A few weeks ago, Brad Keithley wrote an article discussing the proposed POMV draw from the Alaska Permanent Fund. If you’re not up to speed on the issue, here’s the short version of the story.
Alaska has about $60 billion sitting in a constitutionally protected account called the Permanent Fund, which is managed by the Permanent Fund Corporation (PFC). It’s where we’ve been stocking away a portion of our oil money since 1980.
The earnings from this fund are typically either reinvested, or paid out to the residents of Alaska in what we call a Permanent Fund Dividend or PFD. With declining oil production, increasing government services, and the 2015 collapse in oil prices, the State has been burning through its accessible savings accounts for the past few years. Now, the legislature is considering using the earnings from the Permanent Fund to balance the budget.
The proposal on the table is being debated as Senate Bill 26. If passed, this bill would restructure the way the earnings from the fund are used. Rather than distributing earnings based on one half the 5-year average earnings, it would now distribute one-third of the 5-year average balance of the fund multiplied by 5.25%.
What Mr. Keithley brought to light was that the 5.25% number seems arbitrary and much lower than the Fund’s historic performance. By lowering the formula and the split, Mr. Keithley argues that the legislature is unnecessarily reducing the amount of money that flows to the residents (which has flow through impacts on the economy at-large).
I found this argument interesting, so I thought I would do a quick simulation of what that means. This analysis questions the assumptions in the PFC’s forecast, upon which a lot of policy discussion revolves. As for the POMV question itself, that will have to wait until another day.
Now, let me forewarn my readers. The following analysis is very high level just to get a grasp on the magnitude of what we are talking about here. If someone wants to hire us to do a more thorough analysis, email email@example.com.
First, I wanted to double-check Mr. Keithley’s numbers. I confirmed them here. Then, I was curious about the distribution of the earnings rate more than the simple average. What I found was pretty interesting.
The fund earned its highest return of over 25% in 1985 and its largest loss of nearly 18% in 2009. But its average annual return has been 9.68%. The Fund lost money in 5 of the 40 years on record and exceeded 20% returns on 3 occasions. But the most common outcome (17 out of 40 years) was returns between 10% and 20%.
This distribution is very important to an analysis. I’ll show you why in a minute. Let’s start by looking at the PFC’s forecast of the next 10 years (just download the most recent PDF, which is March 2018 as I write this). The two numbers that we are interested in are the “dividends” column in the middle of the page and the “Total Fund Balance” on the far right.
For Fiscal Year 2018 (FY18), they are projecting a deposit into the dividend fund of $726 million and a year-end balance of the fund of $62.652 Billion. What we really care about right now is the amount of money we put in our pockets as Alaskans – the amount of the PFD.
We can approximate that by subtracting the cost of administering the fund (about $40 million a year) and then dividing that number by the number of people who will receive a check. There’s some interesting things we can learn from exploring the projection of that number, but let’s skip it for now. Let’s just call it 650,000 in 2018 and let’s assume 1% population growth with a proportional number of applicants.
This exercise yields a 2018 PFD (issued in October 2018) of around $1,050. Conversely, the statutory formula would calculate out to around $2,560 if their FY18 earnings estimate is correct. Of course, the actual amount looks like it’s going to be $1,600 based on the discussions in the Capital.
Ok, now let’s look at some future years under various scenarios. First, let’s look at the PFC forecast amounts for FY20 and FY28 based on their spreadsheet. And just for fun, I extended their assumptions another 10 years to see what it would look like. Here are the results:
|PFD Amount||Fund Balance (billions)|
|FY20||$ 2,765||$ 68,054|
|FY28||$ 3,704||$ 92,453|
|FY38||$ 4,651||$ 133,954|
Now, there’s a problem with the forecast the PFC published. This forecast assumes that all the earnings that don’t go to the PFD will stay in the fund (either swept into the principle account or held in the earnings reserve). But we know this cannot be true. The State treasury isn’t going to have enough revenue to balance a budget and the other savings accounts are empty. So, we have to assume they will start drawing off the earning reserves account (ERA) to balance the budget.
