I wrote a piece a few weeks back about how Alaska’s current investment earnings laws don’t work together. They create a paradox in which the budget deficit gets smaller if investment earnings get worse. In the extreme, we could balance the budget by losing $7 billion in the stock market.
Because that makes absolutely no sense, we should resolve the paradox. In some regards, that was the objective of the PFD working group. Now that they have finished their work (without making an actual recommendation), I want to write one last post on the topic. Here is one option to fix the underlying problem. Do with it what you will.
Current PFD Structure
The Permanent Fund Dividend (PFD) is a distribution of earnings from the public trust formed from a portion of our oil wealth (the Permanent Fund). Rather than use all of our royalty revenues as we sell our oil, we put 25% away for future generations. Those saved funds generate investment earnings, which are distributed to the beneficiaries (Alaskans). In this way, we transform one-time money into a flow of money that lasts for all time.
To determine how much money can be used, the current law says that we only count realized earnings as net income. Any money that is attached to an asset that hasn’t been sold doesn’t count until it is sold. As a result, there are several years in which the total earnings of the fund are far greater than the net income available for use.
For example, in FY17 the Permanent Fund earned $6.7 billion. However, only $3.2 billion of that entered the PFD calculation. In other years, those unrealized gains become realized and the number that is available for distribution is greater than what the fund earned.
Regardless of how the fund balance changes during a year, AS 37.13.140(a) defines income for the purpose of drawing money out of the Permanent Fund. It says that you add up the last five years of realized earnings, then multiply that by 21%. That formula is not completely arbitrary, but it is not as simple as using the actual earnings from the year.
The point here is that “available income” is not actual income. It’s a defined term that means something a little different than you think. And we use this definition to smooth out volatility that is a normal process of the markets. We have been ok with this process of not using accounting income for nearly 40 years now.
The historic PFD formula, says that we shall distribute 50% of that “available income” to the people of Alaska. The other half of those earnings can be used for whatever the legislature deems appropriate. Historically, those additional earnings have been primarily used to inflation proof the principal account of the Fund.
Current POMV Structure
In 2018, the legislature adopted SB26 which creates another definition of available income. In that law, AS37.13.140(b) was added to the existing law. That new provision states that the amount of money available for appropriations (including the PFD) is limited to 5.25% of the average balance of the fund over the first five of the last six years.
Inflation proofing is not considered to be an appropriation under the new law. Rather, it is just a transfer between the earnings reserve and the principal accounts.
By adding a second definition of available earnings, the legislature created an unintended conflict in the law.
Part (a) says to use 21% of the earnings from the last five years, use half for a PFD, use the other half to inflation proof the principal, and do whatever you want with the remaining funds.
Part (b) says to count up the earnings from the first five of the last six years, divide that by 5, and transfer that money to the general fund. If there’s enough money in the reserve account, you can transfer it to the principal for inflation proofing. And, if you want to pay a PFD, it has to come from the general fund transfer.
As you can see, these laws don’t line up. They instruct the legislature to do different things, with a different definition of income, based on different years. There will be times both laws cannot be followed.
Resolving the Conflict
Fixing this problem is actually incredibly easy. It doesn’t even require changing the PFD formula. All you have to do is use one definition of earnings rather than two. That’s not a big change and there is nothing magic about the way the old law defined earnings.
So, here you go. It’s a simple bill:
(a) Net income of the fund includes income of the earnings reserve account established under AS 37.13.145. Net income available for distribution from of the fund 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, which 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, 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.
AS37.13.140(b) is repealed.”
By replacing the old income definition with the new one, rather than by adding a conflicting definition, the entire problem is remedied. Of course, there are some conforming changes to make. But, the PFD formula itself doesn’t need an adjustment. We can stick to the same relationship we have always accepted (50% of available income goes to the PFD). We just need a definition of income that is consistent with the new POMV approach – which we are likely to see for the foreseeable future.
Using a POMV rather than a rolling average is just another way to get to the same end result. Just like the old definition of income available for distribution (which didn’t count all income and used an average), the POMV approach also smooths out the volatility of earnings.
The only real difference is that the 5.25% of fund balance is a long-term average of total earnings which accounts for inflation, whereas the 21% of 5-year realized earnings is a short-term average that doesn’t account for inflation. In effect, changing the definition of available income would simply shift the inflation proofing formula outside the income definition – A place that it arguably always should have been.
While we can quibble about whether or not we are using the “right” number to set the POMV, aligning the definitions of income seems like a reasonable approach to fixing Alaska’s investment earnings paradox. And doing so is not really a change to the PFD formula at all.