HOUSE FINANCE COMMITTEE January 24, 2022 2:49 p.m. 2:49:41 PM CALL TO ORDER Co-Chair Merrick called the House Finance Committee meeting to order at 2:49 p.m. MEMBERS PRESENT Representative Neal Foster, Co-Chair Representative Kelly Merrick, Co-Chair Representative Dan Ortiz, Vice-Chair Representative Ben Carpenter Representative Bryce Edgmon Representative DeLena Johnson Representative Andy Josephson Representative Bart LeBon Representative Sara Rasmussen (via teleconference) Representative Adam Wool MEMBERS ABSENT None ALSO PRESENT Greg Allen, Chief Executive Officer, Chief Research Officer, Callan and Associates. PRESENT VIA TELECONFERENCE Steve Center, Senior Vice President, Callan and Associates SUMMARY PRESENTATION: PERMANENT FUND PERFORMANCE MEASURES AND IMPACT OF AD HOC DRAWS BY CALLAN AND ASSOCIATES Co-Chair Merrick reviewed the agenda for the meeting. ^PRESENTATION: PERMANENT FUND PERFORMANCE MEASURES AND IMPACT OF AD HOC DRAWS BY CALLAN AND ASSOCIATES 2:50:39 PM GREG ALLEN, CHIEF EXECUTIVE OFFICER, CHIEF RESEARCH OFFICER, CALLAN AND ASSOCIATES, introduced the PowerPoint Presentation: "Permanent Fund Performance Review, and Simulation Model Results." He relayed he had been modeling the Alaska Permanent Fund since the late 1990s. He was asked to analyze effects from an ad hoc draw on the Earning Reserve Account (ERA) and its effects on the percent of market value (POMV) rule. He would first give a performance review. He began with slide 3 titled Broad Capital Market Performance." He indicated that the bar charts represented returns for various asset classes over certain time periods ending on September 30, 2021. He drew attention to the one year bar depicting small capital equity returns at 47 percent, large capital equity at 30 percent, and non-U.S. Equity at 24.4 percent. He highlighted the strength of the equity markets for the year. He pointed to the 16.6 percent return over 10 years that reflected exceptional returns. 2:53:22 PM Vice-Chair Ortiz asked for Mr. Allen to explain large caps versus small caps. Mr. Allen replied that large caps were the largest businesses like Apple, Facebook, IBM, and ExxonMobil. He added that small caps were domestically focused firms worth a market cap of $3 billion. Co-Chair Merrick indicated that Representative Rasmussen joined the meeting via teleconference. Mr. Allen moved to slide 4 titled Global Equity Market Performance. He reported that the U.S. equity market had dominated market performance, but global investment was important in the long run. The difference between global and domestic markets was "striking" over the last 10 years. 2:54:58 PM Mr. Allen moved to slide 5 titled "Market Environment He pointed to the fourth row from the bottom of the table reflecting the private equity index and noted that the return was the highest assets class in the one year period ending on September 30, 2021, at 58.8 percent and had proven to be a very successful investment for the fund over a number of years. 2:55:50 PM Mr. Allen turned to slide 6 titled "Callan Periodic Table of Investment Returns." He relayed that the chart was included to show that the same asset class was not always the best performer year after year. He highlighted the U.S. Large Cap Equity and noted that it remained in the top half of the chart for over 10 years. The Permanent Fund (PF) returns were represented in white and hovered in the middle because it owned all the types of asset classes on the chart. Co-Chair Merrick indicated the Co-Chair Foster, Representative Edgmon, and Representative Wool joined the meeting. Mr. Allen turned to slide 7 titled "APFC Total Fund Cumulative Returns." He communicated that the bar graph showed the return of the Alaska Permanent Fund Corporation's portfolio in blue. The green bar represented its performance benchmark, and the brown bar depicted its objective of CPI plus 5 percent. He detailed that the fund was up 26.6 percent for the year; the CPI plus 5 percent was 10.9 percent. The current year's gains could easily support a 5 percent POMV draw. Mr. Allen indicated that slide 8, also titled "APFC Total Fund Cumulative Returns, showed a longer period of returns. He reported that the Permanent Fund exceeded all benchmarks at 8 percent for 20 years and the performance was remarkable, especially over the last 3 years. 2:58:24 PM Mr. Allen moved to slide 9 titled "APFC Total Fund versus Callan Large Public Fund Databasedisplaying the annualized return rankings relative to large public funds. He pointed to the gray area that represented returns from the tenth to ninetieth percentile. The permanent fund was represented by a blue dot that showed the PF in the top fourth percentile for the current year, twelfth percentile for 5 years, and thirty-eighth percentile for 20 years. The permanent fund outperformed 62 percent of the funds in the database. Mr. Allen highlighted Slide 11 titled APFC Total Fund versus Callan Large Endowment Database." He indicated that the large endowments all had assets over $1 billion. The PF ranked in the middle versus the top because endowments typically invested in private equity. He commented that the PF had been firing on all cylinders" and performing well except for the real estate fund that was in repair. He offered that Callan worked with very large funds and he considered the PF performance outstanding. 