SENATE FINANCE COMMITTEE LOG NOTES 03/25/99 GENERAL SUBJECT(S): BALANCED BUDGET PLAN PRESENTATION Michael O'Leary Jr., Executive Vice President National Director of Planned Sponsored Consultant Services Callan Associates Inc. Jim Lynch, Acting Vice President of Finance and Treasure of the University Foundation University of Alaska The following overview was taken in log note format. Tapes and handouts will be on file with the Senate Finance Committee through the 21st Legislative Session, contact 465-2618. After the 21st Legislative session they will be available through the Legislative Library at 465-3808. Time Meeting Convened: 9:05 a.m. Tape(s): SFC-99 #65, Side A & Side B PRESENT: X Senator Parnell X Senator Adams X Senator Torgerson X Senator P. Kelly Senator Donley X Senator Green X Senator Leman X Senator Phillips X Senator Wilken ALSO PRESENT: SENATOR JOHNNY ELLIS; WILSON CONDON, Commissioner, Department of Revenue; BYRON MALLOTT, Executive Director, Alaska Permanent Fund Corporation, Department of Revenue; ANNALEE MCCONNELL, Director, Office of Management and Budget; DAVID TEAL, Director, Division of Legislative Finance; PHIL OKESON, Fiscal Analyst, Division of Legislative Finance. SPEAKER DISCUSSION CO-CHAIR PARNELL Convened the meeting at approximately 9:05 a.m. He introduced Mr. Michael O'Leary of Callan and Associates. MICHAEL O'LEARY, JR. Executive Vice President, National Director of Planned Sponsored Consultant Services, Callan Associates Inc. Mr. Callan was invited to join the committee. He provided a brief presentation beginning with background on the firm. He stated that Callan is a national investment-consulting firm. They do not manage money. The headquarters is in San Francisco and noted that they have been working with the Alaska Permanent Fund since 1989. Callan and Associates helps firms with strategic planning, planning management structures, selecting managers and then evaluating performances. Mr. O'Leary commented that he wanted to focus on 1) Volatility and 2) Inflation on the capital market and then describe where we think we are with regard to those elements. Stocks are more volatile than bonds. Mr. O'Leary explained the concept of volatility as shown in the graph. He admitted that analyzing projections that use the average as opposed to embracing the low side of average creates much conflict. He pointed out that the graph show the Callan Associates projection using a five-year return. The other part of the projection uses a standard deviation of 15%. 2/3 of the time, in a 12 month period, the expectation of the S&P 500 return to be 9% minus 15% or plus 15%. SENATOR TORGERSON Questioned the volatility/uncertainty graph. He asked if the price of oil drove the market down? MICHAEL O'LEARY Responded that the 3rd quarter of 1990 was the Kuwait invasion; the 3rd quarter last year was a financial scare due to the Asian economic problems. In the 1960's, there was a market crash due to the steel strike. He added that Japan was a wonderful stock market for most of the 1980's, although, ultimately became overvalued and began to deteriorate. SENATOR TORGERSON Understood that oil was going to be stable for the next couple of years. He asked if that would take away from the volatility? MICHAEL O'LEARY Acknowledged that the price of oil was very important to the economy, which is one of the factors, which contributes to the inflation outlook. When oil is not going down, inflation will go up. Returns go up and down. Mr. O'Leary stressed that the concept he wanted to clarify was the "yellow" line on the graph indicated lesser volatility; however, both the yellow and maroon lines move approximately at the same rate. Mr. O'Leary referenced the Perfect Correlation (+1) and Perfect Negative Correlation (-1) - aspects moving in counter directions at the same time. That is what investment professionals would love to find. There is always volatility in the financial world. The red and orange have similar performance patterns but are not occurring at the same time. Strategic planning is about cutting out the peaks and the valleys. Correlation and Diversification Large DB Plan Diversification The next graph indicates that rolling 5-year return for the S&P 500 from 1926 forward. CO-CHAIR PARNELL Asked over the last 50 - 60 years, what have fiscal analysts looked for or is this high risk? MICHAEL O'LEARY Responded about the "risk". Strategic planning is needed to measure the overall volatility of returns. What is the risk? The next graph shows the history of standard deviation. 1) S&P 500 Historic Risk Perspective (1926 to present) Mr. O'Leary asked members to remember 15.4%, which is the standard deviation of volatility of the total returns. Mr. O'Leary questioned the perspective on bonds. In the 1970's interest rates were increasing, market value of bonds was declining. It is not surprising that as interest rates declined, a combination of high level of interest and market level depreciation of the bonds resulted in bond market returns up to 20%. In recent years that numbers has come down, but it is still attractive at 7.5% over the last five years. The next graph is difficult to understand and yet it is very important. Inflation is important for world markets. How does inflation impact the financial market? The overall numbers are higher than the long-term average. A period of declining inflation has been 12.35% with increasing inflation at 3.6%. Periods of increasing inflation have not been good for stocks because that is when interest rates go up. Mr. O'Leary commented that the five-year projection does not indicate a recession, or