Inflation Proofing the Permanent Fund

There was a little bit of a sparring match during the PFD working group meeting last week. Senators Hughes and Stedman seemed to have different impressions about the Percent of Market Value (POMV) approach to managing the Permanent Fund. But, the fireworks came in the form of a misunderstanding about how inflation proofing works.

Let’s clear the issue up a little bit today.

The Basics

Before we dive in too deep, let’s make sure we understand the basics.

Alaska’s Permanent Fund is the place we store a quarter of our mineral royalties. It is a constitutionally created fund – the only place the legislature can’t touch. The Fund is comprised of two “accounts,” – the Principal Account and the Earnings Reserve Account (ERA). [by the way, the firm uses investment principles to manage the Fund; but, the fund has a principal account.]

Mineral royalties are deposited into the Principal Account (sometimes called the “corpus”). This is the account that is protected by the constitution. No money can ever be drawn out of this account without a constitutional amendment that would change the current structure.

A separate account is established by statute. It is commonly called the “earnings reserve account” or ERA. The ERA is where all “realized” gains are deposited. It is the holding account for investment earnings while the legislature decides what to do with the money. Every dollar in the ERA is, by definition, earnings.

Any money in the ERA can be distributed as dividends, transferred to the General Fund to balance the budget, moved into the Principal Account to protect it from future use, put to another state account, or left in the ERA while the legislature decides what to do with it.

Why are there two accounts?

The important takeaway here is that the Permanent Fund, or “the Fund,” is actually two accounts – one that is protected and reserved for all future Alaskans, another that is not protected and is available to current Alaskans.

When the amendment adding Article 9, Section 15 to the constitution was passed in 1976, the idea was that part of our oil wealth should be protected FOREVER. This was the common endowment management philosophy at the time. A certain amount of money was put away into perpetuity and only the earnings from that balance could be used.

That philosophy is built from a simple mathematical truth – As long as you spend less than you earn, you will never run out of money. So, that core amount was dedicated to a principal account that could never be touched. But, anything that was earned was free game. The last line of the Permanent Fund section of the constitution makes this clear:

“All income from the permanent fund shall be deposited in the general fund unless otherwise provided by law.”

Shortly after the Permanent Fund was established, the primary purpose of those earnings became the payment of the Permanent Fund Dividend (PFD). But, the PFD is paid on what is basically 50% of the 5-year average earnings (technically half of 21% of the last 5-years’ earnings).

So, if the Fund earns $1 billion in investment revenue in one year, $500 million of that gets paid out in $100 million distributions each year over the next five years. That’s why we have the ERA (originally called the “undistributed earnings account”). After paying out the first $100 million, the state needed a place to hold the other $400 million to pay over the next four years.

Inflation Proofing the Principal

While the Principal Account is protected from withdraws, it can decrease in “real” value. That’s because the purchasing power of money decreases over time due to inflation. Simply put, $1 billion of earnings in 1980 won’t buy the same things in 2020. To treat all future Alaskans equally, the earnings should have the same purchasing power.

Therefore, AS 37.13.145(c) calls for some of the Fund earnings to be transferred over to the Principal Account each year. That protects those royalty deposits that are meant to last forever from being eroded by inflation.

That amount of the transfer is calculated by multiplying the rate of inflation during the previous calendar year by the balance of the Principal Account as of the last day of the fiscal year that just ended.

Since the money in the ERA is just waiting to be distributed, and since it is not part of the money intended to be protected forever, it wouldn’t make sense to have an inflation proofing provision to protect it. Doing so would be like inflation proofing an excess balance in your checking account. Why would you do that?

In fact, the other 50% of those earnings (the part not used to pay PFDs) mostly goes toward this inflation proofing provision. Therefore, the ERA didn’t historically have a balance large enough to worry about inflation proofing. When it did, the money was swept into the principal account.

Only since the incredible stock market run over the last decade has the ERA balance become large enough to think much about. A combination of factors conspired to grow the ERA balance to nearly $20 billion. That was partly due to the 50% not reserved for PFDs was much larger than inflation; partly due to the large PFD amounts resulting in large undistributed holdings; partly due to less than the PFD formula being distributed; and partly due to a large amount of unrealized gains being assigned to the larger ERA balance.

Where it Gets Tricky (Unrealized Gains)

A complicating factor with the inflation proofing issue is that not all earnings are available to be spent. For example, say some property we purchased for $10 million is now worth $15 million. The value of the Fund has increased due to the appreciation of our asset.

