Legislature(1995 - 1996)

03/29/1996 08:08 AM FIN

Audio Topic
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
  SENATE BILL NO. 51                                                           
       An Act  relating to income  of the permanent  fund; and                 
       providing for an effective date.                                        
  Co-chairman Halford  directed that SB  51 be brought  on for                 
  discussion.  Senator  Rieger explained  that the bill  would                 
  introduce the concept  of real  earnings into management  of                 
  the state's largest endowment account--the Alaska  Permanent                 
  Fund.  Most endowments operate on a principle where earnings                 
  considered usable  are those  that exceeded  inflation in  a                 
  given year.  These moneys are referred to as "real earnings"                 
  in contrast to  "nominal earnings" which reflect  total cash                 
  return to  a fund  compared to  what is  actually earned  in                 
  excess of inflation.                                                         
  Given present dynamics  and increasing numbers of  proposals                 
  for potential use  of the  permanent fund, the  focus is  on                 
  total return,  and  inflation proofing  is an  afterthought.                 
  Under a "real earnings"  concept, inflation proofing becomes                 
  the first priority.   The  remainder of the  return is  then                 
  available for other use.  That is  how university endowments                 
  and most other endowment funds operate.  The first fiduciary                 
  priority is to protect  the principal.  That would  occur if                 
  inflation proofing were automatic.   The proposal  contained                 
  in the legislation is timely because  the permanent fund has                 
  enjoyed a  banner "run up"  over the  past eighteen  months.                 
  "Real earnings" based on the new size of  the fund are equal                 
  to total return under the prior size  of the fund.  The time                 
  is ideal  to make  the policy  change without  disruption in                 
  what "people see  when they look at  what the return  is and                 
  what the legislature sees."                                                  
  JIM KELLY, Director of Communications, Alaska Permanent Fund                 
  Corporation,   came   before  committee.      He  referenced                 
  correspondence from  the board  of trustees  indicating that                 
  the board had  discussed the legislation and did  not intend                 
  to take a position on the bill.   The board is supportive of                 
  any  changes  to  existing  law  which would  enhance  board                 
  ability  to  protect the  principal  of the  permanent fund.                 
  That  portion of  SB 51 which  makes inflation  proofing the                 
  highest priority represents such a change.                                   
  Another portion of the bill, making a change in the dividend                 
  formula by basing it on "real income" instead of net income,                 
  falls  outside   the  scope   of  the   trustees'  area   of                 
  The  fiscal  note  for  the  bill  is   zero  since  changes                 
  incorporated  within  the  bill would  have  no  operational                 
  impact on the corporation.                                                   
  Mr. Kelly  explained that inflation proofing provisions were                 
  enacted  in  1982  at the  request  of  the  first board  of                 
  trustees.  For the past fourteen years, each legislature has                 
  taken  a portion  of annual  income and  appropriated  it to                 
  principal  to  protect the  fund  against inflation.   Those                 
  appropriations  produced a cumulative total of $4.6 billion.                 
  That  action  evidences   the  legislature's  strong,   long                 
  lasting, and unwavering support for protection of principal.                 
  The inflation rate for this year will be 2.82 percent, based                 
  on the calendar  year change and  the consumer price  index.                 
  Since  1978,  inflation  has  averaged  5.11 percent.    The                 
  expectation for the next five years  is that it will average                 
  "somewhere between 3.18 and 3.5 percent.  As a percentage of                 
  annual net income, inflation proofing has ranged from a high                 
  of 55 percent  (1991) to a low  of 25 percent (1989).   This                 
  year, with high  earnings of over  $1 billion, inflation  of                 
  $400 million amounts  to 24 percent.   It is projected  that                 
  inflation   proofing   in    future   years   will   require                 
  approximately  44  percent, on  average.   That is  based on                 
  assumptions that the  fund will be  able to earn a  realized                 
  return "on  the order  of 7.17 percent,  and inflation  will                 
  average something like 3.18 percent."                                        
  For  total  principal  of  $15  billion, every  one  percent                 
  increase in inflation requires approximately $150 million of                 
  net income to be transferred to principal.                                   
