HOUSE BILL NO. 86 "An Act relating to investment of the power cost equalization endowment fund; and providing for an effective date." 3:18:04 PM PAM LEARY, DIRECTOR, TREASURY DIVISION, DEPARTMENT OF REVENUE, provided a PowerPoint presentation titled "State of Alaska Department of Revenue HB 86 PCE Endowment Fund Investment" (copy on file). She relayed her intent to discuss the fund history and the bill. She turned to slide 2 and communicated that the fund's purpose was to fund the Power Cost Equalization and Rural Electric Capitalization Fund, which helped to reduce the cost of energy in areas with high electrical costs. The fund also covered the costs associated with its management. She continued that 7 percent of the monthly average market value of the fund for the previous three fiscal years may be appropriated. She relayed that the fund had been created in 2000 with an appropriation of $100 million from the Constitutional Budget Reserve (CBR). In 2002 the Power Cost Equalization Fund (PCE) received $89.6 million from proceeds of the sale of the four dam pool hydroelectric project; it had received two subsequent appropriations of $182.7 million in 2007 and $400 million in 2012. The fund balance at the end of February 2015 was $986 million. Ms. Leary discussed the bill's purpose on slide 3. She explained that the bill would remove the stated nominal return target of at least 7 percent of the statute. The bill would allow the commissioner of the Department of Revenue (DOR) to invest the fund in a manner that would meet the fund's objectives by providing flexibility as it related to the rate and the risk associated with certain types of investments. She explained that the bill was important because it would enable the DOR commissioner to invest in less risky investments, when appropriate, that would continue to meet the financial needs of the program. She relayed that the bill had a zero fiscal note. 3:20:56 PM JERRY BURNETT, DEPUTY COMMISSIONER, TREASURY DIVISION, DEPARTMENT OF REVENUE, highlighted that one of the fundamentals of asset management was to seek the highest rate of return with appropriate risk levels. He drew attention to the 2015 capital market expectations for return and risk from Callan Associates (slide 4). He noted that Callan Associates was the financial advisor to the Alaska Retirement Management Board and to the Alaska Permanent Fund Corporation (APFC). He pointed to the arithmetic and geometric return and standard deviation (projected risk). He remarked that the geometric return was less than the arithmetic return. He highlighted the 19 percent standard deviation for the broad domestic equity category, meaning that two-thirds of the time returns were expected to be within 19 percent of the 9.15 percent arithmetic return (-10 to 29). He explained that the arithmetic return over time was used to calculate the geometric average (some years would be well below the arithmetic average, while some years would be well above). He noted that the [10-year] geometric return for broad domestic equity was 7.6 percent. He remarked that 7.6 percent was one of the highest returns on the chart; emerging market equities had a return of 7.9 percent, but with a 28 percent standard deviation). Mr. Burnett discussed that when constructing a portfolio to achieve a 7 percent return (given the 2015 capital markets), nearly 90 percent of assets should be equities. He explained that based on a 19 percent standard deviation, a -10 percent return would occur in one out of six years. He discussed that equity markets had been positive for six years in a row; therefore, it was fairly likely that negative returns would occur sometime in the next several years. He relayed that DOR did not feel comfortable building or recommending a portfolio that was 90 percent equities because it was currently beyond the risk tolerance. He elaborated that in 2002 a portfolio achieving an 8 or 9 percent return could have been constructed with similar risk as at present. He noted that it varied from year to year. He communicated that inserting 7 percent in statute could create a situation where the department was managing to a risk that was beyond what was reasonable for the markets. He stated that APFC had an expected rate of return of approximately 6.17 percent in the current year. The department wanted to have the ability to manage appropriate risk while achieving the highest rate of return within the risk tolerance rather than to a fixed number. He noted that the Treasury Division managed over 40 unique asset allocations; the Power Cost Equalization Fund was the only major fund that had a specific target return identified in statute. 