run-a-way growth; it does not look like Asia is going to cascade into a depression. There is a risk of recession as expansion has been very protracted and the economy has a lot of demand given the Y2K problem. He projected the economic outlook was good for the next five years. SENATOR PHILLIPS Asked about the Brazilian situation. MICHAEL O'LEARY Commented that the risk of the bad economic scenario would be the Asian situation continuing to spread and affecting the development of the market is greater today than it was five years ago. It is important to be mindful of yet not something to base policy on. Mr. O'Leary continued that when developing the forecast, there will always be a stock forecast where the single point number is greater than the bond numbers. All forecasts are consistent with the long-term record and based on sound fundamentals. He added that stocks will not always earn more than bonds. The most important tool to have is the determination of what is the yield market on the bond market today. Mr. O'Leary asked are we today? The interest rates are much lower than they were in December 1997. Mr. O'Leary continued, the current yield to maturity - future bond returns. What is the yield to maturity on the market today? 1999 Capital Market Projections (1998 to 1999). He explained the expected return and the expected risk. The five-year capital market projections are rising which reflects that market variations are very high. Mr. O'Leary spoke to the hypothetical examples through the graphs. The historical risk and reward; calendar year returns for three policy mixes; calendar year returns; projected return for three policy mixes. Mr. O'Leary explained the median and risk level. He spoke to the range of "things" that could happen. SENATOR PHILLIPS Asked how many years was the graph based upon? MICHAEL O'LEARY Replied for just one year. SENATOR PHILLIPS Asked what this would be based upon? MICHAEL O'LEARY Explained that the input to the model was used as the base- i.e. the expected return, the broad stock market of 9.4% as the medium and the bond market of 5.6% and the risk "makers". The risk makers drive the market. The odds of having five bad years in a row are lower than the odds of having five good years in a row. Mr. O'Leary concluded his presentation. CO-CHAIR PARNELL A brief discussion followed between Co-chair Parnell and Mr. O'Leary regarding the expected inflation increase of 3.8% over the next five years with a 3% average over this time. He noted that the Committee anticipates building a long-range fiscal plan. Trying to pin point an inflation number is difficult. He asked how to integrate the concerns. It is important to reduce growth projections on stock returns and bond returns. Earnings drive stock returns and earnings are denominated in dollars. SENATOR TORGERSON Commented that the State's model is based on the price of oil. If the State used the assumption that oil was within a couple dollar price range, could we assume that inflation would have major shift also? MICHAEL O'LEARY Responded that if the price of oil is used as a reflection of what is happening in the commodity markets, it generally goes beyond oil price. He stated that would be a reasonable expectation. TAPE CHANGE 99-65 B Tape Change, SFC 99-65, Side B MICHAEL O'LEARY Continued in his response to Senator Torgerson. Another critical element of inflation is health care cost dynamics, which are changing. There is a shift toward the bulk providers such as HMO's resulted in significant cost savings, but now we are seeing traditional inflation in the health care sector. Another concern, which Mr. O'Leary pointed out, are the real estate recovery. Rents are going up, therefore the recovery is affecting future inflation. SENATOR PHILLIPS Asked how would Mr. O'Leary manage the circumstance which Alaska finds itself in now with the budget. MICHAEL O'LEARY Replied that he would not encourage a strategy that would over weight oil or the saving account component of the assets. That would create tremendous oil exposure. SENATOR PHILLIPS Noted that the State has the savings account on one hand and expenditures on the other. What would be the best advice to balance the portfolio. MICHAEL O'LEARY Replied that this is a very apparent fundamental structural issue. The revenue source is diminishing. Terrific position because people anticipated that and planned by saving. Making our savings work harder is the number one potential solution. Structural obstacles, however, do exist. SENATOR PHILLIPS He asked clarification on how to make the savings work harder. MICHAEL O'LEARY Replied that all financial assets should pursue a higher return. How the result of that is distributed would be a public policy question. SENATOR PHILLIPS Noted that the Permanent Fund Investment Board would be allowed to make a position on that issue. He asked Mr. O'Leary if he would support that move. MICHAEL O'LEARY Replied, absolutely, however, the consequence of that is the more stock exposure the more volatility. Volatility means the more earnings available for distribution equals feast or famine. He stated that it is important that to recognize that and come to ways of soothing that out. The State does not want to have peaks and lows. CO-CHAIR PARNELL Thanked Mr. O'Leary for his presentation. He noted that the State has grown more dependent on the shock absorbers. Most recently, the price of oil has dropped, forcing the State to use more and more of the savings account fund. Co-Chair Parnell commented that he wanted to look at more systematic use of the savings through managing the financial