Juneau, Alaska

(907) 699-6788 ed.king@kingecon.com

Alaska Has an Investment Return Paradox

Over the last five years, Alaska has pivoted from being a Petro-state to a Trust Fund kid. Thanks to years of saving and re-investing a quarter of our oil royalties, we now have over $66 billion in the bank. And, those billions of dollars go to work every day, bringing billions of friends home to Alaska each year.

Since 2015, our financial assets have earned us $19 billion. At the same time, we collected $11 billion in oil money. In FY20, investment revenues will pay for 48% of our government services – on top of the PFD.

There is no question that we are now reliant on investment returns to pay the bills. And, the more money our financial managers make for us, the better – Right?

That’s where this story gets interesting.

The Baseline

Let’s just assume the fiscal year 2021 budget (which will be proposed on December 15th, 2019) looks a lot like the one we have today. That is, let’s pretend we need about $4.2 billion to pay the bills next year.

The current PFD statute will require right about $2 billion to pay. Which means we need a total of $6.2 billion to pay for the current size of government plus the full PFD.

Current revenue projections suggest we can cover about $2 billion of that with taxes and royalties. And, the allowable use of investment earnings is set at $3 billion.

So, we need $6.2 billion and only have access to $5 billion. In other words, we are staring at a $1.2 billion budget gap before we get started.

The Paradox

But, what happens if we get better than expected investment returns? Say the Alaska Permanent Fund Corporation (APFC) does an awesome job and generates a 10% return next year.

That would mean earnings increase by $2 billion over current projections. In that case, we only have a $1.5 billion deficit. That’s right – the extra money increases the deficit by over $250 million.

And what if the market tanks? Say the Corporation loses $1 billion for the year. In that case, the deficit decreases by $530 million.

The figure above shows this paradox. Earning more money creates a bigger financial problem under the current set of laws.

In fact, we would have a balanced budget if the Corporation loses $7.4 billion next year (a -11% return).

Since it makes absolutely no sense to root for a stock market crash so that our budget is balanced, let’s think this through.

The Problem

In simple terms, the problem stems from the fact that the withdraw limit is not tied to earnings, while our cash outflows are.

The amount of money we are allowed to take from the earnings reserve account (ERA) is set as a Percent of Market Value (POMV). For next year, that means that we are only allowed to spend $3 billion from the ERA – no matter what. Even if we receive $10 billion in income, we can only use $3 billion of it.

Meanwhile, the Permanent Fund Dividend (PFD) is set at one-half of net income. If we saw $10 billion in earnings next year, the PFD calculation would go up to $2.63 billion (that’s about $4,100 each).

More earnings result in a bigger PFD calculation. But, the amount we are allowed to spend does not change. Hence, the problem.

That extra $630 million would have to come out of the same $3 billion POMV transfer, increasing the deficit by the same amount. That implies we would need to cut the budget (or raise taxes) by over $600 million to balance the budget and pay the full PFD.

At the same time, we would have an extra $7 billion of earnings sitting in the bank that we aren’t allowed to touch.

This is a very troubling disconnect that was created by SB26 back in 2018. It creates these artificial deficits whenever we earn too much money.

The Solution

Because of this paradox, it is clear that something must change. Although these laws do not technically conflict, they cannot live in harmony as they are currently written.

For this reason, addressing the PFD statute has come to the forefront of legislative conversations. And, for this reason, I wrote a six-piece series about how the legislature may try to address the problem.

But, that series focused mainly on reducing the PFD (or passing a tax) to address the budget gap. However, we need to address this paradox regardless of how we solve the larger fiscal problem.

The solution lies in one of three paths:

  1. Change the POMV to follow earnings
  2. Change the PFD to match the POMV approach
  3. Separate the two laws completely

Option 1: Change the POMV

We could fix the paradox by changing the POMV. That would mean allowing the withdraw limit from the earnings to track actual earnings. To do that, either create an adjustable rate, which follows changes in the real earnings; or, change the draw to match the amount of earnings that actually exist.