3:24:59 PM Representative Edgmon asked why a lower number was not identified. Mr. Burnett did not believe a lower number should be identified. For example, if the target return was 5 percent, the asset allocation may be less risky than what was responsible over time. He relayed that no number would be durable; what may be good at present may be very bad at another time. He noted that in 1982, money market rates had been at 10 or 11 percent and mortgage bonds could be purchased with 18 percent interest rates. He explained that a portfolio constructed for that time may be very different. He reiterated that it was not possible to set a durable number that made sense in the long-term. Representative Edgmon asked for verification that it would be at the discretion of DOR and its fund managers to manage the target year after year. He surmised that the target may be 6 percent in some years and 5 percent in others. He wondered why the department had not elected to pick a target that was more commensurate with the state's other long-term endowments such as the CBR. Mr. Burnett answered that DOR would look at an asset allocation that was durable and would set the expected rate of return off of a reasonable risk asset allocation rather than looking at setting an allocation to a specific target number. Management factored in that the fund needed a certain amount of income annually; there was a payout rule that was 7 percent of the prior three years' monthly rolling average balance. The fund was managed to meet its intent, but the asset allocation was not set to a hard number. Representative Edgmon asked what assurance he would have as a rural legislator that the fund was being managed for the long-term. Mr. Burnett answered that the returns were available for review. Additionally, the DOR commissioner and staff were available to discuss the strategy and returns. He noted that the legislature had annual hearings on fund performance. He explained that other funds did not have target returns identified in statute. He cited the CBR, the Alaska Permanent Fund, and the Higher Education Fund as examples. He explained that the flexibility provided more assurance in an environment like the present that the commissioner would not try to set to a 7 percent level, which may result in lost money the following year. 3:28:45 PM Representative Edgmon stated that the PCE endowment fund was large enough that if managed in a conservative manner it should be able to satisfy the annual outlay of PCE costs (approximately $42 million to $45 million). He wondered what return the fund would target. He noted that the fund was close to $1 billion and small number of 4 or 5 percent was needed. He surmised that management would want to stick to a target rate over time. He wanted to ensure that money managers would not have free reign to ride the market and make more risky investments when they were not needed. Mr. Burnett replied that each of the funds managed by DOR had a purpose including expected payout, duration and other. The department set new asset allocations annually on July 1 based on capital market expectations; the allocation did not necessarily change every year. Department staff analyzed risk and program needs on a full-time basis. He noted that under the legislation the commissioner would manage the fund to meet the needs of the PCE program. Representative Edgmon surmised that the probability was that the department would be managing the fund for a rate below 7 percent. Mr. Burnett replied that it was most likely that the fund would be managed for a rate below 7 percent in 2015. He could not predict the target rate for 2016. Representative Guttenberg asked how the objectives for the PCE fund were defined. He wondered about the definition and objective of the Rural Electric and Capitalization Fund. He believed the objectives may be different or in conflict if the 7 percent target was removed from statute. He was concerned about what the state was "letting out of the box." Mr. Burnett responded that determining asset allocations was based on the legal purpose of each of the funds. He explained that the PCE fund's purpose was to equalize the power cost per kilowatt hour, making grants and power cost equalization available to eligible electric utilities. He relayed that a payout rule of 7 percent of previous years was currently in statute. He communicated that the PCE fund had earned about 20 percent in 2014 and an average of 14 percent over the past five years; since inception it had earned just over 6 percent. He explained that the department would look at the fund's specific purpose just like it did for each of the other funds it managed. He added that there was nothing unique about the fund and its purpose that created a different look. The department considered the fund's legal requirements, its purpose, its timeframe, and other. 