CS FOR SENATE BILL NO. 326(STA) "An Act relating to investments of Alaska Permanent Fund assets; and providing for an effective date." This was the first hearing for this bill in the Senate Finance Committee. Co-Chair Wilken stated this bill, offered by the Senate Rules Committee by Request of the Division of Legislative Audit, "modifies the investment guidelines for the Alaska Permanent Fund." BOB STORER, Executive Director, Alaska Permanent Fund Corporation, testified that whereas most public funds merely follow the prudent investor rule to make their asset allocation decisions, the Permanent Fund is additionally guided by a statutory list, which dictates criteria for the types of investments that could be made. This legislation is requesting increased flexibility in the management of the fund for two reasons. First, in the near future the Fund would reach its statutory limitations, forcing it to sell assets based solely on these restrictions. Second, this flexibility could be utilized to develop a future management tool. Mr. Storer gave a Power Point presentation as follows. 1 Alaska Permanent Fund Senate Finance Committee Senate Bill 326 Investment Flexibility 2 Summary of Fund's statute changes 1980 - SB 161, Sponsored by Sen. Tim Kelly, Sen. George Hohman, Sen. Mike Colletta, and Sen. John Sacket SB 161 created the Alaska Permanent Fund Corporation to manage the Permanent Fund and started the existing statutory list of allowed investments. This list extended beyond the Fund's initial investment limitation of Treasury bonds to include corporate bonds, certificate of deposits and bankers acceptances. The list initially allowed the Permanent Fund to invest in shares of savings and loans associations, but this provision has since been removed. 1982 - SB 684, sponsored by Gov. Jay Hammond SB 684 allowed the Permanent Fund to invest in common stocks, partial ownership of real estate properties (not to exceed 40%), loans for commercial real estate and deposits of US dollars held oversees. 1989 - HB 69, Sponsored by Gov. Steve Cowper HB 69 gave the APFC authority to invest in non-domestic (International) stocks and bonds. 3 Summary of statute changes (cont.) 1992 - SB 39, sponsored by the Senate Finance Committee SB 39 gave the APFC authority to invest in A rated corporate bonds to a maximum of 5%. Prior to this change, the Fund could only be invested in bonds rated AA or higher. 1994 - HB 373, sponsored by Legislative Budget and Audit Committee HB 373 allowed the fund to own up to 100% in real estate properties worth less than $150 million, and up to 67% in properties worth greater than $150 million. 1996 - HB 525, sponsored by the House Finance Committee HB 525 gave the APFC authority to invest in corporate bonds rated BBB or higher. 1999 - HB 156, sponsored by the Legislative Budget and Audit Committee HB 156 allowed the Fund to leverage real estate investments and increased asset allocation limit for stocks to 55% of the total market value of the Fund. HB 156 also created the "basket clause" that allows up to 5% of the Fund to be invested in alternative investments or to be applied to existing asset allocations to expand their limits. In addition, HB 156 allowed the Permanent Fund to be the sole owner of any real estate property, regardless of value. Mr. Storer responded to criticism that increasing the flexibility of the Fund would be too risky, by emphasizing that the Fund's prudent use of the basket clause must be considered. The Fund has only now begun to utilize the basket clause provisions established five years ago. 4 Fund's historical asset allocation [This graph demonstrates the percent of funds allocated to: U.S. Fixed Income, U.S. stocks, Non-U.S. Fixed Income, Non- U.S. stocks and Real estate, between the years 1978 and 2002.] Mr. Storer emphasized the changes in the asset allocation of the Permanent Fund as it was "given the ability to invest in expanded legislative authority". He emphasized the judicious nature of the Permanent Fund in expanding investments. 5 Benefits of proposed changes · Investment flexibility · Increased returns · Increased diversification Mr. Storer qualified that the Fund needs increased investment flexibility to enable future administrators of the Fund to meet the needs of the dynamic investment management industry. Additionally, increasing the Fund's investment flexibility would make a five- percent real rate of return more probable. Increased investment flexibility does not necessarily translate into increased risk, but rather into greater diversification. Investing in diverse investment classes actually reduces risk. Mr. Storer added that, "risk is measured not by losing money, but by the volatility of returns from year to year." 6 Potential questions · Too much risk? · How will the Board of Trustees use this flexibility? · Derivatives? Mr. Storer reiterated the traditional judiciousness of the Permanent Fund. Considering other public funds, the increased investment flexibility proposed in this legislation would be a conservative structure. Mr. Storer continued by giving some specific examples of the Fund's possible implementation of this legislation. 