CHAIRMAN TAYLOR brings up SB 170 (DISPOSITION OF PERMANENT FUND INCOME) as the first order of business before the Senate Judiciary Committee today. SENATOR RIEGER, Prime Sponsor, states discussions took place in the legislature in the early 1980s regarding the order of priorities of uses of the permanent fund earnings. The result of those discussions was that dividends were given priority over inflation proofing of the permanent fund. Sentor Rieger feels that was an incorrect prioritization. He considers the permanent fund to be a long range fund for Alaska which needs protection for future generations. Senator Rieger believes not inflation proofing the fund puts it in jeopardy. SB 170 would place inflation proofing as the top priority by referring to income as real income. Senator Rieger acknowledges that this could slow the rate of growth of dividends. He notes that in the previous committee, the Director of OMB (The Office of Management & Budget) testified that the Administration was in support of SB 170. SENATOR HALFORD comments he would never send the House a title stating "AN ACT RELATING TO THE INCOME OF THE PERMANENT FUND." He indicates that changing the priority between inflation proofing and dividends should not necessarily have an effect on the dividend payment schedule. Senator Halford asks if the change would make the reserve more critical for dividends than for inflation proofing. SENATOR RIEGER explains that the change would retain, in statute, the various provisions describing the uses of earnings of the fund, other than removing the statutory provision which would re-invest a sum equal to inflation. That would no longer be necessary. SENATOR HALFORD comments that would not be necessary due to the change from net income to real income. SENATOR RIEGER states that when there is positive inflation, real income would be smaller than total return. SB 170 attempts the least amount of switching around of the statutes. Senator Rieger states that the earnings reserve is necessary under the current regime to cover short falls in inflation proofing, or to cover short falls in the pay out rule because of five year averaging. If inflation proofing is given a higher priority, then one of the reasons to have the reserve is removed. SB 170 does not speak to what should be done with the reserve. Number 119 SENATOR HALFORD states that there is more involved than changing the priority between dividends and inflation proofing. He expresses concern with other provisions and their effect on dividends due to the way the bill is drafted. Senator Halford asks the difference between what would be taken out in the net income scenario, versus the real income scenario. SENATOR RIEGER responds that the corporation appears to be backing away from their conservative assumption, the long term greater return being 9 percent total return, with a 6 percent inflationary environment. Senator Rieger thinks the corporation is discovering the advantages of reviewing asset allocation as a fundamental portfolio strategy. In many forcasts, an inflationary environment is using up two-thirds of the total return. SENATOR HALFORD asks if it would still use up more than half. SENATOR RIEGER responds it would not always do so. Some forecasts put inflation at the 4 to 5 percent range, with the total return above 10 percent. Senator Rieger states that it would depend upon the amount allocated to equities, as opposed to the amount allocated to bonds. Senator Rieger hopes that the permanent fund will earn more than a prudent portfolio while managing the money in a more diversified manner. SENATOR LITTLE asks if Senator Rieger intends to change the title of SB 170. SENATOR RIEGER replies he does not have a problem with tightening up the title, but feels the Rules Committee would be the best place to address that concern. CHAIRMAN TAYLOR expresses desire to deal with the title now in a committee substitute. Number 204 JIM KELLY, Research & Liason Officer, Alaska Permanent Fund Corporation, states that SB 170 will protect the permanent fund principal better than the status quo, in the case of a conflict over the fund by the trustees. Asset allocation is done annually with five year projections of capital returns. Mr. Kelly explains that assumptions are used to determine earnings for asset classes. The main job of the trustees is to determine how much money they are going to put into those asset classes. The corporation estimates a rate of return at 8.37%, on average, over the next five years. They project an inflation rate of 4 percent, therefore, beating inflation by 4.37 percent. Mr. Kelly notes that after five years, the corporation would beat inflation by only 3 percent, which is closer to the historical average. CHAIRMAN TAYLOR asks Mr. Kelly if he is projecting 4%. MR. KELLY clarifies that this year the corporation is looking at a 5% rate of return. Inflation is only 2.95%. Mr. Kelly explains that for the first seven months of the year, a rate of return of 7.95% is projected, which would beat inflation by 5 percent. Mr. Kelly projects that the corporation would beat inflation by 4.37%, with inflation projected at 4%. CHAIRMAN TAYLOR points out that since President Clinton expressed concerns, the interest rates were increased by the Federal Reserve in order to slow inflation. MR. KELLY informs the committee of a board meeting tomorrow, March 10, discussing this issue. Mr. Kelly reiterates that the corporation's best estimate is a rate of inflation of 4%. SENATOR DONLEY asks how income is treated when the decision is made to sell stock. MR. KELLY responds that earnings are net income, when realized gains are taken into account. Mr. Kelly states that over the long term, the corporation views net income and total return as the same, because eventually the profits are taken. A projected 9% average earnings includes returns on investments, stocks, dividends, interest, and capital gains. SENATOR DONLEY notes that when stock is sold, a great deal of income could come in at one time. MR. KELLY informs the committee that in the spring of 1987, the corporation sold $700 million from the index account, which resulted in $300 million in profits. The index account is a bankers trust, with the corporation deciding when to sell. Mr. Kelly notes that the corporation has $5 billion in the stock market now. That investment has been averaging $7 million per month in realized gains. Number 267 SENATOR HALFORD notes that sheet #1 is the status quo, while sheet requests that the comparisons be made in real dollars instead of nominal dollars in order to realize the purchasing power of the dividends. The dividend seems to climb although it does not. Senator Halford explains that the status quo shows a dividend of $1166 