How the Permanent Fund Works

Talking about the Permanent Fund can be confusing. There are a lot of moving pieces. But, the illustration above shows how all of those pieces connect. The rest of this article will try to break the key points down a little more clearly.

There is a rich history around the fund, its intent, and its creation. That makes for some very interesting debates. My goal today is not to talk about the past. Instead, I am writing this post to answer the seemingly simple question: How does the permanent fund work?

To any lawyers in the room, I apologize for being imprecise in my language here as I try to turn the jargon into English.

What is the Alaska Permanent Fund?

To get started, let’s talk about the structure of the fund itself. Our Permanent Fund is a sort of savings account that holds about 25% of the royalty money we get from leasing our mineral rights to companies that get our oil out of the ground and to the marketplace. The money in the principal of the fund is off limits to politicians.

We created the Permanent Fund when Alaskans opted to pass a constitutional amendment in 1976 — Right before oil started flowing down the trans-Alaska pipeline. Here is how the fund works according to the constitution:

Why do we have a Permanent Fund?

I won’t get into the weeds here. But, the popular story about how the Permanent Fund came to be goes back to 1969. After the state selected some promising land on the North Slope, it held a lease sale. Oil companies knew this was a good place to find oil based on the discovery of Prudhoe Bay just a year earlier.

That lease sale generated $900 million of bonus bids — Enough money to fully fund the state budget for nearly a decade without any other revenues. But, before the first drop of oil ever started flowing, that enormous windfall was gone.

As the story goes, Alaskans were afraid that legislators would spend every penny of money as it came into the state coffers. So, they decided to take away some of the money from the legislature. Instead, they wanted to put some of that money away for future generations, knowing that the oil would stop flowing some day and not trusting politicians to plan for the future.

Where does the Permanent Fund Dividend (PFD) come from?

The PFD is a distribution of the earnings from the Permanent Fund to Alaskans. It’s sort of like a how a corporate dividend is a distribution of profits to the stock owners of a corporation. Each year, we calculate how much profit we made off the pile of money sitting in our fund. Then, we divvy that money up.

According to the current law, the calculation has two steps. First, determine how much profits there are by totaling all “realized” earnings from the last five years, then multiplying that by 21% (if you’re interested, here’s more about that 21% number). Step two is splitting this “income available for distribution” in half — 50% to the people and 50% to the general fund.

Since the money in the Permanent Fund came from our oil royalties, the PFD is indirectly tied to oil development. However, the size of the statutory PFD in any given year has more to do with how well the stock market performs than what the price of oil is doing.

What is the argument about “stealing” the PFD?

When Alaskans created the Permanent Fund in 1976, they didn’t address what the fund was for. The constitution simply says that we can’t touch the money in the fund. But it also says the earnings from the fund can go wherever the legislature wants.

The debate about how to use that money happened in the finance committee rooms. Some people wanted to use the money to remove the need for taxes. Others wanted to use it to build up our young state with infrastructure projects. Still others wanted to give all of that money to the people, while maintaining a smaller government paid for with taxes.

In 1980, elected officials decided that we would get rid of personal income taxes and give every Alaskan a check from these earnings. The debate continued in 1982. At that point, they settled on splitting the difference. Half of the money would go toward reducing the need for personal taxes. The other half would go to the people as an annual dividend.

As oil production declined and oil prices crashed in 2014, that old debate reemerged. Now, oil money isn’t enough to pay the bills. So, some people think we should raise taxes to cover spending while keeping the PFD. Others say we should use the fund earnings to remove the need for taxes.

Governor Walker took it upon himself do the latter. He cut the PFD in half with his red pen. Whether or not he was allowed to do that went all the way to the Alaska Supreme Court. The court ruled that he was allowed to short-fund the PFD without the actual law being changed. Ever since then, legislators have ignored the way the law says to determine the PFD, opting to set the amount based on what they think we can afford instead.

Because the law still says that half of those earnings belong to Alaskans, some people think that giving less than that amount is equivalent to taking away something that legally belongs to them. Thus, they consider it “stealing” from them.

What is the “earnings reserve account?”

Right from the beginning of the discussion about creating a Permanent Fund, Alaska looked to other places around the world. University endowments, sovereign wealth funds, public foundations, and private trusts all provide insight into how to manage a large sum of money over a long period of time.

Alaska adopted the standard endowment approach of the time: a protected principal with accessible earnings. That means that money deposited into the fund is locked away forever. But, the earnings from the fund are fair game. This structure ensures that the beneficiaries can’t burn through their money, while providing them with a sustainable income stream.

The challenge with this approach is that investment earnings fluctuate a lot from year to year. It’s hard to manage a university budget or even an individual lifestyle when you never know what your income will be. You have to be diligent with your money, saving some when income is high so that you can cover costs when it’s not.

For example, a person with a $1 million trust might get a check for $100,000 one year and nothing the next. An irresponsible person could find themselves on a beach one year and on the streets the next. It’s smarter not to spend all of that big check when it comes in.

That implies that you have to have another savings account to hold your excess earnings during good years, which you draw from during the bad ones. That’s what the earnings reserve account (ERA) is.

The ERA holds the fund’s earnings. During good years, the account gets more deposits (from the fund’s earnings) than we use. So, it grows. During bad years, the account doesn’t get as many deposits (from the funds earnings) as we use. So, it shrinks.