The former is self-explanatory. The latter is basically just replacing the current transfer limit with the 50% of net income that the PFD doesn’t use. [side note: this is the default outcome if the ERA balance is run down to zero, regardless of what laws are in place]

Of course, this approach would require us to address the inflation proofing issue. But, that is not difficult. We just need to remove the inflation from the earnings before applying the 50/50 split that is currently on the books.

This approach protects the current PFD law and the ERA balance. However, it does not provide stability to the budget process.

It would look something like this:

Sec. 37.13.140. Income.
 (a) Net income of the fund includes income of the earnings reserve account established under AS 37.13.145. Net income of the fund shall be computed annually as of the last day of the fiscal year in accordance with generally accepted accounting principles, excluding any unrealized gains or losses. Income available for distribution equals 21 percent of the net income of the fund for the last five fiscal years including the fiscal year just ended, minus the amount calculated under AS 37.13.145(c), but may not exceed net income of the fund for the fiscal year just ended plus the balance in the earnings reserve account described in AS 37.13.145.

 (b) The corporation shall determine the amount available for appropriation each year. The amount available for appropriation is 5.25 percent of the average market value of the fund for the first five of the preceding six fiscal years, including the fiscal year just ended, computed annually for each fiscal year in accordance with generally accepted accounting principles. In this subsection, “average market value of the fund” includes the balance of the earnings reserve account established under AS 37.13.145, but does not include that portion of the principal attributed to the settlement of State v. Amerada Hess, et al., 1JU-77-847 Civ. (Superior Court, First Judicial District).

AS 37.13.145 (b) At the end of each fiscal year, the corporation shall transfer from the earnings reserve account to the dividend fund established under AS 43.23.045, 50 percent of the income available for distribution under AS 37.13.140, and to the general fund, an amount not to exceed the remaining 50 percent of the income available for distribution under AS 37.13.140.

 (e) The legislature may not appropriate from the earnings reserve account to the general fund a total amount that exceeds the amount available for appropriation under AS 37.13.140(b) in a fiscal year.

 (f) The combined total of the transfer under (b) of this section and an appropriation under (e) of this section may not exceed the amount available for appropriation under AS 37.13.140(b).

Option 2: Change the PFD

I wrote about how to change the PFD at length last month. So, I’ll skip the details here.

The bottom line is that to create harmony between the POMV and PFD laws, they should use the same base. So, if the PFD amount is to be restricted by the POMV limit, the best option is probably to tie the PFD amount to the POMV.

This is the approach SB103 takes. It works, so long as you are willing to make a substantial change to the PFD.

Option 3: Separate the Laws

Finally, a remedy to this whole issue is to just remove the “conflict” directly. That’s actually easy to do. Just treat the POMV transfer and the PFD as separate processes.

In this approach, the historical PFD calculation is protected and the transfer to the general fund is stable.

That’s because the current PFD law is reactive to market changes. It is always half of the actual earnings. Therefore, a responsive PFD can never exceed actual earnings and eat into the balance. We just need to avoid overusing the remaining earnings for other uses (which is why the POMV exists).

Doing this is a one-page bill (plus all the inevitable conforming changes). [Note: the actual numbers used in this approach would need to be evaluated.]

Here goes:

AS 37.13.140 (b) The corporation shall determine the amount available for appropriation each year. The amount available for appropriation is 5.25 2.5 percent of the average market value of the fund for the first five of the preceding six fiscal years, including the fiscal year just ended, computed annually for each fiscal year in accordance with generally accepted accounting principles.

AS 37.13.145 (e) Notwithstanding the transfer to the dividend fund under (b) of this section, the legislature may not appropriate from the earnings reserve account to the general fund a total amount that exceeds the amount available for appropriation under AS 37.13.140(b) in a fiscal year.

 AS 37.13.145 (f) The combined total of the transfer under (b) of this section and an appropriation under (e) of this section may not exceed the amount available for appropriation under AS 37.13.140(b).

Conclusion

It is very clear that something needs to change in the relationship between the POMV and PFD. The paradox that these two laws create should affirm that to everyone. The only question is what change we should pursue.

Because this website is not a platform to advocate for policy changes, I won’t tell you which one I prefer. But, any of them would work. I just urge the governor and the legislature to resolve this issue sooner rather than later.

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