Legislature(2003 - 2004)

03/29/2004 09:04 AM Senate FIN

Audio Topic
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
     CS FOR SENATE BILL NO. 326(STA)                                                                                            
     "An Act relating to investments of Alaska Permanent Fund                                                                   
     assets; and providing for an effective date."                                                                              
This  was the first  hearing  for this  bill in  the Senate  Finance                                                            
Co-Chair  Wilken  stated this  bill,  offered  by the  Senate  Rules                                                            
Committee  by  Request   of  the  Division  of  Legislative   Audit,                                                            
"modifies the investment  guidelines for the Alaska Permanent Fund."                                                            
BOB STORER, Executive  Director, Alaska Permanent  Fund Corporation,                                                            
testified that  whereas most public funds merely follow  the prudent                                                            
investor  rule  to  make  their  asset  allocation   decisions,  the                                                            
Permanent  Fund is additionally  guided by  a statutory list,  which                                                            
dictates criteria  for the types of investments that  could be made.                                                            
This  legislation   is  requesting  increased  flexibility   in  the                                                            
management  of the fund for two reasons.  First, in the near  future                                                            
the Fund would  reach its statutory limitations, forcing  it to sell                                                            
assets based solely on  these restrictions. Second, this flexibility                                                            
could be utilized to develop a future management tool.                                                                          
Mr. Storer gave a Power Point presentation as follows.                                                                          
     Alaska Permanent Fund                                                                                                      
     Senate Finance Committee                                                                                                   
     Senate Bill 326                                                                                                            
     Investment Flexibility                                                                                                     
     Summary of Fund's statute changes                                                                                          
     1980 - SB 161, Sponsored by Sen. Tim Kelly, Sen. George                                                                    
     Hohman, Sen. Mike Colletta, and Sen. John Sacket                                                                           
          SB  161 created the Alaska  Permanent Fund Corporation  to                                                            
          manage   the Permanent   Fund  and  started  the  existing                                                            
          statutory  list of allowed investments. This list extended                                                            
          beyond   the  Fund's  initial  investment   limitation  of                                                            
          Treasury  bonds to include corporate bonds, certificate of                                                            
          deposits  and  bankers  acceptances.  The  list  initially                                                            
          allowed  the Permanent Fund to invest in shares of savings                                                            
          and  loans associations, but this provision has since been                                                            
     1982 - SB 684, sponsored by Gov. Jay Hammond                                                                               
          SB  684 allowed  the Permanent  Fund to  invest in  common                                                            
          stocks,  partial ownership of real estate  properties (not                                                            
          to  exceed  40%), loans  for  commercial  real estate  and                                                            
          deposits of US dollars held oversees.                                                                                 
     1989 - HB 69, Sponsored by Gov. Steve Cowper                                                                               
          HB  69 gave the APFC authority  to invest in non-domestic                                                             
          (International) stocks and bonds.                                                                                     
     Summary of statute changes (cont.)                                                                                         
      1992 - SB 39, sponsored by the Senate Finance Committee                                                                   
          SB  39  gave  the APFC  authority  to  invest in  A  rated                                                            
          corporate  bonds to a maximum of 5%. Prior to this change,                                                            
          the  Fund  could only  be invested  in bonds  rated AA  or                                                            
     1994 - HB 373, sponsored by Legislative Budget and Audit                                                                   
          HB  373 allowed the fund to own up to  100% in real estate                                                            
          properties  worth less than $150 million, and up to 67% in                                                            
          properties worth greater than $150 million.                                                                           
      1996 - HB 525, sponsored by the House Finance Committee                                                                   
          HB  525 gave  the APFC  authority to  invest in  corporate                                                            
          bonds rated BBB or higher.                                                                                            
     1999 - HB 156, sponsored by the Legislative Budget and Audit                                                               
          HB   156  allowed  the   Fund  to  leverage  real   estate                                                            
          investments   and increased  asset  allocation  limit  for                                                            
          stocks  to 55% of the total  market value of the  Fund. HB
          156  also created the "basket clause" that allows up to 5%                                                            