But, the ERA is a statutorily created account to hold earnings. It is not part of the fund we created in the constitution. Every dollar in the ERA is, by definition, earnings from the fund. It’s not quite a savings account, because money constantly flows through it – fund earnings in, general fund and dividend transfers out. It’s merely a holding account. And even if this holding account had a zero balance for a time, the actual fund is still protected by the constitution – which will constantly generate more earnings flowing into the ERA forever.

What is the POMV people talk about?

When the dot com bubble popped twenty years ago, anyone that was living off investment earnings ran into a serious problem. Their revenues were negative. Universities and sovereigns didn’t have any money from their endowments to pay their bills. If they had managed their money well with an earnings reserve account, things would have been fine. But, they hadn’t.

So, many large funds decided to change the way they dealt with things. They still wanted to protect the principal balance so that beneficiaries couldn’t run the fund out of money. But, they also wanted to smooth out the ups and downs of the market a little better than trusting the beneficiaries to do it. Enter the Percent of Market Value (POMV) approach to endowment management.

Under a POMV approach, you don’t need to worry about having an earnings reserve. Instead of distributing earnings as they happen, you basically give the beneficiaries an allowance. Regardless of how much earnings the fund actually generates, the trustees write a check for a predetermined percentage of the fund’s value – usually around 4% to 6%.

For example, a person with a $1 million trust would get a check for $50,000 per year forever. That way they never have a zero income year and also can’t blow the nest egg on new cars and fun vacations.

If the fund generates a bigger return than the POMV draw, the balance gets bigger and future checks grow. If the fund doesn’t make a better average return than the POMV, the fund gets smaller and the checks shrinks. The trick is getting the percentage correct to match the goals of the fund.

Some funds want to build in growth, so the POMV is smaller than expected returns. Other funds rely more heavily on the fund for present operations, so the percentage is set at expected returns. So long as the POMV rate is equal to or less than actual average returns, this structure does both jobs – protecting the principal balance and providing a stable income stream.

What do people mean by “overdrawing” the Permanent Fund?

During the last decade, the stock market has been on fire. Consequently, our Permanent Fund generated a lot of earnings. Combine that with record high oil prices, and suddenly Alaska had way more money than it needed. So, the earnings reserve balance grew and grew.

Even after oil prices crashed in 2014, we kept growing the earnings reserve account. The legislature opted to use our constitutional budget reserve (CBR) to cover the revenue shortfall, rather than using our investment earnings. By 2018, the ERA had grown to an incredible $19 billion balance, plus another $6 billion of unrealized appreciation on assets.

Once the CBR was running too low, while oil prices were not recovering, the elected officials finally turned their attention to the investment earnings. However, the line between the principal of the Permanent Fund and the holding account for its earnings had been blurred. Despite the constitutional guidance that all earnings from the fund belong to the general fund, people had grown accustom to considering those earnings to be off limits. So, the legislature placed a limit on how much they could draw from that reserve account in any given year.

In theory, the draw from the ERA should be less than the average annual earnings from the fund. Therefore, the ERA balance should grow over time. In effect, the POMV limit imposed by the legislature in 2018 turns those excess earnings in the holding account into part of the protected principal, but with an escape clause that they can still use that money if they really want to.

The number that comes out of the POMV calculation is called a “sustainable draw” from the ERA. But, remember that the constitution already protects the principal. There is no such thing as an unsustainable draw from the Fund. The current POMV protects the balance of the holding account, not the fund itself.

So, when people talk about “overdrawing” the fund, they really mean using some of the balance of the ERA (the money saved during really good years that is meant to offset the really bad ones) to deal with the current crisis.

Should we protect the ERA balance from the same fate as the CBR?

Yes. Absolutely. 100% we should. We just need to talk about the right way to do that. Because we lacked a good structure, the legislature spent nearly $20 billion out of savings from our budget reserves without blinking an eye. There was never any concern about the long-term impacts of doing so. The current concern that spending savings meant losing the associated earning power it held was absent.

Now that all of that money is gone, elected officials have come around to understanding that some type of spending or revenue limit is necessary. That is why they passed the POMV limit.

However, that limit is ineffective. It’s very likely to be broken next year. We need a better structure to protect this money. One option is to move the ERA balance into the principal, then use the current constitutional structure of the Fund, or change it to a real POMV structure.

The problem with this approach is that doing so would very likely result in some cash flow management problems. We would need a budget reserve to make that work. But, they’ve already drained those. So, we would need to leave a few billion dollars behind in one of our accessible savings accounts. However, we also need to make sure we don’t spend those accessible savings on things we can’t afford.

The statutory POMV limit tries to walk this line. But, the current POMV fails to recognize the whole picture. It only limits investment earnings without considering the volatility in our other revenue streams or the needs of the current economy. A better approach is to put all of the state’s revenues and expenditure needs under one roof.

That is exactly what an effective constitutional spending limit does. It allows us to determine what our needs are and limits spending to meet them. Then, it considers all of the state’s revenue and assets when determining how to meet those needs. If we have excess revenues, we save them for a rainy day. If we have a pandemic that shuts down our economy, it allows us to use those savings to meet those needs.

Summary

The narrative around the Permanent Fund, the dividend, the earnings reserve, and the POMV approach has really muddied the conversation during the last few years. Unfortunately, it’s turned into a battle of sound bites rather than actual understanding. Some people with a superficial understanding of the situation are even resorting to name-calling. Others that merely mimic talking points are making the problem worse.

I am hopeful that Alaskans can start the conversation with a better understanding of the basics before they latch on to bad information. This article is intended to help build some of that fundamental knowledge base. If you’d like to discuss this topic further, I’m happy to talk.

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