SJR 18-CONST. AM: PF APPROPS/INFLATION-PROOFING  VICE CHAIR OGAN announced SJR 18 to be up for consideration. MR. BOB STORER, Executive Director, Alaska Permanent Fund Corporation, said they have always felt that inflation proofing was an important issue in the Permanent Fund to make sure that all generations benefit equally from it. To date, the fund has been fully inflation proofed. The board has unanimously recommended memorializing inflation proofing in the constitution. They propose doing that by adjusting how much can be appropriated in any single year to no more than five percent of the total fund. That computation is based on five percent of the five-year moving average of the market value of the Alaska Permanent Fund Corporation. This formula is consistent with about 70 percent of the foundations and universities across the country. They believe they can earn a real rate of return over time of five percent in excess of inflation. He explained that the status quo only inflation proofs the principal of the fund and it consists of royalty mineral money, revenues, special appropriations and inflation proofing. The Legislature has always inflation proofed the fund and the three components are almost all equal. Right now the principal is about $22 billion. They want to limit the amount that can be appropriated from the real income of the fund over time. "Under the status quo, the entire earnings reserve can be appropriated and that can vary from year to year." In other years, when the earnings reserve comprised about 25 percent of the fund, a quarter of the fund could have been appropriated, but if that happened in the last couple of years when the earnings reserve was actually negative, then there would be nothing available for appropriation. He said that the earnings reserve right now is about $2 billion, which is a product of the last six weeks. MR. STORER explained that there is more stability with this methodology than using a realized income basis for what is available for appropriation and the dividend is computed from realized income. They are very comfortable saying they could do this consistently. SENATOR OGAN said he heard that the average draw on the Permanent Fund was about four percent. MR. STORER replied that on average, that's a reasonable statement, but that it is a volatile number. MR. BOB BARTHOLOMEW, Chief Operating Officer, Permanent Fund, said the way the fund has been invested has changed a lot over the last 20 years. When the fund was first invested, it was 100 percent in bonds and almost all of the earnings of the fund was cash flow interest income. The formula was designed to work that way. Twenty years later, we're in stocks that have a lot of their return through capital appreciation. We do get dividends, but the majority of the return comes from the growth in the value of the stock....So, early on when we say that the payout for the dividend was roughly about 4 percent of the fund, all our income was coming in in cash and we were paying it all out. Today, that percentage is dropping because a lot of the growth comes from the appreciation of assets and we don't sell our assets. We hold on to real estate for a long time; stocks that are in the index fund - we just hold the index fund. We might hold it for 10 or 12 years. All of that appreciation that's happening in assets does not go into the dividend formula today. So that dividend formula, how much cash income we have is a percentage of our total income, is just dropping. By switching to the payout of market value, we're computing, and we recommend, that all the distributions from the fund take into account the entire fund and the change in value, which is both your cash flow and your appreciation. MR. STORER added that the fund is about 26 years old and was created after the bear market of 1973 - 74. Very few public funds were invested in the stock market. Basically, the thinking was fixed income and then cobbled from there to go into equities in the early 80s and international equities in around '88 - '89. With equities you can expect a higher return, but more volatility from year to year. Using a smooth payout of the market value actually creates less volatility than the realized income methodology that we use right now - which goes to the fifth item, which is predictability. What we have learned and what we think is advantageous to decision makers, be it the Permanent Fund or the Legislature, is the look back provision. We are stating that it should be the moving average of the five years of the five prior fiscal years. The advantage to decision makers in the Legislature [is that] when you come into session in January, you will know exactly how much money is available, be it for dividend, government, etc. You will have that knowledge right there. For those of us at the fund managing the assets, one of the main things you try to do with the hidden costs of the fund is transaction costs. When you're trading your portfolio, if you think of it right now, we won't know how much will be appropriated for the dividend until the computation is completed on June 30. Three weeks later, we'll have to have about one billion dollars liquidated and moved over to the Department of Revenue for processing in the dividend division. We strive very hard to mitigate the effects of transaction costs as much as possible. If we have greater predictability on that fact, we will have the knowledge to be able to address the liquidation in some systematic way which will further reduce the costs associated with liquidating those kinds of assets.... SENATOR OGAN asked if they go with the five percent, what would last year's dividend be versus what it's projected to be. MR. STORER replied that they looked at that question and came up with two answers. One is that there would be no change in the dividend if the formula for computing the dividend remains the same. There are two formulas, one based on realized income and then one based on the POMV approach. They have strongly encouraged the Legislature to change the formula of the dividend in a manner consistent with this as well, although he is not advocating that at this time. He estimated that by using the 50/50 split the dividend would be larger than it is currently until 2010 