  Mr.  Kelly  noted that  the  proposed legislation  speaks to                 
  "real income"  and ensures  that nothing  but "real  income"                 
  would be distributed.  With the  exception of 1990 and 1991,                 
  since  conception of the  fund, nothing but  real income has                 
  been  distributed.  The earnings  goal of the corporation is                 
  to beat  inflation and produce  real income at  a rate of  3                 
  percent.  That 3 percent target is likely to be increased to                 
  4 percent at the May 2, 1996,  board meeting.  The 3 percent                 
  target was  set when  the permanent  fund  was largely  into                 
  fixed  income investments.   Over  the years,  the fund  has                 
  become more involved  in equity investments which  produce a                 
  higher rate of return.  Investment performance in  the 1980s                 
  and  1990s has been so good that  it has beaten inflation by                 
  5.5 percent in the nearly twenty  years the fund has been in                 
  Referencing a handout (copy on file in the committee  master                 
  file for SB  51), Mr. Kelly noted  that the trustees  are in                 
  the process of  setting asset allocations for  the next year                 
  and   three-years  hence.     When  this   is  accomplished,                 
  assumptions  regarding future  earnings  will likely  change                 
  based   on  capital   market  assumptions   and   new  asset                 
  allocations from the board.  Based on the most likely choice                 
  to be made by  trustees, the total median return  (cash plus                 
  appreciation) over the next five years  is 8.42 percent.  If                 
  the corporation is  unable to  gain appreciation because  of                 
  the market, the  least that could  be made would  be a  4.68                 
  percent median return.                                                       
  The $1.7 billion in income for  the current year reflects an                 
  11 percent return.  With inflation of 2.8 percent, there has                 
  been over 8  percent of real return.  Markets go up and down                 
  as  does  inflation.    In  terms  of income  available  for                 
  distribution, if the  tradition of  protecting principal  is                 
  maintained (through  the proposed bill or not) the state has                 
  available  the  "real  income"  of  the  fund.    Mr.  Kelly                 
  reiterated that the  goal is 4  percent.  On  a $15  billion                 
  fund that  amounts to  $600 million  a  year.   As the  fund                 
  builds  to  $20 billion,  there  would  be  $800 billion  of                 
  distributable income.                                                        
  Senator Rieger pointed to both  the $1.7 billion return  and                 
  unrealized  gains  of  $2.2  billion.     He  then  directed                 
  attention to  a tabulation  evidencing best  and worst  case                 
  projections   of  future  earnings  and  explained  that  it                 
  incorporates  the  $2.2 billion  in  unrealized gains.   One                 
  scenario  reflects total use of all  funding in the earnings                 
  reserve  and the other reflects no use of those moneys.  The                 
  Senator noted that  in one scenario, transfer to the general                 
  fund (even  after payment of  a $1,000 dividend  every year)                 
  "hits a billion  dollars by the end  of the run, per  year."                 
  In  the  other  case,  the  dividend  grows  to  "just under                 
  $2,000," but  no cash  is used in  the general  fund.   That                 
  results  in  $23 billion  in  the earnings  reserve account.                 
  Real earnings in the future are consistent with total return                 
  in the past.   The  question of inflation  proofing and  the                 
  potential threat to inflation proofing  from those who might                 
  propose  use of earnings beyond  what goes into dividends is                 
  guarded against by passage of SB 51.                                         
  Discussion  of  past  year  gains  and  application  of  the                 
  dividend formula  followed between  Co-chairman Halford  and                 
  Mr. Kelly.   Senator Rieger stressed that  the proposed bill                 
  does nothing to corporate capital gains.                                     
  Co-chairman Halford voiced  his understanding that  the bill                 
  would take inflation proofing out of corporate income before                 
  the dividend formula is applied.   Mr. Kelly concurred.  The                 
  Co-chairman next  noted projections that  inflation proofing                 
  in the future would require 44  percent of future income and                 
  asked what that  would do to the formula for dividends.  Mr.                 
  Kelly  responded  that   of  the   money  made  each   year,                 
  approximately  10.5  percent  goes to  dividends.    For the                 
  present year  it would amount  to a  $40 million  reduction.                 