3:00:54 PM Mr. Allen discuss Slide 11 titled "APFC Total Fund versus Callan Large Public Fund Database" portraying the annualized risk rankings using the standard deviation; the fund's risk relative to peer funds. He remarked that efficient portfolios had high returns and low risk. The PF relative to large public funds had high returns and low risk and was ranked in the middle compared to endowments. 3:01:33 PM Representative Edgmon asked Mr. Allen to repeat the information regarding endowments. Mr. Allen responded that he was comparing large pension funds to endowments like Yale or Harvard. He explained that endowments' investment strategy was to heavily invest in private equity. The public funds had been slow to adopt practices around private equity. The PF invested in private equity fairly early, roughly 18 years ago. Private equity was a long term investment strategy rather than a short term investment that looked like a "J" curve. Private equities were the top performing assets in the prior year. He elucidated that the PF had morphed into an endowment fund. An endowment created sustainable resources into the future, and the PF invested like an endowment, which was why its performance was so notable. Representative Edgmon used a sports metaphor to describe the incredible market returns over the last year. He wondered if the year was unusual. Mr. Allen responded that since 2008 investments had risen, which benefitted the private equity markets and therefore, the PF. He offered that in general, Callan believed in investing in private equity; it was the highest asset class over the long run. However, he also advocated for investment diversity. He remarked that the last 12 years yielded "extraordinary" investments and he did not expect the market to crash. 3:05:27 PM Vice-Chair Ortiz asked Mr. Allen to explain what it meant to be invested in private equity. Mr. Allen responded that private equity investors invested capital in a company or startup that was not publicly listed or traded and was a form of venture capital. He elaborated that the private investors were betting on long-term growth of the company that would ultimately be publicly traded, which was very lucrative. They were investing in risky companies but were also diversifying investments. The advantage for private equity investors was "private ownership," which was not subject to the same regulations as public companies and did not involve shareholders. It required patience because it was impossible to get money out of a private investment before it paid off. 3:07:53 PM Representative LeBon appreciate the information on private equity. He commented that the Alaska Permanent Fund Corporation (APFC) was proactive in its investing. He believed that it was necessary to have talented staff to make good investment decisions. He asked if Mr. Allen had an opinion of the investors at the APFC. Mr. Allen responded in the affirmative and voiced that he was amazed at the ability of APFC to have developed the stable staff they had, which was challenging with job competition from the east and west coasts. The largest challenge was competition from higher wages in the private sector. He highly regarded the APFC's investment staff. 3:10:26 PM Representative LeBon asked if APFC offered a competitive bonus program in comparison to others. Mr. Allen responded that it was better than bonuses paid at the average public fund that typically did not pay bonuses. He offered that in some ways it was a reward just working for the PF. There was a certain amount of prestige working at APFC, which was attractive in itself. He noted that working for a successful $80 billion sovereign wealth fund was a unique situation. 3:12:05 PM Representative Wool asked about the risk rankings. He asked if the trade-off for private equity investments was more risk. Mr. Allen replied that although private equity was riskier because it was not publicly traded it was not priced daily like stocks. Therefore, private equity was less risky when measured against standard deviations. Therefore, the PF ranked high in earnings and low in risk because of its private equity assets. He indicated that private equity reported every quarter, which had a smoothing effect on earnings; if everything went down, private equity would decrease more, but it was more disguised. He noted that the PF "drifted into an endowment model" and was ahead of other large public funds in its investing strategy. The public funds were doing better but were probably 8 years behind the APFC. 3:14:58 PM