. The median expected return is 8.25 percent with the balance inflation proofed. If the earnings were not realized there would be difficulty inflation proofing. The range of inflation proofing includes the deposit of the realized earnings reserve into the fund. Under a median case, the principle balance would be $19,699 billion dollars at the end of the year 2000. This would increase to $24,551 in the year 2001. Vice Chair Bunde clarified that the chart indicates what would have occurred if HB 18 had been law and the excess earnings were placed back into the fund. Mr. Storer discussed page 7: the range of ending realized earnings reserve balance. Realized earnings drop from $3.9 billion dollars in FY00 to $928 million dollars in FY01. This reflects the deposit into the principle. Additional realized income in FY01 would be $928 million dollars. In the lower case scenario there would be virtually no income or a probability of negative income. At the 90th percentile the Earnings Reserve Account would be a negative $953 million dollars by the year 2003. There is a 10 percent chance that the Account could grow to $6.2 billion dollars. Vice Chair Bunde clarified that by law the Corporation is required to use the imprudent investor rule. Mr. Storer agreed and added that a prudent investor would use the median base. Mr. Storer reviewed the range of total distributed income. The mid case scenario at the end of the year 2000 would be $1,260 billion dollars of available distributed income. If the decision were made to put the earnings reserve balance into the corpus the distributed income for the year 2003 would be $1,390 billion dollars under the median scenario. He reviewed further scenarios and noted that available distributed income could range from $190 million dollars to $1,976 million dollars in the year 2003. Mr. Storer referred to the range of the per capita dividend. In 1999 the dividend was $1,770 thousand dollars. By the year 2003, the dividend would be $2,264 thousand dollars under the median scenario. The pay out could range from $263 dollars to $3,240 thousand dollars by the year 2003. Co-Chair Mulder stressed that there is a range of volatility. In response to a question by Co-Chair Mulder, Mr. Storer clarified that current statute provides that the determination of the dividend is derived from one half of the balance in the Earnings Reserve Account if there are not sufficient funds to make a pay out on the five year rolling average. Co-Chair Mulder observed that in a protracted bear market where a deposit of the Earnings Reserve balance were made into the Permanent Fund there would no longer be funds available for the default mechanism to kick in with any strength similar to the current size of the dividend. Mr. Storer noted that the Earnings Reserve is currently $7.7 billion dollars. Unrealized gains are $3.6 billion dollars. The balance of $4.1 billion dollars is income realized through February 29, 2000. This is the amount that would be available for transfer into the principle of the Fund. Vice Chair Bunde questioned the affect of the legislation on the dividend. Mr. Storer stated that the deposit of $250 million dollars would have a nominal affect on dividends. Co-Chair Mulder questioned if there would be risk to the dividend. Mr. Storer stated that the more that is retained the less the impact on the dividend on the out going years. Co-Chair Mulder observed that the intent is not to create risk to dividends, but to make a contribution to the Fund. Vice Chair Bunde questioned how much the legislature had deposited into the Fund over the last 10 years. Mr. Storer did not have an exact number, but stated that the amount has been significant. HB 18 was Heard and Held in Committee for Further deliberation.