In the next table, I left everything the same, except I drew $2 billion off the earnings reserve each year (escalated for inflation). And I set a simple rule. Pay for government first, then the dividend, then inflation proofing. Here’s what that adjusted forecast looks like:
|PFD Amount||Fund Balance|
|FY20||$ 2,745||$ 63,717|
|FY28||$ 2,857||$ 64,350|
|FY38||$ 2,437||$ 86,217|
This is something a lot closer to the real status quo (meaning, the legislature inflation proofs the principle, pays the statutory formula, and draws $2 billion off the ERA to balance the budget). We would have to put a lot more effort into incorporating a revenue and spending forecast to get it closer to reality, but this is a better starting place than the PFC’s forecast.
There are a couple of things of note in the above table. Notice the lower amounts in FY28? That’s the impact of lost compounding interest on the money diverted to government spending. But the lower dividend in FY38 – that’s due to the ERA running empty, forcing a choice between funding the budget or the PFD (the model funds the budget first).
But even this doesn’t really capture what we should expect to occur without legislation that changes things. The above figures are generated by using average rates of return and inflation, as projected by the PFC. There are two problems with this. First, the rate of return they are using is basically 6.3% and the inflation rate they are using is 2.25%. Both of these values are lower than historic averages (9.68% and 3.6% respectively). In other words, their forecast is assuming a 4% real rate of return rather than the observed 6% real rate of return. Those 2 percentage points add up.
Second, using an average value when looking at compounding interest rates is misleading. For example, here are a few different rates of return applied to $100:
|1st Year Return||5%||-10%||15%|
|Balance End of Year 1||$105.00||$90.00||$115.00|
|2nd Year Return||5%||20%||-5%|
|Balance End of Year 2||$110.25||$108.00||$109.25|
|Average of Rates of Return||5%||5%||5%|
To deal with this problem of using a flat rate, I fit the historic returns and the historic inflation rates with a distribution fitting tool to come up with probability distributions that mimic history. Then, I exposed each year’s balance to random samples from these distributions. This let’s the future mimic history and let’s us see how things shape up.
I let the model run out for 20 years, to see what happens to the PFD and the fund balance over time. Below are the 80% confidence range of possible futures without any legislation that changes PFDs and assuming a $2 billion (inflation adjusted) draw each year to fund the budget:
|Low PFD Amount||Mean PFD Amount||High PFD Amount|
|FY20||$ 2,499||$ 3,337||$ 4,172|
|FY28||$ 2,820||$ 5,550||$ 8,260|
|FY38||$ 1,706||$ 6,880||$ 11,148|
|Low Fund Balance||Mean Fund Balance||High Fund Balance|
|FY20||$ 59,971||$ 68,340||$ 76,238|
|FY28||$ 72,187||$ 88,768||$ 108,198|
|FY38||$ 102,942||$ 127,484||$ 158,015|
Note the relatively hefty dividends that can be paid while still funding the budget. However, there is something hidden in the data here. In about 28% of the simulations, the ERA was depleted, without enough money to pay any dividends and cover the budget call, at least once during the 20 year period.
This topic is a lot more complicated than we can fully analyze for free. But, there are some things that you should note. First, there really is a significant risk in the status quo. That risk should be addressed and good on the legislature for at least having the debate.
Second, we don’t think the PFC’s forecast is an accurate starting place for a conversation. As the consideration of taxes and cuts to the PFD are explored, policy makers should ensure they have the best available information.
Third, we don’t think the PFC’s investment targets reflect their performance. It appears that things may be less dire than perceived by those lower targets. Yes, the prudence will lead to fund growth, but it comes at a cost to Alaskans in the near term.
And finally, there is a lot more work to be done on this topic. We don’t support writing anything is stone and we believe that any actions that are taken should be slow and deliberate.
Stay tuned for more on this topic.