But, that $5 million of gains is not in spendable form. In order to use those gains, we would first have to sell the property. That’s what we call “unrealized gains” (money earned, but not in spendable form).

By law, only realized gains flow into the ERA and enter the PFD calculation. While those gains are unrealized, they count toward the account that owns the asset. Since all investments in the Fund are proportionally owned between the accounts, the unrealized gains are proportionally assigned to each account. For example, if the principal account holds 80% of the Fund balance, then 80% of the unrealized gains are alllocated to the principal account.

Ok, that was painful. But, if you followed along, you might see the issue. If that $5 million of increased value was due to inflation, and if those unrealized gains are already credited to the principal account, then isn’t the account already inflation proofed by that amount?

The answer is yes, but only temporarily. While that property is owned, a full inflation proofing transfer means that the principal is overfunded. But, once those gains are realized, they leave the principal account and move to the ERA. At that point, the correct principal balance is restored.

The bottom line is that the Principal Account is tracked in two part – the protected principal (which needs to be inflation proofed) and the allocated unrealized gains (part of which comes from inflation). If you look at the total principal balance, the account is usually overfunded for inflation (because of the “self-proofing” that happens from held assets). But, if you only look at the constitutional part of the Principal Account balance, the inflation proofing mechanism works.

Percent of Market Value (POMV) – Concept

If you read that last section, you might appreciate that this “old” endowment model (with a protected principal account and a separate holding account for earnings) can be a little clunky. It works – since only earnings are accessible, the principal can never be reduced. But, it has complications and annual cash flows can be very volatile.

If you are trying to run a university, or if you are counting on earnings from a trust to pay your expenses, it would be difficult to plan without knowing how much money you will have. Also, the market crash of 2000 exposed these beneficiaries to the reality that they might not have access to any money in some years. Negative returns were a real possibility and a real big problem.

So, most endowments and perpetual trusts sought out ways to insert more predictability into their revenue streams. To do this, they changed the rules of the endowment to a Percent of Market Value approach. By picking a realistic return target, which accounts for inflation, the withdraw from the fund could be more stable without jeopardizing the viability of the balance to endure forever.

Let’s say that you expect to earn an average annual return of 8% per year. And, say that you expect inflation to average 2% – 3% per year. In this case, you could be confident that the balance would be protected forever (including inflation) so long as you don’t spend more than 5% per year. In some years the Fund will earn 10%, in others it will lose money. But, so long as the average real return is really at least 5%, the fluctuations will work themselves out.

When the fund overperforms, the balance will grow (and temptations to spend the surplus are abated). And, when the fund loses money you will dip into the principal a little bit (so you don’t have to sell your car whenever the markets crash). This provides a much more stable financial climate for the beneficiaries.

It’s actually the same process as having a holding account for your earnings – if you kept to a strict budget that didn’t change with the amount of earnings you have. But, by using the POMV approach, you don’t need to manage separate accounts or worry about unrealized gains.

Also, the issue of inflation proofing is built right into the process. There is no need to transfer enough money to offset inflation. It happens automatically over time.

POMV – Alaska Application

SB26 (a bill that passed in 2018) set a limit on how much money the legislature can transfer from the ERA each year. Those transfers are not allowed to exceed 5.25% of the average balance from the first 5 of the proceeding 6 years (that number goes down to 5% starting in FY22).

This is kind of like a POMV approach to endowment management, but not quite. It’s actually more like a spending limit, but it only limits one source of funds.

The reason it is not quite a POMV approach is because of the constitutional construction of the fund. Without changing the constitution, we aren’t allowed to dip into the principal during bad years. But, that’s a cornerstone to making a true POMV system work.

Consequently, we need to keep a holding account open. That way we can access the money if we need to smooth out some bad years without violating the constitution. But, this hybrid approach to the Fund creates some complications and a lot of confusion.

Complications and Confusion

Take this example. Say the ERA balance is zero and the fund earns $1 billion in the year. Or, equivalently, say the ERA balance is $3 billion and the Fund loses $2 billion in the year. And say the POMV is $3 billion.

In this situation, the maximum transfer out of the Permanent Fund is $1 billion. Taking more than that would be a withdraw from the Principal Account, which would violate the constitution

This brings up two issues. First, the treatment of earnings is asymmetric. Second, we need to keep a large enough accessible balance to weather any storm.