3:33:59 PM Ms. Leary added that 7 percent had been the target; however, having the target identified in statute had resulted in a return of -13.87 percent in 2009. The return had been negative 4 years out of 15; it had also been as high as 21.8 percent with the same target. She elaborated that a target may come to fruition, but may not. She clarified that capital market expectations were only expectations based on known economic factors; there generally tended to be a 10-year expectation. Representative Guttenberg asked if the department's responsibility would fit inside the successes of the permanent fund. He wondered how the end result would differ if the department had moved its management into the permanent fund portfolio. Mr. Burnett replied that the permanent fund had some unique assets that the Treasury Division would not consider holding due to their illiquidity. He explained that because the PCE fund was non-dedicated it had to be available and liquid at some level at all times. He stated that DOR would not make the recommendation, but if the legislature chose to change the purpose of the fund [the portfolio could invest in illiquid assets]. He furthered that the permanent fund was a constitutionally dedicated fund and held assets that could not provide money for 5 to 10 years (e.g. private equity or long-term real estate investments), which would never be considered for a state-managed fund. Additionally, the permanent fund may hold assets that Treasury was not allowed to hold under Securities Exchange Commission rules. Co-Chair Thompson asked committee members to be cognizant of the time and relayed that the bill would be heard again at a later date. Vice-Chair Saddler wondered if the bill had been prompted by the desire to revert to more a prudent investment rule, the declining revenue stream required by lower energy prices, or by fear of the coming market correction. Mr. Burnett answered that there had been no consideration of the declining need for a revenue stream. The decision had been based on a prudent investment rule and the unwillingness to take on risks beyond what were prudent. Vice-Chair Saddler stated that when the AKLNG gasline project came to fruition 25 percent of its royalties would be dedicated towards the energy needs of rural Alaskans off the Railbelt. He asked if the bill would allow the PCE endowment fund management to adjust to the reality of a new funding source with the same purpose. Mr. Burnett answered that if the money went into the fund it would allow for changes. He elaborated that the purpose of the fund, the realities of the marketplace, and the fiscal realities of the state were all taken into consideration by the department. 3:38:00 PM Representative Edgmon clarified that it was 20 percent of the royalty revenues [that would be dedicated to rural Alaska energy needs when the AKLNG project came to fruition]. Representative Munoz asked if the fund was managed in-house or by outside managers. Mr. Burnett replied that the fixed income component was managed internally; the rest was managed by external managers. Representative Munoz asked if the management fees were typical. Mr. Burnett agreed. Representative Munoz asked about 14 percent earnings from the previous year. Mr. Burnett clarified that the earnings had been 20.7 percent the previous year and averaged 14.5 percent over the past five years. He added that the fund had grown quite rapidly over the past several years. Representative Munoz asked for the growth in dollars. Ms. Leary replied that earnings had been $171 million in 2014. Representative Munoz spoke to a payout of roughly $45 million to communities. She wondered if the balance of the earnings was deposited directly into the fund or for other purposes as well. Mr. Burnett answered that the earnings that were not used for fund management or the PCE program remained in the fund. Representative Gattis asked why the PCE fund had not originally been set up like the other state-managed funds. Mr. Burnett answered that he did not recall the discussion on the original language related to the fund's investment purposes. He relayed that the fund had been implemented in 2002. He was not certain that any changes had been made to the fund's investment since inception. He relayed that it was not the first year DOR had requested the change; the department had identified the issue as problematic in previous administrations as well. Representative Gattis asked if it was the first time a bill had been presented. Mr. Burnett replied in the negative. Representative Gattis surmised that a bill had failed in the past and the department was giving it another attempt. Mr. Burnett replied in the affirmative. He thanked the committee for hearing the bill. Ms. Leary informed the committee that DOR had a great website that included significant information about the PCE fund and other funds managed by the Treasury Division. Additionally, the website included cash management and all aspects of the division. HB 86 was HEARD and HELD in committee for further consideration. Co-Chair Thompson discussed the agenda for the following day. Vice-Chair Saddler informed committee members that the Department of Health and Social Services budget subcommittee would hear a Medicaid 101 presentation the following morning.