Legislature(1995 - 1996)
03/29/1996 08:08 AM FIN
* first hearing in first committee of referral
= bill was previously heard/scheduled
= 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 responsibility. 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 existence. 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 percent. 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 activities. 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 concurred. 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 half. 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. ADJOURNMENT The meeting was adjourned at approximately 11:00 a.m.