Representative Edgmon noted the POMV structure and the current draw rate of 5 percent. He asked how Alaska compared to other wealth funds and their percentage draws, which he heard was lower at 3 percent and 4 percent. He wondered how the draw effected earnings and returns as well as risk. Mr. Allen replied that the lower the percentage draw meant the PF could take less risk and meets it objective. He explained that there was short-term and long- term risk. Callan calculated that the 5 percent draw was more like a 4.6 percent draw due to high returns. He believed that the current percentage was likely sustainable over the long run, with enough to cover the 5 percent and inflation. Endowments only withdraw the necessary amount in order to preserve the purchasing power for the next generation and the amount had to be adjusted for inflation. The fund needed to grow by 4.6 percent and 2.25 percent for inflation, which put it in the middle of the risk range. He exemplified that if the board needed to take some equity off the table and put more into bonds, then the percentage of the draw would need to decrease. He indicated that a typical endowment took a 4.5 percent to 5 percent draw, which was universally considered sustainable. He expressed concern regarding the legacy of the constitutional language creating the ERA. He voiced that it was outdated and a POMV was a better way because if the ERA ran out of money the state could reach a zero draw. He argued that the language was in conflict with the POMV, and he would further discuss the issue during the presentation. 3:19:43 PM Representative Edgmon requested that the presenter slow down his explanations to better follow the information. 3:20:05 PM Mr. Allen moved to slide 14 titled "Simulation Model Results. He related that Callan built a model of the PF in the late 1990's that generated a whole range of probabilities. He recalled times when there were proposals to withdraw all the money out of the ERA each year, which was the impetus for the model. He outlined that he would review Accounting Concepts and History and the Spending Rule and Appropriation History of the fund. He would then discuss modeling scenarios with ad hoc draws and the range of outcomes. 3:22:00 PM Representative Johnson asked Mr. Allen to provide more of his personal history and background. Mr. Allen reiterated that Callan was a consultant to the PF. He relayed that the APFC board expected Callan to comment on the performance of the fund. Callan also helped the APFC to find outside investment managers when needed. In addition, they advised the board on asset allocations and modeling. Callan had worked for the APFC board for over 30 years. Representative Wool asked if Callan had consultants singularly assigned to the APFC. Mr. Allen replied in the negative. 3:25:20 PM Mr. Allen moved to slide 15 titled "Statutory Net Income (Realized Return): Statutory Net Income (SNI) in each year is the sum of total income (dividends, coupon payments, real estate income, etc.), plus realized capital gains minus realized capital losses. Gains are realized when assets are sold for an amount above their purchase price (cost basis). Gains realization events include annual turnover in equity and bond accounts, rebalancing related turnover, sales to fund distributions, distributions from private market investments, etc. Mr. Allen indicated that another component that turned into SNI was realized gains. The fund had never in its history had as much unrealized gains. He reported that SNI fed the ERA. Representative LeBon spoke of the importance of inflation proofing the principle to maintain the PF's future value. Mr. Allen concurred with Representative LeBon's statement. He thought inflation proofing was critical to maintaining the purchasing power of the fund. 3:28:18 PM Mr. Allen discussed Slide 16 titled "Earnings Reserve Account Beginning Realized ERA $11.5B + Statutory Net Income $7.9B Appropriations to Principal Distribution $3.1B = Ending Realized ERA $16.3B + Pro Rata Unrealized Gains $4.8B = Ending ERA Balance $21.2B = Earnings Reserve Account is equal to total cumulative Statutory Net Income minus total cumulative spending minus total cumulative appropriations to Principal plus a pro-rata share of unrealized gains or losses. ERA receives a pro-rata share of unrealized gains or losses based on the size of the ERA relative to the size of Principal. ERA receives 100% of SNI if SNI is positive. ERA receives pro-rata share of SNI if SNI is negative. Mr. Allen summarized that the ERA and principle split the market value of the fund. He reviewed the formula on the slide that determined the ERA balance and offered that the ERA could easily pay the POMV draw in the current year. 3:29:45 PM Mr. Allen examined Slide 17 titled Historical Statutory Net Income Last Ten Years: Statutory Net Income has been positive in all of the last ten years. "Normal" years have been in the $3 - $4 billion range. 