due to the market volatility. But, the $1963 dividend from a couple of years ago, would have been smaller. SENATOR THERRIAULT said the calculation of the dividend is a completely separate issue than what he is proposing. He is just proposing a smoothing method for the cash that is available. MR. STORER replied that is correct. SENATOR THERRIAULT said because of the market valley we are in, if they switched the dividend calculation to a smoother model, it would result in higher... TAPE 03-48, SIDE B  ...it would not allow the valley to be as deep. MR. STORER replied that is correct; it would smooth out and lines would cross at 2010. SENATOR THERRIAULT asked what surety he could give them. MR. STORER answered that they do a lot of modeling of the probabilities of achieving a goal. Every quarter they take all the known information about the fund and look forward 10 - 15 years. They model it through 326 different permutations of different returns, inflation, etc. They also look at a 90 percent probability of it occurring at ten percent probability, etc. He is suggesting a median case of all the permutations. MR. BARTHOLOMEW added that under current formulas and with the recent extreme volatility, the earnings reserve could go to zero. If that happens, there is no assurance; there could be a zero distribution. The POMV, as proposed, would assure a payout every year. There is actually more assurance and more predictability with the proposed change. MR. STORER added that although predictability is important, one of the key things about this proposal is the discipline it brings during the bull market phases. Imposing the limit in the bull markets leaves reserves for the bear market times and one can comfortably distribute a predictable amount of money however the Legislature deems appropriate. SENATOR FRENCH asked if they had adopted the POMV model at the outset of the fund, how big would the fund be today. MR. STORER replied that the key to the answer is that there was only one year in which the fund was 100 percent in fixed income and they paid out more than five percent. "The fund would be the same size." MR. BARTHOLOMEW said the main difference would be that we wouldn't have the risk of going to zero on June 30 that we have now. He elaborated that the fund made $1.1 billion in April and that's why we've gone from almost no dividend up to there being enough money for a dividend. "That's the kind of volatility you don't want to have subject to your payout method." MR. STORER added that we have benefited from an extraordinary bull market during the entire period and the real earnings have been in excess of six percent during that whole period as well. SENATOR FRENCH said this assumes that the fund makes eight percent per year. In years that make less than eight percent, with a five percent payout, he asked whether that would make the fund go down. MR. STORER answered yes; they are assuming that they can earn about eight percent over time and that historically inflation has been about three percent. That's how they came up with the figures for demonstration purposes. We are in a period now where our returns are negative and inflation is modestly up he said. SENATOR FRENCH asked what a period of deflation would do to the model. MR. STORER replied that there have been two extremes back through 1926: one is deflation and the other is higher inflation. Both would have an impact on the fund. The higher inflation period, at least the last time commodities rose and so there would probably be higher income coming to the state....One of the keys in portfolio construction is diversification. So, we have about half of the fund invested in equities and the balance is in primarily high quality fixed income securities and real estate. If deflation was over a short period of time, then we would not be able to achieve our goal, I believe. We'd make money in bonds, but there would be an impact on the stock market. But then the assumption is that we would come out of that and we would achieve our goals again. If you go back to the extreme of the depression, then you're going to have a 5 or 10-year problem. We can't get around that aspect.... MR. BARTHOLOMEW thought Senator French's point was one of the key policy decisions facing the Legislature when they are looking at this proposal. For the benefit of assuring there will be a payout every year, the fund is taking on the risk that in some short term period it could get spent down a little bit, with the idea that it would be built back up in the future. The benefit of that is that you don't have a $22 billion fund that provides nothing to the state and what would that mean to the economy and to the citizens. SENATOR FRENCH asked if using this model would moot the Attorney General's pending decision on what earnings are. MR. BARTHOLOMEW said that opinion would have an affect until November 2004. SENATOR THERRIAULT asked them to comment on the proposal to simply freeze the statute that was first put into place when the fund was invested only in bonds. MR. STORER responded that with regard to the dividend payout, it's not really compatible with contemporary investment thinking. It would create a problem longer term. SENATOR THERRIAULT asked him to comment on the potential scrutiny from the IRS. MR. STORER replied that there were a lot of discussions in the 80s about the taxability of the fund. To keep a low profile, one of the things they did was make it distinct that the Permanent Fund Corporation managed the assets of the fund and that any appropriations would occur on a year to year basis through the legislative process. The corporation was constructed in a way to keep that autonomy as well. Legal opinions have always said there is a risk if the dividend was memorialized in the constitution so it was not for a government purpose. CHAIR SEEKINS inserted that he intended to hold SJR 18 through the interim for further work. MR. STORER commented that he didn't think that SJR 18 increased the risk of the fund being attacked by the IRS. However, SJR 19 talks about placing a dividend commitment into the constitution and would present a question. SENATOR THERRIAULT said he understood and agreed with him. CHAIR SEEKINS said they would hold SJR 18 for further work.