resources. JAMES LYNCH Acting Vice President of Finance, Treasurer of the University of Alaska Foundation, University of Alaska Mr. Lynch was invited to join the Committee. Mr. Lynch spoke to the University of Alaska Foundation. He noted that it was formed in the early '70's to solicit contributions and manage those investments for the University. The Foundation has approximately $117 million dollars, of which $55.9 million of that is the foundation itself. For administrative purposes, that money has been consolidated into endowments. The State of Alaska is the largest manager of these funds at this time. Additionally, the Comet Fund is involved. Mr. Lynch provided a little history regarding how the University and the foundation management of the funds changed over time. In 1978, the Land Management trust fund had about $2.5 million dollars, which was cash and fixed income. We were spending off that fund, the current income. In 1989, the fund had growth to about $13.9 million dollars and invested into investment securities. Investments were fairly conservative. At that time, the current income was being spent, but the State was inflation proofing the principle by using the CPI. In 1997, the fund had grown to $43.2 million dollars. The current income was still being spent and inflation proofing. At that time, the State was only spending a percentage of the current income because of concern that inflation might increase. In 1997, the Legislature authorized the University to use a "total return" concept at which time the two funds were consolidated. Mr. Lynch spoke to the objectives of managing the funds. 1) Preserving the principle, 2) maximizing the distribution and 3) minimizing the payoff throughout the fluctuations. There is a lot of volatility in the market. He added, that there are a couple of threshold issues, which work to addressing the conflicts and objectives. 1) Intergenerational equity; and 2) Utilization of total return. CO-CHAIR PARNELL Asked Mr. Lynch for an explanation of intergenerational equity. JAMES LYNCH Replied that intergenerational equity was the ability to purchase for future beneficiaries what the endowment can purchase for today's beneficiaries. It would be the real purchasing power of the investment portfolio. The economics perspective of the total return is investing for the maximum return. The objective is to put the money where it can earn the most. He spoke to a realized gain versus an unrealized gain. Mr. Lynch continued, from a management perspective the "Total Return" would connect the investment decisions and short term spending considerations. In dealing with the trade-off, there are certain questions that must be answered. He asked how much would be needed for distributions to the beneficiary. Additionally, one should ask how much is needed to preserve the purchasing power. And how to inflation proof at 4%. He added that it is important to know how much risk the State can take. He continued, the strategic outcomes are important and the State will need to develop a consistent methodology for the earnings. That decision would be determined on the asset allocation to equities. SENATOR PHILLIPS Asked if it would be a 30/70 split and if it would be similar to other university endowments. JAMES LYNCH Replied that Alaska is not atypical. He acknowledged that we have a long-term investment horizon. The shift to equities is getting larger on an annual basis. SENATOR LEMAN Asked if we were off in the run-off of prices due to the shift in the portfolio? JAMES LYNCH Replied that we have a large allocation to real estate and alternative investments and that it is very difficult to get into those types of investments. It is a long and slow process and the horizon is 6 to 8 years. The funds dedicated to those assets classes are sitting in an S&P fund. Mr. Lynch continued, noting that along with that the State must develop spending methodologies. He explained the source for this analysis was from NACUBO Endowment Survey provided in 1998. He noted that any spending rate that is based on earnings would cause variability in the distribution. That should be avoided. Mr. Lynch referenced the chart, which illustrates how the State got to where they are with the spending rate. SENATOR WILKEN Referred to the Theoretical Fund Earnings Rate and Inflation Assumptions graph. JAMES LYNCH Explained that he was building a model with the same variability in earnings and volatility. He pointed out the effect on spending for the beneficiary? CO-CHAIR PARNELL Stated that if 5% of earnings each year would allow for a sustainable payout given the volatility of earnings. JAMES LYNCH Continued addressing the distribution results based on difference assumptions. Mr. Lynch concluded his presentation. SENATOR WILKEN Referenced the inflation proofing method used by Mr. Lynch. He asked if the earnings under the asset management would affect the amount needed to inflation proof. JAMES LYNCH Stated it would not. The attempt was to set an asset allocation expecting a long-term earnings at 9%. That would be the 5% average spending rate. SENATOR WILKEN Asked if the spread would be greater than the CPI. JAMES LYNCH Replied that in the good years it would be over inflation proofed and in the bad years it would be paying out. That is what smoothes the distribution. SENATOR WILKEN Clarified that the CPI plus the spending must be greater in order to inflation proof. CO-CHAIR PARNELL Thanked the participants. He stated that the Committee would have public testimony tomorrow morning at 9:00 a.m. ADJOURNMENT The meeting adjourned at 10:15 A.M. SFC-99 (8) 3/25/99 a.m.