7 Permanent Fund asset allocation [This bar graph demonstrates the percentage of the Fund that was, or would be invested in: Traditional asset classes, Basket clause-stocks, Basket clause-private equities, and Basket clause-hedge funds, on the following dates: 12/31/03, 6/30/04, 12/31/04 and 6/30/05] Mr. Storer stated that recently, because of the appreciation in the equity market, the Fund has begun utilizing the basket clause. The Fund would soon implement two more strategies, which fall under the basket clause: a hedge fund strategy, and a diversified portfolio referred to as private equities. Within a few years, the Fund's five-percent of alternative investments allowed for in the basket clause would be exhausted. Co-Chair Wilken asked if all Permanent Fund managers have access to the provisions of the basket clause. Mr. Storer replied that not all of the managers have access to the basket clause. Specific managers are granted the authority to use the provisions of the clause based on resolutions, statutes and individual contracts. Senator Bunde asked how the Permanent Fund would have been affected if the hedge fund and private equities strategies that are proposed for 2005, were enacted in 1995. Mr. Storer responded that higher returns would have been realized if the proposed allocations were implemented in 1995; however, if they were enacted in 2000 the private equity portion would not have done well and the hedge fund portion would have "added superior returns". Senator Bunde inquired as to how the Permanent Fund's investment portfolio would have been affected as a whole, given the scenario. Mr. Storer speculated that given the bear market, the overall result would have been similar to what is currently being achieved by those investment strategies. Senator B. Stevens asked for a clear interpretation of the bar graph on slide seven titled, "Permanent Fund asset allocation". Mr. Storer clarified that the bar graph represents the existing investment authority of the Fund. Senator B. Stevens asked if requiring a five-percent limit in each investment class, and considering certain alternative investment strategies are appreciating in value, is forcing the Fund to utilize realized earnings to remain within the five-percent limit. Mr. Storer affirmed and elaborated that the Fund would be forced to liquidize securities and take the realized gains if the five- percent limit was approached. Senator B. Stevens suggested that if the percentage limit was increased to 10 percent, and distribution guidelines were retained, the need to use realized earnings would diminish. As a result the realized earnings would not grow at the rate they are currently. Mr. Storer qualified that during this period the Fund's other investments would also be realizing earnings, especially private equities. The amount of realized earnings would be significant, although less than if forced liquidation were required. Under the expanded clause, the realized earnings would likely be equal to or greater then the current basket clause. Senator B. Stevens asked if the investment status quo were maintained and the basket clause increased, whether the potential for realized earnings would diminish. Mr. Storer predicted realized earnings would increase over the long term: a period of five or more years. SFC 04 # 60, Side B 09:51 AM Mr. Storer continued that in the in near term, if the basket clause were expanded, he would expect realized earnings to be the same or higher than current earnings. The differences would be attributed to market performance and Fund policy not dictated by statute. Senator B. Stevens remarked that every managed fund has imposed limitations on investment classes and when those limits are reached the fund is forced to realize earnings. Possible reductions in realized earnings due to an extended basket clause would be incidental under the Percent of Market Value (POMV) pay out plan, but the possible reduction in realized earnings could significantly affect the current pay out method. Mr. Storer informed that when the Fund develops asset allocation a target allocation is established for each asset class. Restrictions are then created to avoid a high-turnover environment, which would result in high transaction costs. He informed that policy currently imposes these bans and that this legislation would make the bans statutory. Senator B. Stevens asked if these provisions are not already statutory. Mr. Storer replied that statutory provisions have always existed; however, the Fund is nearing the limitations for the first time in its history. Senator Hoffman clarified that allowing the Fund administrators to alternatively invest 10 percent of the assets of the Fund would translate into making accessible $2.8 billion. He recalled dialog on this legislation in the Senate State Affairs Committee in conjunction with the Board of Trustees' other recommendation that the Fund be managed under a POMV system. He expressed concern that when dependent upon a certain income source, higher risk investment options are not taken. He used the example of a retirement investment fund that is invested in higher risk ventures when the worker is younger and transitions to lower risk investments as the worker nears retirement. If the POMV plan were implemented, dependence on the Fund's earnings would gradually increase suggesting investment in lower risk ventures. Mr. Storer replied that when developing a portfolio, an investment time horizon, risk tolerance, and expected returns are considered in order to ensure a sufficient cash flow. He noted that unlike a retirement fund, an endowment fund with a POMV method is not managed for eventual liquidation of assets but rather the real income is used to supply a predictable cash flow. The POMV plan would insure the long-term viability of a fund. If the Fund's earnings were eventually used to fund both dividends and State government, its