  Since  the dividend is calculated on a five-year basis, that                 
  amount   would  be  compounded   over  time.    Transitional                 
  provisions in the bill would count  four years of net income                 
  and one year of real income for the first year.   The second                 
  year would count three years of net income  and two years of                 
  inflation  proofing  reduced net  income.   The  $40 million                 
  reduction would  thus be $80  million the second  year, $120                 
  million the third, $160 the fourth,  and $200 million by the                 
  end of five years.                                                           
  Co-chairman Halford raised  concern regarding dividends  and                 
  explained  that  he asked  permanent  fund staff  to provide                 
  projections  based  on the  status  quo versus  the proposed                 
  bill.  He then directed attention to tabulations (copies  on                 
  file  in  the master  file) and  noted  that the  bill would                 
  reduce the constant value of the dividend to $606.00 in 2001                 
  versus  a  real value  of  $1,002 in  that  same year.   The                 
  reduction would occur  under the  proposed bill because  the                 
  pool of funds for  the dividend would be reduced  by removal                 
  of  inflation  proofing  moneys   before  the  dividend   is                 
  calculated.    Mr.  Kelly  concurred.   Co-chairman  Halford                 
  reiterated that the real value of the dividend is reduced by                 
  $400 in "just five years."   He acknowledged concern in some                 
  sectors that  the dividend would grow to "some huge amount."                 
  He then pointed to  the graph he distributed and  noted that                 
  "the dividend never gets to $1,200,  in real dollars, before                 
  2006 . . . ."                                                                
  Senator Randy Phillips  concurred in need for  protection of                 
  the permanent fund.  He suggested that the fundamental issue                 
  is protection of the fund versus protection of the dividend.                 
  Co-chairman Halford noted  that the permanent  fund dividend                 
  protects the principal in the eyes of the public.                            
  Senator Sharp  voiced  his understanding  that the  proposed                 
  bill  would  not  require   greater  amounts  for  inflation                 
  proofing than  those presently provided.   Senator  Phillips                 
  reiterated  that the question should  be how best to protect                 
  the fund.   Senator Rieger's proposal would  inflation proof                 
  first and  pay dividends  later.   The question  is, "Do  we                 
  protect the  dividends, or do we protect  the permanent fund                 
  itself."   Co-chairman  Halford noted  that the  legislature                 
  could  change the  priority for  dividends versus  inflation                 
  proofing  without  changing  the  dividend  formula.     The                 
  proposed bill  applies the existing formula  after inflation                 
  proofing is removed.   That has the effect of  "reducing the                 
  dividends pretty drastically  over time."   The  Co-chairman                 
  noted  that  the original  debate  on priority  of dividends                 
  versus inflation proofing  was "almost  a draw in  advocates                 
  and supporters  of the  permanent  fund."   The question  of                 
  priority is different from the  taking of inflation proofing                 
  before  dividends  are   calculated.    Co-chairman  Halford                 
  advised  that  he did  not have  as  strong a  feeling about                 
  priorities are he does about the reallocation resulting from                 
  the proposed bill.                                                           
  Senator  Phillips   voiced  agreement  with   protection  of                 
  permanent  fund principal.   The question is  how that might                 
  best be done.                                                                
  END:      SFC-96, #60, Side 1                                                
  BEGIN:    SFC-96, #60, Side 2                                                
  Co-chairman Frank voiced  support for  use of "real  income"                 
  versus  nominal income.  He  further spoke to the mitigating                 
  effect  of five-year  averaging  of  dividends and  inquired                 
  regarding the impact of increasing the percentage from 21 to                 
  25 percent.   Senator Rieger noted  that the increase  would                 
  represent a policy call for the  legislature.  He noted that                 
  the corporation currently  pays out 55 percent  in dividends                 
  rather than 50 percent as perceived by the public.                           
  Senator Phillips asked  that Mr.  Kelly apply provisions  of                 
  the  proposed  bill  to both  past  dividends  and principal                 
  amounts.  Mr. Kelly advised that it would have had no effect                 
  on the principal.   He agreed to apply  it to dividends from                 
  inception in 1982 to the present time.  Co-chairman  Halford                 
  reiterated  that projections  indicate that,  over time,  44                 
  percent of income would be  required for inflation proofing.                 
  If  44  percent  is taken  out  of  the  formula before  the                 
  calculation is made, the dividend is reduced by that same 44                 
  Senator  Phillips again  asked  which of  the two--inflation                 
  proofing  or  dividends--would  be  the  most  effective  in                 
  protecting the principal  of the fund.   Co-chairman Halford                 
  voiced his belief that both protect the fund.  They are  not                 
  in conflict.   The  dividend and  inflation proofing  can be                 
  paid.  Over the  history of the fund, there  has continually                 
  been a surplus.  The legislature has deposited  that surplus                 
  into  principal.   That  surplus  could  be  used for  other                 
  FORMER   REPRESENTATIVE   ORAL   FREEMAN  next   spoke   via                 
  teleconference from Ketchikan.  He attested to the fact that                 
  the permanent fund is working exactly as it was intended to.                 
