The House passed HCR13 earlier this week, mostly along caucus lines. The resolution is now in the Senate. It states that the legislature is committed to protecting the Permanent Fund and ensuring the continuation of the PFD for future generations.
While the language is not actually in the resolution, the House Speaker stated that their goal is to grow the fund balance to $100 billion by 2040. Let’s explore this goal a little bit.
The first question we need to ask is, “what balance are we talking about?” The Permanent Fund is established by the Alaska Constitution and is made up of royalty deposits. Over $17.2 billion of royalty money has been deposited to the Fund since 1978. Another $2.7 billion of general fund money capitalized the fund in its early years. And, nearly $22 billion of earnings have been reinvested into the principal account. As of January 31st, 2020, the constitutional balance was $41.8 billion.
Earnings from the Fund are a little different. The realized and unappropriated portion of the earnings is held in a statutorily created account called the ERA. While we refer to this account as part of the fund, it is really just another savings account managed along side the Permanent Fund. The money in this account is not protected and the legislature can use it whenever it wants (regardless of any statute that says otherwise).
The current balance of the ERA is $15.5 billion – although half of that money is slated to be moved out of that account over the next 16 months. Any additional realized earnings over the next year will add to the ERA balance.
Then there are unrealized gains – which are not technically protected by the constitution, but also haven’t made it to the ERA yet. These “limbo” earnings amount to $9.4 billion.
So, when we talk about the balance of “The Fund,” it is not immediately clear what that means. However, we can use the context and word choice to get a good idea. Because the House wants to protect the balance, they can only be referring to the unprotected earnings. After all, it would be meaningless to add legislative language to what the constitution is already protecting.
From this inference, we can assume that the House is talking about avoiding the use of the savings account to pay a statutory PFD. By paying a smaller PFD, they would like to grow the combination of constitutionally protected principal and undistributed earnings to $100 billion. Right now, the balance of those accounts add up to $66.7 billion. That means they are looking for $33.3 billion, or 50% growth, over the next 20 years.
One factor that will determine how fast the fund grows toward that $100 billion goal is the amount of money that is deposited according to the constitutional requirement. Of course, the amount of royalty deposits depends on the price of oil and the volume of production.
Over the last several years, the Department of Natural Resources has transferred around $300 to $400 million per year into the principal account of the Permanent Fund. Over the next 20 years, our model suggests that the average of possible futures works out to $7.6 billion of future deposits into the Fund.
Of course, the actual number is highly uncertain. If prices are low, or if anticipated developments don’t occur, those deposits might be more like $3.6 billion. And, if everything works out in our favor, we could see $12.1 billion of deposits between now and 2040.
Therefore, one way to ensure hitting the $100 billion target is to promote resource development. Any action that injures project economics would make the goal harder to achieve – even if that action raises more money in taxes. Lost production results in fewer royalty deposits and a smaller Fund balance that generates fewer earnings.
Adding the average royalty deposits to the current Fund balance generates an expected balance of about $74.3 billion in 2040. In other words, if we spend every penny of earnings in FY21 through FY40, the Fund would still have nearly $75 billion in it when we reach 2040..
In order to grow the fund to the target level, we need to add another $25 billion over the next 20 years. That’s a simple annual accretion rate of $1.25 billion per year.
If we wanted to, we could consider that $25 billion to be a liability, very similar to the way we think about our pension obligations. Each year we would make a contribution toward achieving the goal. This approach would actually result in a much cleaner accounting of revenues and expenditures than the horrendous way they do it now.
Regardless of how we keep the books, reaching the goal of $100 billion requires the difference between what the Fund earns and what we withdraw to average $1.25 billion per year. Put another way, the compound average growth rate of the fund needs to be about 1.5% above the draw rate to hit the target.
Equivalently, the average withdrawal from the fund should be limited to the earnings rate minus 1.5% to reach the goal. With the APFC currently projecting earnings of 7% per year, the withdrawn amount can be up to 5.5% of the annual fund balance and still hit the target.
Maximum FY21 Withdraw
As shown, the maximum average annual withdrawal depends on the return assumption. At current earnings rate projections, the POMV rate could be increased to 5.81% of the 5-year average fund balance and still hit the $100 billion goal.
Or, if we are committed to the 5% POMV after FY21, then the withdraw in FY21 could be much larger. Finding out how big the withdraw can be is a simple exercise. Just plug in a 7% earnings rate, add the average expected royalty deposits, and subtract 5% of the 5-year average balance each year. Then solve for the withdraw that results in $100 billion at the end of FY40.
When you do that math, the Fund needs to be $60 billion at the end of FY21 to hit the $100 billion target in FY40. That implies that using the current projections from the APFC, and sticking to the 5% POMV after FY21, the legislature could withdraw every penny the fund earns in FY21, plus another $7 billion, and still hit that $100 billion by 2040 goal.
The current earnings rate projection from the corporation is actually lower than its target rate of return of 5% plus inflation. With an inflation assumption of 2.25% going forward, the target return would be 7.25%. The current projection is also much lower than the historical performance of the Fund – which is right around 9%.
If you plug in the target return, the POMV could be increased to 6.08% of the 5-year average balance and still hit the $100 billion target. Or, we could get there by withdrawing up to $15.9 billion in FY21, then sticking to the 5% POMV after that.
Although the Fund has done a great job in the past, it would probably be hard to replicate the last 40 years of returns. But, just for fun, let’s plug in that 9% average earnings rate. In that case, the POMV could be increased to 7.93% of the 5-year average fund balance, and we would still hit the $100 billion in 2040 target. Or, the legislature could drain the entire ERA balance today and still reach their goal.
While everyone in Alaska wants to ensure future generations benefit from our exhaustible resources after they are gone, the constitution already provides that protection. However, the constitutional language doesn’t do enough to really achieve intergenerational equity.
So, from that perspective, the House is on the right track about needing to do more than the minimum. However, the resolution that was passed doesn’t really achieve much. It was intended to be a signal that the House would not support a draw higher than the current POMV rate.
However, the stated goal of $100 billion by 2040 is actually incredibly easy to reach. As shown, hitting that target and drawing additional funds out of the ERA are not mutually exclusive. The POMV rate is currently set at a level that will exceed the stated goal – even at the current earnings projections. We will far exceed that goal if the APFC hits its earnings target or better.
Of course, there is nothing that says that $100 billion by 2040 is the correct target to have. In fact, we might need the fund to grow even faster than that to really achieve the right balance between the present and future generations. So, the idea that growing the fund is part of a long-term solution to Alaska’s financial problems is spot on. It’s just that the arbitrary POMV number and a complete disregard for oil revenue uncertainty completely misses the mark.
If the $100 billion by 2040 target is what the legislature wants to commit to achieving, they can use a little more of the ERA balance to get through the next couple years of depressed oil revenues and still get there. I would just caution all of us against spending money without a real long-term strategy. Aspirational goals and arbitrary guardrails are not a plan.