          of  the Fund to be invested in alternative  investments or                                                            
          to  be applied  to existing  asset  allocations to  expand                                                            
          their  limits. In addition,  HB 156 allowed the  Permanent                                                            
          Fund  to be the  sole owner of  any real estate  property,                                                            
          regardless of value.                                                                                                  
Mr. Storer  responded to criticism  that increasing the flexibility                                                             
of the  Fund would  be too  risky, by  emphasizing  that the  Fund's                                                            
prudent use  of the basket clause  must be considered. The  Fund has                                                            
only now begun  to utilize the basket clause provisions  established                                                            
five years ago.                                                                                                                 
     Fund's historical asset allocation                                                                                         
     [This graph demonstrates the percent of funds allocated to:                                                                
     U.S. Fixed Income, U.S. stocks, Non-U.S. Fixed Income, Non-                                                                
     U.S. stocks and Real estate, between the years 1978 and 2002.]                                                             
Mr. Storer emphasized the changes in the asset allocation of the                                                                
Permanent Fund  as it was "given the  ability to invest in  expanded                                                            
legislative  authority". He emphasized  the judicious nature  of the                                                            
Permanent Fund in expanding investments.                                                                                        
     Benefits of proposed changes                                                                                               
        · Investment flexibility                                                                                                
        · Increased returns                                                                                                     
        · Increased diversification                                                                                             
Mr.  Storer  qualified  that the  Fund  needs  increased  investment                                                            
flexibility to enable future  administrators of the Fund to meet the                                                            
needs of the dynamic  investment management industry.  Additionally,                                                            
increasing  the Fund's  investment  flexibility would  make a  five-                                                            
percent  real rate  of return  more probable.  Increased  investment                                                            
flexibility does not necessarily  translate into increased risk, but                                                            
rather   into  greater   diversification.   Investing   in   diverse                                                            
investment  classes actually  reduces risk.  Mr. Storer added  that,                                                            
"risk is  measured not  by losing  money, but  by the volatility  of                                                            
returns from year to year."                                                                                                     
     Potential questions                                                                                                        
        · Too much risk?                                                                                                        
        · How will the Board of Trustees use this flexibility?                                                                  
        · Derivatives?                                                                                                          
Mr.  Storer   reiterated  the  traditional   judiciousness   of  the                                                            
Permanent  Fund.  Considering  other  public  funds,  the  increased                                                            
investment  flexibility  proposed  in this  legislation  would be  a                                                            
conservative structure.                                                                                                         
Mr. Storer continued by  giving some specific examples of the Fund's                                                            
possible implementation of this legislation.                                                                                    
     Permanent Fund asset allocation                                                                                            
     [This  bar graph demonstrates  the percentage of the  Fund that                                                            
     was,  or  would be  invested  in:  Traditional  asset  classes,                                                            
     Basket  clause-stocks,   Basket clause-private   equities,  and                                                            
     Basket  clause-hedge funds, on  the following dates:  12/31/03,                                                            
     6/30/04, 12/31/04 and 6/30/05]                                                                                             
Mr. Storer stated that  recently, because of the appreciation in the                                                            
equity market, the Fund  has begun utilizing the basket clause.  The                                                            
Fund would soon implement  two more strategies, which fall under the                                                            
basket clause:  a hedge fund strategy,  and a diversified  portfolio                                                            
referred  to as private  equities.  Within a few  years, the  Fund's                                                            
five-percent  of alternative investments  allowed for in  the basket                                                            
clause would be exhausted.                                                                                                      
Co-Chair Wilken asked if  all Permanent Fund managers have access to                                                            
the provisions of the basket clause.                                                                                            
Mr. Storer replied  that not all of the managers have  access to the                                                            
