SB 43-APPROP: EARNINGS RESERVE TO PERM FUND MARK HODGINS, staff to Senator Ward, sponsor of SB 43, explained SB 43 will transfer an amount, equal to the unappropriated balance of the Earnings Reserve Account on June 30, 1999, into the principal of the Permanent Fund. Number 162 JIM KELLY, Director of Communications for the Alaska Permanent Fund Corporation (APFC), made the following comments. SB 43 would appropriate the funds in the Earnings Reserve, less the dividend and inflation proofing costs, into the principal of the Permanent Fund. SB 43 is similar to past legislation except that the Government Accounting Standards Board (GASB) has adopted Rule 31 which changes the accounting standards applied to the Permanent Fund. The 6/30/98 annual balance sheet for the Permanent Fund was calculated using GASB Rule 31. That rule requires both unrealized and realized gains be considered as income. By including the unrealized gains, the total Earnings Reserve amount is probably higher than the amount the Legislature expects to appropriate. MR. KELLY explained in the past the balance sheet total did not include unrealized earnings, but GASB Rule 31 requires the APFC to mark its funds to market. VICE-CHAIR GREEN asked what the difference was under the previous accounting system. MR. KELLY replied if one looked at the regular projection sheet, the Earnings Reserve for the year ending June 30, 1999, will be about $2.7 billion. The dividends, based on the statutory formula, will reduce that amount by $989 million. Inflation proofing, calculated at 1.54 percent, will reduce it further by $287 million, leaving $695 million in current year income to add to the Earnings Reserve balance. The 1998 cash balance in the Earnings Reserve was about $1.4 billion; the $695 million will increase the cash balance to $2.084 billion. In addition, the Earnings Reserve contains an unrealized cash balance of $3.8 billion. It is unclear whether SB 43 would appropriate $2.084 billion or $5.8 billion according to GASB Rule 31. The APFC has contracted with a legal firm to review the GASB ruling and Alaska statutes to provide an opinion on what "earnings reserves" means. Number 222 SENATOR PHILLIPS noted that his staff contacted Mr. Kelly's office in early January and was told the projected amount for 6/30/99 was $1.9 billion, after inflation proofing and dividend costs were deducted. He questioned why the projection is now over $2 billion. MR. KELLY replied his office was probably basing the earlier projection on the September quarterly report; the latest projection was based on the December quarterly report which wasn't available in early January. SENATOR MACKIE asked Mr. Kelly if he thought SB 43, as written, will appropriate the entire $5.8 billion. MR. KELLY said SB 43 could be interpreted to do so. SENATOR MACKIE asked what the projection for the excess interest earnings is this year. Number 253 MR. KELLY replied $695 million will be left after dividend and inflation proofing costs are deducted. SENATOR ELTON pointed out SB 43 does not mention inflation proofing and asked if that omission will cause a problem. MR. KELLY answered that the same dollars would be put into the Permanent Fund, but not specifically into the inflation proofing segment. The effect, in terms of dollars, would be the same, but the explanation will be more complicated. SENATOR ELTON suggested that the sponsor be informed. Number 267 ROSS KINNEY, Deputy Commissioner of the Department of Revenue, gave the following testimony. He echoed Mr. Kelly's statement that GASB promulgates regulations, and in order to get a "clean" opinion from the auditing firm that audits the Permanent Fund records, GASB guidelines must be adhered to. GASB Rule 31 is unclear, for accounting purposes, about how the Permanent Fund income is recognized. A firm decision needs to be made as to whether the unrealized gains and losses should actually be added to the corpus of the fund. MR. KINNEY stated that during the last few weeks, a tremendous amount of discussion has occurred about Governor Knowles' long range fiscal plan. The plan proposes that approximately $4 billion be transferred from the Earnings Reserve to the Constitutional Budget Reserve (CBR). If SB 43 is enacted as written, that transfer could not occur. Additionally, the Legislature could not appropriate funds from the Earnings Reserve for any other purpose it desires. Once that appropriation is made it cannot be touched because the principal of the Permanent Fund is constitutionally protected. The principal of the Permanent Fund can be increased in three ways: through dedicated oil revenues; through the appropriation of Earnings Reserve or general funds; and through inflation proofing, which has occurred on an annual basis. MR. KINNEY cautioned that one risk the Legislature could incur, if it appropriates the full amount of the Earnings Reserve to the corpus of the Permanent Fund, is that Alaska could find itself in a position where it cannot pay out the total dividend entitlement if it is calculated using the traditional 5 year average and 10+ percent. The state might only be able to pay a dividend amount based on 50 percent of the amount in the Earnings Reserve. That situation could occur if a major market correction took place along with high inflation. The state has never come up against the Earnings Reserve limitation for dividend calculations, but it is not out of the question. Also, the Earnings Reserve limitation comes into play in years 2, 3, and 4, in the Governor's long range plan. At this point in time, the Administration does not support SB 43, pending a thorough review of the Governor's long range plan. VICE-CHAIR GREEN asked for clarification of the GASB changes. MR. KINNEY said the change was to a definition. Alaska statutory language related to the Permanent Fund defines income as interest, dividends, and realized gains. Up until 1997, GASB accepted that definition. However, as the result of the Orange County situation and other factors, the term "mark to market" has come into play. That term means that all financial statements require that the value of assets held have current market values placed upon them based on current market conditions. That changes the definition of income to interest, dividends, realized gains, and unrealized gains and losses. That definition results in an income increase of $4 billion in the Earnings Reserve as compared to the statutory definition, which does not include unrealized gains. The statutory definition is used to calculate the dividend because APFC does not want to pay a dividend based on unrealized gains. VICE-CHAIR GREEN asked for an example of an unrealized gain. MR. KINNEY explained that if a person bought Microsoft stock at $50 per share and that stock increased to $100 per share, the unrealized gain would amount to the $50 increase. If the stock was sold for $100 per share, you would realize a $50 gain. For dividend calculations, that $50 gain is only recognized when the stock is sold. Under GASB's definition, the $50 unrealized paper gain must be recognized as income even though the stock has not been sold. He noted all income from the Permanent Fund goes into the Earnings Reserve. Mr. Kelly's financial statements now show a fourth income component: unrealized gains and losses. That is where the question comes into play. APFC does not know what the interpretation for the Earnings Reserve amount under SB 43 would be. VICE-CHAIR GREEN asked if the bill could be crafted to exclude unrealized gains. MR. KINNEY replied that is the question the APFC has posed to its legal counsel. SENATOR MACKIE maintained an amendment could be offered during the budget process to appropriate a specific amount of dollars to the corpus. MR. KINNEY stated there is no difference as to whether the money is in the Permanent Fund corpus or in the Earnings Reserve from a dividend calculation standpoint. The only difference is that the corpus of the Permanent Fund is not inflation proofed for the amount that sits in the Earnings Reserve but it is still added together when looking at the total assets of the Permanent Fund. SENATOR PHILLIPS asked how the $2 billion in the excess earnings reserve is being invested. MR. KELLY replied for investment purposes, all of the money is co- mingled; he could not determine which investments were from the principal and which were from the Earnings Reserve. SENATOR MACKIE asked if it is earning at the same rate as the Permanent Fund. MR. KELLY said that it is. SENATOR PHILLIPS asked if the CBR is being invested using the same principles as the Permanent Fund. MR. KELLY replied this year the Permanent Fund is earning about an 8.83 percent total rate of return, a little higher than the CBR. VICE-CHAIR announced SB 43 would be held in committee for consideration at a later date.