in five years, while SB 170 cuts that dividend almost in half. Senator Halford asks what the reasoning is behind that and how would work. MR. KELLY responds that the real income, the amount on sheet #9, is net income minus inflation proofing. That explains the difference in dividend amounts. In response to Senator Halford, Mr. Kelly states that SB 170 takes the inflation component out of the net income. SENATOR HALFORD asks how we would re-prioritize inflation proofing versus dividends without doing that. MR. KELLY replies that putting a line in the law saying, "not withstanding any other provision of law, inflation proofing shall be paid first." SENATOR HALFORD feels that dividends or inflation proofing first work well. However, he does not want to adopt a schedule that will increase the ability to spend General Fund money at the expense of the dividend revenue. CHAIRMAN TAYLOR asks if it would actually have that impact. SENATOR HALFORD says the chart illustrates that impact. MR. KELLY points out that on sheet #9, the add column under Reserves is a large portion of the dividend stream. SENATOR HALFORD asserts that a huge reserve is being built in order to get the money to the General Fund. MR. KELLY states that sheet #10 illustrates what happens when a huge reserve is built. SENATOR HALFORD comments that then the dividend would be cut in half. SENATOR RIEGER explains that the best case forecast shown as #1 seems very conservative because it reflects the same assumptions of the dividend fund of ten years ago. At that time, two-thirds to three-quarters of the permanent fund was in bonds. He notes that the size of the dividend, when used for comparison, actually makes a draw on the reserves in order to pay that amount. The dividend is inflated; the comparison is unfair. SENATOR HALFORD points out the progression of falling dividends under SB 170. SENATOR RIEGER states more realistic returns need to be reviewed. The rate of growth of dividends is slower. He refers to sheet #11 and notes that the dividend is still $2000 at the end of the page. SENATOR HALFORD comments that $2000 in real dollars is probably less than the current dividend. MR. KELLY asks the committee to compare sheet #3, with sheet #11. SENATOR HALFORD suggests that the same assumptions should be taken with or without SB 170. He asks if there is a sheet with a 9.93% rate of return and 4% inflation. MR. KELLY replies that sheet #3 fits those specifications. SENATOR HALFORD comments the comparison would be sheets #2, #3, and Number 362 SENATOR LITTLE asks for an explanation of the charts regarding financial projections of the permanent fund. MR. KELLY responds sheet #1 was the basic chart; the other charts reflect different assumptions. Mr. Kelly discusses the various components of the charts. The specific differences in the charts are expressed in the bold type at the bottom right corner of the sheets. SENATOR HALFORD asks how much time the corporation would need to do the same set of charts in real numbers. MR. KELLY replies the charts have already been completed. SENATOR HALFORD requests a copy of the charts. CHAIRMAN TAYLOR asks which chart gives the highest yield. MR. KELLY directs the committee to sheets #15 and #16. Sheet #15 assumes that the money is added to the reserve account, while sheet sheets assume there would be an 11.33% rate of return. SENATOR HALFORD asks if there is a comparison of the current status with those returns. MR. KELLY responds that a comparison is contained in sheets #7 and CHAIRMAN TAYLOR and SENATOR HALFORD discuss those two sheets. MR. KELLY states the corporation expects to beat inflation by 4.5% over the next five years. If a formula of growth for the dividend was compared to a cap, this would allow the dividend to grow over the long term. SENATOR HALFORD opposes changing the formula, which would drastically reduce future dividends. For every $100 million taken out of the dividend revenue stream, $32 million would be taken away from children and $15 million would be taken away from retired and senior citizens. He asks if the sponsor is interested in making inflation-proofing a higher priority, or the changing the formula. Number 437 SENATOR RIEGER responds nothing has been earned unless inflation has been beaten. Accounting has not been structured to accommodate inflation. We are leading ourselves to believe that we are doing better than we really are. He thinks real earnings should be used when adopting policies, otherwise it is misleading. The method on which earnings are based needs to be restructured. SB 170 would structure payouts on what is really earned, which would give the most protection to the corpus. In concluding, Senator Rieger states SB 170 prioritizes inflation-proofing. SENATOR HALFORD states what is being done to dividends is for the benefit of the reserve. He thinks it would help with inflation- proofing the permanent fund management structure, which would be better than a cap. SB 270 could be drafted to match the current permanent fund payout, the reserve would then not be as needed. The reserve would then be more likely to be placed in state revenues to help fund government. Senator Halford states that changing the permanent fund dividend formula, while continuing to spend, would result in disaster. CHAIRMAN TAYLOR suggests providing a formula in the bill which would roll the reserves into the corpus of the fund after they reach a certain level. SENATOR HALFORD talks about the schedules for setting dividends. He thinks reducing the dividends and using that reduction for government expenses would be a regressive form of taxation. CHAIRMAN TAYLOR thinks both the long-term and short-term concerns can be addressed by changing where the money goes. Number 514 SENATOR HALFORD states that Hammond's original proposal was much simpler than all this stuff: put half the money back into the principal for inflation-proofing, and put the other half into dividends. CHAIRMAN TAYLOR states that formula isn't any good if the fund is only earning 10%, and inflation just hit 15%. A simple answer to a complex problem will normally be incorrect. SENATOR HALFORD asks Mr. Kelly what the highest rate of return has been on the permanent fund. MR. KELLY responds the highest rate of return was somewhere around 12% to 13%, but he could not say for certain. CHAIRMAN TAYLOR says he thought it was up around 14% or 15% a couple of years ago. MR. KELLY replies that would have been total return; he is speaking ng of cash return. Number 535 CHAIRMAN TAYLOR comments the committee needs to look at a title change and discuss the issue further. The Chairman asks if there is any further comment on SB 170. Hearing none, the chairman announces he will bring SB 170 up at a later date.