basket clause.  Specific managers  are granted the authority  to use                                                            
the provisions  of  the clause  based on resolutions,  statutes  and                                                            
individual contracts.                                                                                                           
Senator Bunde asked how  the Permanent Fund would have been affected                                                            
if the hedge fund and private  equities strategies that are proposed                                                            
for 2005, were enacted in 1995.                                                                                                 
Mr. Storer  responded that higher  returns would have been  realized                                                            
if the proposed  allocations were  implemented in 1995; however,  if                                                            
they were enacted in 2000  the private equity portion would not have                                                            
done well  and the  hedge fund  portion would  have "added  superior                                                            
Senator Bunde  inquired as  to how the  Permanent Fund's  investment                                                            
portfolio would  have been affected as a whole, given  the scenario.                                                            
Mr.  Storer speculated  that  given  the  bear market,  the  overall                                                            
result would have  been similar to what is currently  being achieved                                                            
by those investment strategies.                                                                                                 
Senator  B. Stevens  asked for  a clear  interpretation  of the  bar                                                            
graph on slide seven titled, "Permanent Fund asset allocation".                                                                 
Mr. Storer  clarified  that the  bar graph represents  the  existing                                                            
investment authority of the Fund.                                                                                               
Senator B. Stevens  asked if requiring a five-percent  limit in each                                                            
investment  class, and  considering certain  alternative  investment                                                            
strategies  are  appreciating  in  value,  is forcing  the  Fund  to                                                            
utilize realized  earnings to remain within the five-percent  limit.                                                            
Mr. Storer affirmed and  elaborated that the Fund would be forced to                                                            
liquidize  securities  and  take the  realized  gains  if the  five-                                                            
percent limit was approached.                                                                                                   
Senator  B. Stevens  suggested  that  if  the percentage  limit  was                                                            
increased to 10 percent,  and distribution guidelines were retained,                                                            
the need to  use realized earnings  would diminish. As a  result the                                                            
realized earnings would not grow at the rate they are currently.                                                                
Mr.  Storer qualified  that  during  this  period the  Fund's  other                                                            
investments  would also  be realizing earnings,  especially  private                                                            
equities.  The amount  of realized  earnings  would be significant,                                                             
although less  than if forced liquidation  were required.  Under the                                                            
expanded clause,  the realized earnings would likely  be equal to or                                                            
greater then the current basket clause.                                                                                         
Senator  B.  Stevens  asked  if  the  investment   status  quo  were                                                            
maintained  and the basket clause  increased, whether the  potential                                                            
for realized earnings would diminish.                                                                                           
Mr. Storer predicted realized  earnings would increase over the long                                                            
term: a period of five or more years.                                                                                           
SFC 04 # 60, Side B 09:51 AM                                                                                                    
Mr. Storer continued that  in the in near term, if the basket clause                                                            
were expanded,  he would expect realized earnings  to be the same or                                                            
higher than  current earnings. The  differences would be  attributed                                                            
to market performance and Fund policy not dictated by statute.                                                                  
Senator  B. Stevens  remarked that  every managed  fund has  imposed                                                            
limitations on investment  classes and when those limits are reached                                                            
the  fund is  forced to  realize earnings.  Possible  reductions  in                                                            
realized  earnings  due  to  an  extended  basket  clause  would  be                                                            
incidental  under the Percent of Market  Value (POMV) pay  out plan,                                                            
but the possible reduction  in realized earnings could significantly                                                            
affect the current pay out method.                                                                                              
Mr. Storer informed  that when the Fund develops asset  allocation a                                                            
target allocation is established  for each asset class. Restrictions                                                            
are then created  to avoid a high-turnover environment,  which would                                                            
result in high transaction  costs. He informed that policy currently                                                            
imposes these  bans and that  this legislation  would make  the bans                                                            