[Note: there are certainly some accounting tricks that attorneys would agrue can allow us to “borrow” money rather than withdraw it from the Principal. Or, some might argue that the ERA can have a negative balance without violating the constitution. Some might even question which deposits into the principal are truly protected by the constitution. Maybe that will be tested in court someday. But, the plain language says “no” and that’s the assumption I will use here.]

Earnings Asymmetry

In a true POMV approach, the beneficiaries get fairly stable revenues. If the fund earns $1 billion in one year and $5 billion in the next, the POMV approach smooths out that volatility by distributing $3 billion in each year. It does not matter that there are $2 billion of excess earnings in one year. And, it does not matter that there is a $2 billion overdraw in the other. The system is built on averages and works over the long run.

But, look what happens in our hybrid approach if there is no holding account balance. In year one, the $3 billion draw is not allowed. There is only $1 billion of accessible cash, so only $1 billion can be used. In the next year, there would be enough money to catch up, but the POMV doesn’t allow that to happen. We are only allowed to use $3 billion, despite the $5 billion of earnings.

This asymmetry is a problem that undermines the entire approach. And, the only way to work around it is to hold enough money in an accessible account to always get the full POMV draw. But, that leads to a different problem.

Accessibility

Every dollar in the ERA is accessible. They are earnings, by definition – or else they wouldn’t be in the account. Therefore, all of the money in the ERA can be used by the legislature just like money in any other savings account. The POMV limit sets a guideline, but the legislature has the ultimate power to appropriate. If they want to spend that money, they can.

And, therein lies the problem. We need to keep enough money accessible to deal with the asymmetry problem; but, accessible money is unprotected. At any point, a future legislature can sweep in and use the entire balance of the ERA for whatever they want. They could distribute it to the people, finance a gas pipeline, build the Susitna Dam, forward fund education for a decade, or whatever they deem appropriate.

This creates a tension that does not exist in a true POMV approach. We need to keep accessible reserves, but we don’t want them to be accessible.

Inflation Proofing in this Hybrid Approach

The Alaska Permanent Fund Corporation (APFC) has a target return of 5% above inflation each year. Because the POMV number is based on a 5-year average balance, and because the balance normally grows each year, the allowable withdraw leaves more than enough money behind (on average) to deal with inflation.

Importantly, the POMV limit is based on the total fund balance, not just the principal account balance. That means it leaves enough money behind to inflation proof the entire Fund – both the principal amount saved for future generations and the excess earnings sitting in the ERA. Because the POMV rate is set below expected real returns, and because the rate includes inflation proofing the ERA balance, the draw is below what it really needs to be. Therefore, the ERA balance should grow over time.

And, placing a withdraw limit on the ERA does not prevent the legislature from spending the accessible cash. Therefore, all of those royalty deposits we placed in the principal account over the years are not protected from inflation by simply setting a statutory POMV limit.

If we could trust the legislature to follow the statutory POMV limit forever, we wouldn’t need to worry. But, as long as the POMV is just a guideline, we still need to make transfers from the ERA to the Principal Account to offset inflation.

This creates a tension. We need to make some money inaccessible to combat inflation, but we also needs to maintain enough accessible reserves to make the POMV work in this hybrid approach. There will be times we can’t do both.

That suggests that we need to take another look at how the current system is designed. It probably make more sense to set a target accessible cash amount sufficient to handle the cash flow volatility.

Something like this might work:

“If the sum of the unrealized and realized earnings within the fund is less than 25% of the total fund balance, and if the amount of accessible earnings in spendable form is less than 10% of the total fund balance, inflation proofing under AS 37.13.145(c) shall be carried forward until such a time those conditions are met.”

Some provision such as this would balance the tension between the need to protect the principal and also maintain adequate accessible reserves. The 25% figure should be adequate to weather market corrections of observed size, and still make the POMV transfer. The 10% figure ensures that the holdings are in spendable form.

If the retained earnings are above those limits after the inflation proofing transfers are made (like it is now), we should debate where that extra money should go. We could move it over to the principal account to grow the amount of protected money. Or, there may be other places to store that money that make more financial sense.

Of course, none of this solves the threat of future legislatures raiding the ERA. Only a constitutional amendment could do that. But, it might fix the confusion about inflation proofing under the statutory POMV approach.