2018 and 2021 experienced outsized Statutory Net Income due to: Strong equity markets; High unrealized gains balances; Increased rebalancing activity resulting in Equity sales; Private markets transactions. Mr. Allen reported that in 2021 the PF had large, realized income gains of $8 billion. 3:30:35 PM Mr. Allen moved to slide 18 titled "Historical Earnings Reserve Account Last Ten Years:" With healthy Statutory Net income levels Earnings Reserve balance has grown consistently since 2012. As ERA balance grows proportion of unrealized gains allocated to ERA increases. In 2020 $4 billion of ERA was appropriated to Principal. This had the knock-on effect of reducing the percent of unrealized gains allocated to ERA. Unrealized ERA as percent of total at an historic high at the end of 2021. Mr. Allen pointed to 2012 and noted that the ERA balance was only 2.2 billion when the state did not have the POMV and only paid out the dividend formula, which was a much smaller draw. 3:31:27 PM Mr. Allen continued to Slide 19 titled "Historical Principal Account Balance _ Last Ten Years. The Principal Account balance has grown steadily over time as a result of oil revenue and inflation proofing appropriations. $4 billion appropriation to Principal in 2020. Another one scheduled in 2022. The unrealized portion as a percentage of total is at its highest point in the last ten years. The unrealized portion of Principal causes some asymmetrical volatility in the principal balance over time, as Principal absorbs entire unrealized loss balance. 3:31:48 PM Mr. Allen turned to Slide 20 titled "Historical Ending Market Value Last Ten Years:" Market value has grown steadily over last ten years. Slight drop in FY 2020 as markets hadn't fully recovered in June. Extraordinary increase in FY 2021 with market recovery. APFC Public and Private Equity portfolios contributed significantly to this growth in 2021. Mr. Allen highlighted the incredible gain in market value between 2020 and 2021 [$65.3 billion to 81.9 billion]. 3:32:15 PM Mr. Allen moved to the Monte Carlo Simulation on slide 21 titled " Stochastic modelling assumes median market outcomes in each year. Results are generally intuitive, and the models are easier to build. No need to consider "corner cases" or things that happen at the limits. Lend themselves to graphical representations of variables over time. Simulation modelling assumes a range of potential market outcomes in each year. Captures the impact of volatility. Requires you to consider things that happen at the limits (negative SNI, zero ERA, net unrealized losses (cost basis below market value), etc.). Results are less intuitive and more difficult to represent graphically over time. Assigns probabilities to various ranges of outcomes for variables of interest (versus point estimates). Requires multi-dimensional assumptions for market variables (return, standard deviation, correlation, auto-correlation, etc.). Mr. Allen explained that Callan created 2,000 scenarios based on varying assumptions for stocks, bonds, interest rates, inflation, currencies, etc. 3:33:01 PM Representative Josephson thought the presentation was very helpful. He referred to slide 18 regarding the historical ERA earnings reporting roughly $21 billion in 2021. The PF reported that the ERA total was $15.7 billion with the uncommitted amount at $8.9 billion (POMV draw plus unrealized gains). He wondered what the real balance was. Mr. Allen was unsure of the exact amount. The ERA balance was reported on the last day of the fiscal year. He elaborated that since the first day of FY 22 on July 1, 2021, the balance was the $21.2 billion minus $4 billion that was withdrawn at the end of the fiscal year. He knew that since July 1, 2021, there had been significant realized gains and would likely be larger than the prior estimate. Representative Josephson noted having heard that the account balance should reflect 3 times the draw. Therefore, the $8.9 billion number looked comfortable to him. He noted the legislator from Sitka having suggested moving $8 billion into the principle of the fund. He asked for comment. Mr. Allen advised that the more in the ERA the better." He conveyed that the ERA was an artificial concept and irrelevant since moving to the POMV endowment model. He recommended that the legislature constitutionalize the spending rule and eliminate the ERA and the concept of principle. He stressed the importance of constitutionalizing the POMV formula, and the POMV percentage. He understood that the legislature could spend as much as it wanted out of the ERA and contended that having unstable spending was a distraction" for the PF managers. He maintained that most endowments only had a spending rule, and the withdraw amount was known and could not be violated. He elaborated that currently, the more money in the ERA the better because it did not "get in the way of the spending rule. However, he cautioned that withdrawing to principle from the ERA as a way to curtail spending was risky, especially in years markets were down significantly; the ERA balance would become negligible. He suggested that an ERA 4 times the draw was better, but it only worked under the discipline not to overspend and to follow the rules. He emphasized maintaining the 5 percent spending rule because an extra draw of $2 billion or $3 billion hurts the value of the fund and "was basically taking money from the future and giving it to the present." He opined that implementing a spending rule simplified everything. 