Senator  B.  Stevens  asked  if these  provisions  are  not  already                                                            
Mr. Storer  replied that statutory  provisions have always  existed;                                                            
however, the Fund  is nearing the limitations for  the first time in                                                            
its history.                                                                                                                    
Senator Hoffman  clarified that allowing the Fund  administrators to                                                            
alternatively  invest 10  percent of  the assets  of the Fund  would                                                            
translate into  making accessible  $2.8 billion. He recalled  dialog                                                            
on  this  legislation  in the  Senate  State  Affairs  Committee  in                                                            
conjunction  with the Board of Trustees'  other recommendation  that                                                            
the Fund be managed  under a POMV system. He expressed  concern that                                                            
when dependent upon a certain  income source, higher risk investment                                                            
options  are  not  taken.  He  used  the  example  of  a  retirement                                                            
investment  fund that is invested  in higher risk ventures  when the                                                            
worker is younger  and transitions to lower risk investments  as the                                                            
worker  nears  retirement.   If the  POMV  plan  were  implemented,                                                             
dependence   on  the  Fund's  earnings   would  gradually   increase                                                            
suggesting investment in lower risk ventures.                                                                                   
Mr. Storer replied  that when developing a portfolio,  an investment                                                            
time horizon,  risk tolerance, and  expected returns are  considered                                                            
in order to  ensure a sufficient cash  flow. He noted that  unlike a                                                            
retirement  fund,  an endowment  fund  with  a  POMV method  is  not                                                            
managed  for eventual  liquidation  of assets  but  rather the  real                                                            
income  is used to  supply a predictable  cash  flow. The POMV  plan                                                            
would  insure the  long-term  viability  of a  fund.  If the  Fund's                                                            
earnings  were eventually  used  to fund  both dividends  and  State                                                            
government,  its  investment  portfolio   must  be  restructured  to                                                            
maintain  multiple  cash  flows.  He  spoke  to  the  advantages  of                                                            
investment  flexibilities to enhance  the Fund's ability  to provide                                                            
Senator Bunde  referenced Senator  B. Stevens' earlier comment  that                                                            
the  current   payout  system   forces  sale   of  high   performing                                                            
investments  resulting in realized  gains. If this legislation  were                                                            
adopted under  the current payout system, dividends  would likely be                                                            
higher. However,  if both  this legislation  and the POMV plan  were                                                            
adopted,  fluctuation   of  dividend  amounts  would   decrease.  He                                                            
cautioned  against forcing  poor  management decisions  to  increase                                                            
dividend amounts,  warning that the  future value of the  Fund would                                                            
be jeopardized. He was undecided on the matter.                                                                                 
Senator  B. Stevens  spoke to  Senator Hoffman's  point,  expressing                                                            
agreement  with Senator  Hoffman's example  of the  management  of a                                                            
"finite  pool" of capital.  However, Senator  B. Stevens  emphasized                                                            
that the  Permanent Fund  is not  a finite capital  fund because  it                                                            
receives royalty  payments and statutory  inflation proofing  funds.                                                            
Co-Chair  Wilken asked  the witness  to comment  on Senator  Bunde's                                                            
Mr. Storer responded  that the current pay out methodology  is based                                                            
on a  five year  moving average  of  realized income.  To date,  the                                                            
income  from the Fund  has been  used for three  purposes:  dividend                                                            
payments, special  appropriations to the principal  of the Fund, and                                                            
inflation proofing  of the Fund. More realized income  translates to                                                            
a greater  pool  of money  available for  distribution.  Due to  the                                                            
current   strict  formula   for  distribution,   any  program   that                                                            
accelerates realized income would produce a larger dividend.                                                                    
Senator  Olson  introduced  members  of  the  Kotzebue  High  School                                                            
Leadership Program who were attending the meeting.                                                                              
Co-Chair  Green recalled  that  adoption of  the  basket clause  was                                                            
discussed  extensively  during  1998  and 1999,  with  some  parties                                                            
viewing the provision with  skepticism and others "with a great deal                                                            
of  faith". Through  those  discussions  she  came to  realize  that                                                            
placing a  ceiling within  a system creates  constraints on  choices                                                            