investment portfolio must be restructured to maintain multiple cash flows. He spoke to the advantages of investment flexibilities to enhance the Fund's ability to provide revenue. Senator Bunde referenced Senator B. Stevens' earlier comment that the current payout system forces sale of high performing investments resulting in realized gains. If this legislation were adopted under the current payout system, dividends would likely be higher. However, if both this legislation and the POMV plan were adopted, fluctuation of dividend amounts would decrease. He cautioned against forcing poor management decisions to increase dividend amounts, warning that the future value of the Fund would be jeopardized. He was undecided on the matter. Senator B. Stevens spoke to Senator Hoffman's point, expressing agreement with Senator Hoffman's example of the management of a "finite pool" of capital. However, Senator B. Stevens emphasized that the Permanent Fund is not a finite capital fund because it receives royalty payments and statutory inflation proofing funds. Co-Chair Wilken asked the witness to comment on Senator Bunde's statement. Mr. Storer responded that the current pay out methodology is based on a five year moving average of realized income. To date, the income from the Fund has been used for three purposes: dividend payments, special appropriations to the principal of the Fund, and inflation proofing of the Fund. More realized income translates to a greater pool of money available for distribution. Due to the current strict formula for distribution, any program that accelerates realized income would produce a larger dividend. Senator Olson introduced members of the Kotzebue High School Leadership Program who were attending the meeting. Co-Chair Green recalled that adoption of the basket clause was discussed extensively during 1998 and 1999, with some parties viewing the provision with skepticism and others "with a great deal of faith". Through those discussions she came to realize that placing a ceiling within a system creates constraints on choices leading to success. The State expects the Permanent Fund's Trustees to have the ability to invest "widely and deeply". Constraints diminish that ability and at times force the Fund's Trustees to compromise the profitability of the Fund. The dividend should not be the focus of discussion when considering this legislation, but rather the two clear objectives that are stated in the Alaska Permanent Fund Corporation's "Sponsor statement for SB 326" [copy on file]. Mr. Storer agreed. He assured that the Corporation has been judicious in exercising the authority granted to it by the legislature. At no time in past discussions with the legislature has the dividend been the focus. The goals of this legislation remain twofold: to insert housekeeping legislation to express the need and intent of the basket clause and to increase the basket clause from five to 15 percent. Senator Stedman made a motion, supported by the Permanent Fund's Board of Trustees, to reduce the limit to 10 percent, which would provide the Permanent Fund Corporation with flexibility in the next few years. The Trustees' eventual alternative investment goal remains 15 percent. Co-Chair Wilken questioned the language in Section 1, amending AS 37.13.120 (e), which states that the Corporation could "borrow money if the borrowing is without recourse to the corporation and the fund." He asked if this language would allow the Corporation to not repay loans. Mr. Storer replied that the Corporation could not pledge the principal of the Fund. The Corporation only has a small amount of leverage to borrow from within its real estate portfolio, approximately 15 percent of assets. The Fund operates subsidiaries as limited liability corporations and collection on loans made to these subsidiaries could not access the Permanent Fund. Co-Chair Wilken noted the delay in publication of the Producer Pricing Index for January and February 2004 and asked whether the Trustees have discussed this. Mr. Storer responded that the matter has not been discussed in detail. He informed that the Producer Pricing Index figures for December 2003 are being studied extensively as they will be used to determine the level of inflation proofing. Co-Chair Wilken commented that this information affects inflation and interest rates. Mr. Storer relayed that inflation appears to be rising, but very slowly. Senator Hoffman asked if the Board of Trustees considered the State's future dependency on the Fund when crafting the proposed legislation. Mr. Storer answered, "absolutely". The Trustees' strategy is to focus on investment diversification, which will enhance the Fund's ability to meet the State's future needs. Senator Bunde suggested that under the current payout system the Board of Trustees could be pressured into selling assets to increase realized earnings, and consequently, a greater dividend. He asked the witness if this scenario is feasible. Further, he inquired if the proposed legislation would prohibit such exploitation by a future Board of Trustees. Mr. Storer acknowledged that a Board of Trustees could affect realized gains either for good reason or artificially, and stated that such a probability exists whether or not this legislation is implemented. Co-Chair Green offered a motion to report the bill from Committee with individual recommendations and accompanying fiscal note. There was no objection and CS SB 326 (STA) MOVED from Committee with zero fiscal note #1 from the Department of Revenue.