3:39:00 PM Representative Josephson asked what he meant by the word "distraction." Mr. Allen replied that the uncertainty of not knowing how much a draw would be made it difficult to manage the fund effectively. Representative Rasmussen spoke of political realities. She asked if there was a way to quantify the benefit of a one- time extra draw from the ERA. Mr. Allen thought that the modeling would answer her question. He requested that Representative Rasmussen clarify her question. Representative Rasmussen wanted to know if there was a way to quantify a benefit if the PF was consolidated into one account. She thought that a one-time overdraw might be a political concession to win constitutionalizing the spending rule to ensure an overdraw would never happen again. Mr. Allen deemed that the benefit would take some of the worst case scenarios off the table. He would further answer when he got to more relevant slides and thought they would clarify the benefits of eliminating the ERA construct and maintaining only the POMV model. 3:42:44 PM Mr. Allen relayed that the next slide showed the scenario reflecting the annual return year-after-year. He discussed Slide 22 titled "Projected Returns (No Volatility)": This results in unrealistically smooth paths for financial variables (EMV, ERA, Principal, etc.). Does not reflect the impact of year-to-year market volatility on financial variables of interest. Monte Carlo simulation introduces volatility. Mr. Allen commented that the PF never had the same returns for two years in a row and the model was unrealistic. He briefly portrayed Slide 23 titled "Projected ERA Balance (No Volatility)": ERA Balance expected to grow in early years due to Statutory Net Income being amplified by current high unrealized gains balances. ERA balance stabilizes in 2024 once unrealized gains normalize. After 2024 median projected draw and Statutory Net Income are similar in size resulting in relatively flat ERA. Mr. Allen turned to next scenario showing the first example of bad returns with volatility (Trial 178). He described the scenario on Slide 24 titled "Simulated Returns with th Volatility 95 Percentile Tail Risk Scenario Bad outcomes for the ERA balance generally have multiple low or negative return years in a row and do not necessarily contain a "really bad" year Large negative single years (like 2008) feel terrible, but the ERA is generally robust to those events as long as here is a recovery soon after. In this hypothetical scenario ("Trial 178") the current ERA holds up pretty well until 2027 in spite of persistent negative returns in 23-26. Mr. Allen explained that in 2022 the PF experienced 7 percent growth but in 2023 to 2026 experienced negative growth from -7 percent to -10 percent. In 2027, the PF experienced very slight growth but experienced a negative 18 percent in 2028. He stressed that a bad case scenario for the PF was multiple negative years and really low returning years. He turned to the next slide that portrayed the consequences on the SNI. Mr. Allen moved to slide 25 titled "Simulated Statutory Net Income with Volatility 95th Percentile Tail Risk Scenario:" High SNI in 2022 due to positive total return and current high unrealized gains. Negative returns in 2023-2025 (combined with gains realization from rebalancing and draws) wipes out current unrealized gains resulting in unrealized losses at total portfolio level. Turnover then results in net realized losses in 26, 27, 28 and 29. ERA balance is small relative to principal, so ERA gets a small proportion of net realized losses (negative SNI) in 26, 27, and 28. Mr. Allen moved to slide 26 titled "Simulated Statutory Net Income with Volatility 95th Percentile Tail Risk Scenario:" 2022 return slightly above median resulting in 2022 ERA being slightly above result on previous slide (so far so good). Declining SNI (due to gains realization and negative returns) combined with cumulative effect of POMV draw erodes ERA balance until it is exhausted in 2028. ERA balance remains at zero in 2029 due to zero SNI in that year. Slight positive SNI in 2030 bumps ERA up to about $700 million in 2030. Mr. Allen voiced that a zero ERA meant that there would be no POMV payout and illustrated the problem with the ERA; the balance could be depleted and could limit the POMV. He pointed out that the scenario began with the largest ERA