leading to success. The  State expects the Permanent Fund's Trustees                                                            
to have  the  ability to  invest "widely  and  deeply". Constraints                                                             
diminish  that ability  and at times  force the  Fund's Trustees  to                                                            
compromise  the profitability of the  Fund. The dividend  should not                                                            
be the focus  of discussion when considering  this legislation,  but                                                            
rather  the two  clear  objectives  that are  stated  in the  Alaska                                                            
Permanent Fund  Corporation's "Sponsor  statement for SB  326" [copy                                                            
on file].                                                                                                                       
Mr.  Storer  agreed.  He  assured  that  the  Corporation  has  been                                                            
judicious  in  exercising   the  authority  granted  to  it  by  the                                                            
legislature.  At no time  in past discussions  with the legislature                                                             
has the  dividend  been the  focus. The  goals of  this legislation                                                             
remain twofold:  to insert housekeeping  legislation to express  the                                                            
need and  intent of  the basket  clause and to  increase the  basket                                                            
clause  from five  to 15  percent. Senator  Stedman  made a  motion,                                                            
supported by the  Permanent Fund's Board of Trustees,  to reduce the                                                            
limit  to  10  percent,  which  would  provide  the  Permanent  Fund                                                            
Corporation  with flexibility in the  next few years. The  Trustees'                                                            
eventual alternative investment goal remains 15 percent.                                                                        
Co-Chair Wilken  questioned the language  in Section 1, amending  AS                                                            
37.13.120  (e), which  states  that  the Corporation  could  "borrow                                                            
money if the  borrowing is without  recourse to the corporation  and                                                            
the fund." He asked if  this language would allow the Corporation to                                                            
not repay loans.                                                                                                                
Mr.  Storer  replied  that the  Corporation  could  not  pledge  the                                                            
principal of  the Fund. The Corporation  only has a small  amount of                                                            
leverage  to   borrow  from  within   its  real  estate   portfolio,                                                            
approximately  15 percent of assets. The Fund operates  subsidiaries                                                            
as limited  liability corporations  and collection on loans  made to                                                            
these subsidiaries could not access the Permanent Fund.                                                                         
Co-Chair  Wilken noted  the  delay in  publication  of the  Producer                                                            
Pricing Index  for January and February  2004 and asked whether  the                                                            
Trustees have discussed this.                                                                                                   
Mr. Storer  responded  that the  matter  has not  been discussed  in                                                            
detail.  He informed  that the  Producer Pricing  Index figures  for                                                            
December 2003 are being  studied extensively as they will be used to                                                            
determine the level of inflation proofing.                                                                                      
Co-Chair Wilken  commented that this  information affects  inflation                                                            
and interest rates.                                                                                                             
Mr. Storer  relayed that  inflation appears  to be rising,  but very                                                            
Senator  Hoffman  asked if  the  Board of  Trustees  considered  the                                                            
State's future  dependency  on the Fund when  crafting the  proposed                                                            
Mr. Storer  answered,  "absolutely".  The Trustees'  strategy  is to                                                            
focus on investment  diversification, which will enhance  the Fund's                                                            
ability to meet the State's future needs.                                                                                       
Senator Bunde  suggested that  under the  current payout system  the                                                            
Board  of  Trustees  could  be  pressured  into  selling  assets  to                                                            
increase realized  earnings, and consequently,  a greater  dividend.                                                            
He asked  the  witness if  this scenario  is feasible.  Further,  he                                                            
inquired   if  the   proposed   legislation  would   prohibit   such                                                            
exploitation by a future Board of Trustees.                                                                                     
Mr.  Storer acknowledged   that a  Board  of Trustees  could  affect                                                            
realized gains  either for good reason  or artificially,  and stated                                                            
that such a  probability exists whether  or not this legislation  is                                                            
Co-Chair Green  offered a motion to  report the bill from  Committee                                                            
with individual recommendations and accompanying fiscal note.                                                                   
There was  no objection  and CS  SB 326 (STA)  MOVED from  Committee                                                            
with zero fiscal note #1 from the Department of Revenue.                                                                        

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