  There is no  reason nor rationale for  "tinkering or messing                 
  with it when  it's working  great."  The  general public  is                 
  highly suspicious of changes in the fund.                                    
  Mr.  Freeman  referenced  similar  discussion  of  inflation                 
  proofing  in the late  1980s.  At that  time, he advised, he                 
  posed questions regarding  what would happen in  a situation                 
  where inflation equals  earnings.  If inflation  proofing is                 
  the first  priority, all  earnings would  be  used for  that                 
  purpose.  The general public would  soon question need for a                 
  fund that produces no benefit for its people.                                
  Mr. Freeman stressed that the dividend is the life insurance                 
  policy for  the permanent  fund.   When the  fund loses  the                 
  confidence, backing, and support of  the general public, the                 
  permanent  fund  will  disappear.    He suggested  that  the                 
  proposed bill is not worth the effort put into it.                           
  In response  to a  hypothetical situation  posed by  Senator                 
  Rieger, Mr. Freeman  stressed that  the second  half of  the                 
  earnings  of the permanent fund has  taken care of inflation                 
  since 1982 and has  produced an excess of $2.2 billion.   He                 
  voiced his  belief  that  the fund  would  be  undamaged  if                 
  inflation proofing was short in  a particular year since the                 
  history  of the fund  indicates that  would not  happen year                 
  after year.   Co-chairman Halford  remarked that moneys  are                 
  traditionally maintained  in the earnings reserve account to                 
  cover  a shortfall  in  any particular  year.   Mr.  Freeman                 
  Co-chairman Halford  noted that Senator Rieger  had prepared                 
  an  update  based on  nominal  dollars using  current income                 
  numbers and  requested  that projections  also  be  prepared                 
  based on real  dollars.  Senator  Zharoff asked if, at  some                 
  point,  inflation proofing  consumes  all of  the  earnings.                 
  Senator  Rieger responded,  "There's  always a  hypothetical                 
  like that."  He  then explained that people have  noted that                 
  half  is  going  to  dividends  and are  wondering  what  is                 
  happening  with the other half.   Proposals are offered with                 
  increasing frequency concerning  what to  do with the  other                 
  half.  Some of them will eventually garner enough support to                 
  pass.    When  that  happens, 100  percent  of  the  nominal                 
  earnings of  the permanent  fund will  be spoken  for.   The                 
  loser will be inflation proofing.                                            
  SB 51  reflects truth in  advertising of what  the permanent                 
  fund is really  achieving.   At the present  time, the  fund                 
  pays  out half  of  the inflation  component as  a dividend.                 
  That misleads the  public into thinking that "this  was only                 
  half of the  performance of  the fund that  is being  paid."                 
  The proposed change  is timely because of  fund performance.                 
  The proposed bill  could be effected without  impacting "the                 
  amount that is  put on  the table."   Senator Zharoff  noted                 
  that the other  half is not  being spent.   It "rolls  right                 
  into the corpus of the fund."                                                
  Co-chairman  Halford  voiced  his  belief  that  the  public                 
  understands that half the income is used for dividends while                 
  the other half provides inflation proofing.  He acknowledged                 
  an advocacy that believes that some  of the income should go                 
  through government and  "get spent through government."   He                 
  suggested that  the combined  effects of  the proposed  bill                 
  would  result  in  inflation proofing,  a  reduction  in the                 
  dividend formula, and a building  account that would be used                 
  to  fund  some  governmental  service.   The  public  should                 
  ultimately  decide what services it wishes  to buy.  Senator                 
  Sharp concurred.  He suggested that inflation proofing first                 
  and applying  the dividend  to half  of the remainder  would                 
  cause the public  to question the purpose  for the remaining                 
  Co-chairman  Halford  suggested  that the  bill  be  held in                 
  committee  for  updated  projections.    He  said  it  could                 
  possibly be heard again in the coming week.                                  
  The meeting was adjourned at approximately 11:00 a.m.                        

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