Juneau, Alaska

(907) 699-6788 ed.king@kingecon.com

PFD Cuts Were Probably Unnecessary Sacrifices

Alaska has hired some very good people to manage the Permanent Fund, and they are good at their jobs.

Every year, the Alaska Permanent Fund Corporation (APFC) beats the market benchmark and spins off billions of dollars of investment earnings.

Over the last 41 years of managing our money, the APFC has averaged an impressive 9.7% return on investment. If you pull out the effects of inflation, they managed an average 6.1% real return.

If those historic returns resemble what the next 40 years will be, the cuts to our PFDs over the last 3 years were probably unnecessary sacrifices.

SB26 and the POMV Draw

In case you haven’t heard about the POMV draw yet, let me give you the highlights.

Traditionally, the legislature only transferred enough money out of the earnings account to pay the PFD.

Pretty much all of the remaining earnings were reinvested into the principle of the Fund. That process slowed down over the last 10 years, and has now completely stopped. As a result, there are now over $16 billion sitting in the earnings reserve.

While the Constitution has always allowed the use of the Permanent Fund earnings to pay for State government, FY19 is the first year that the Legislature will move money from the Permanent Fund to the General Fund. They will do this via a provision in SB26, a bill the legislature passed earlier this year.

SB26 set a Percent of Market Value (POMV) that can be transferred to the General Fund (basically giving themselves a statutory framework to do what the Constitution already allowed).

The POMV was intended to solve the State’s budget problem by replacing falling oil revenues with some of these investment revenues. Rightfully so, everyone was worried about drawing down the fund balance too far and damaging its long-term health.

So, they asked the APFC for a reasonable estimate of how much money they could take. The APFC suggested that 5.25% was the highest they felt comfortable going.

The Problem

The problem is a 5.25% draw isn’t enough money to fill the deficit and also pay the statutory PFD in most years.

So, the legislature will need to choose between cutting services, raising taxes, breaking the statutory draw limit, and/or underfunding the PFD, in pretty much every year. Over the last three years, PFD cuts and budget reductions were the way things ended up.

Now, if 5.25% is the average real return we should expect over the long-term, that’s one thing. That would mean we have a long-term budget gap that needs addressed.

But if that number is lower than what a sustainable draw really is, we are trying to solve a problem that doesn’t exist.

Confidence Problem

The APFC has set a long-term earnings goal of just 6.5% before inflation (about 4.3% real).

But, the APFC is better at their job than they give themselves credit for. In the 41 years of investing, they have failed to make at least 6.5% only 10 times.

In other words, they beat that target rate over 75% of the time.

And, since SB26 uses a lagging 5-year average fund value, the draw for FY19 works out to be only 4.6% of the beginning year balance.

The 5-year average return has been less than 4.2% of the beginning year fund balance only during two periods – after the dot-com bubble burst in 2001, and after the housing bubble popped in 2008. And those periods were followed by high growth.

I’m not sure where that 5.25% number came fromThat’s why I wrote a piece a few months ago that pointed out the disconnect between this number and the Fund’s historic performance.

Statutory Net Income

My guess is that there is confusion in the air. People may be contemplating the “Statutory Net Income” rather than the “Accounting Net Income” as the return on the fund.

To understand the difference, think of it this way. Pretend you own a house. While you own it, you are building equity by paying down the loan. But, the house also increases in value from inflation and changes in the housing market.

So, you have equity in your house from appreciation, but it’s hard to access. However, once you sell your house, that equity becomes real money in your checking account.

In accounting, they call that inaccessible equity “unrealized earnings.” It’s money that belongs to you, but that you haven’t “realized” yet.

That’s what happens in the Permanent Fund too. If they buy a stock at $100 per share, and next year it’s selling for $120 per share, then the value of the asset they own has increased by 20%. That gets booked as an increase in the value of the Fund, but the money isn’t “realized” yet.

Here is where “Statutory Net Income” (SNI) comes in. From the perspective of SNI, the money doesn’t exist until they sell that stock. Until then, those $20 per share of earnings sit in limbo (which we call the “unrealized earnings account”).

If you look at the change in the value of owned assets, that is “accounting net income.” But, if you only look at what earnings have been “realized,” that’s “statutory net income.”

As of July 1, 2018, there were about $8.2 billion of earnings that are on the books but have not be realized ($2.4 billion of those are allocated to the earnings reserve, on top of the $16 billion I mentioned earlier).

Since there are unrealized earnings, the SNI is lower than the actual earnings the Fund has made. If you only look at SNI, the APFC has made an average return of a little over 5% (inflation adjusted).

Smoothing Effects

Using the SNI has a smoothing effect on the returns of the Fund.

It works like this.

When investments are going up in value, investors want to hold on to those assets. The result is that those earnings stay “unrealized” in the year they are earned. This has the effect of reducing the SNI rate of return for the year, below the accounting return.

And, when the markets are bad, investors sell off those declining assets. That results in “realizing” the value of the asset, transferring the balance from the unrealized account to the earnings account. As a result, the SNI shows a better return than actual performance.

There are good reasons to use smoothing techniques when distributing funds. We are all happier getting $1,500 PFDs every year, than getting a $4,500 PFD in one followed by $0 in the next two (if you’re interested in this point, I suggest looking into “Prospect Theory”).

The government is the same. We don’t want to hire 1,000 new teachers this year and then have to lay them off next year. We want some stability in the budget.

So, we want to have some way of smoothing out the volatility in investment returns when we use them to pay dividends or for the budget.

One way to introduce smoothing is by using the “unrealized” balance to shield the earnings reserve account from volatility.

There are two other common smoothing techniques in the world of finance. One is averaging, the other is POMV.

All of these techniques result in less volatility. But any number that is created by smoothing is going to lag behind the actual performance of the fund. If the fund is growing, any smoothing efforts will understate actual performance.

The 5.25% POMV

The draw limit from SB26 set the POMV rate at 5.25%. That number is fairly close to the long-run SNI real rate of return, with enough unrealized assets to push up the historic returns if desired.

That means that the POMV and the SNI are both being used as smoothing techniques. Oh, did I mention that they are also using the 5-year lagging average fund balance?

The result of using this triple smoothing approach (without de-trending) is an artificially low draw limit.

While It’s good to be prudent, we can’t ignore the impacts being overly cautious. By doing so, we end up paying unnecessary taxes (including PFD reductions).

Fund Growth

Taking a 4.2% draw while making an average 6.1% return will result in the fund growing faster than inflation, and in addition to royalty deposits.

Some people may feel like fund growth is a good thing. However, it is only good when you are trying to grow the fund for some purpose. Otherwise it is just unnecessary sacrifice.

It would be sorta like eating bologna sandwiches for lunch every day of your career, so that you can eat lobster every day in retirement. That doesn’t make a lot of sense to most people.

When oil started to flow from the North Slope, our forefathers had the foresight to know it would not last forever. In order to ensure that future generations of Alaskans enjoyed some of the benefits of our exhaustible resources, they knew they could not spend it all in the present.

Knowing that future budgets would grow and future revenues would shrink, they realized they needed to grow the fund to the point that the earnings from the fund would act as “money wells.” As the oil wells dried up, revenues from these money wells would replace those lost revenues.

In other words, the purpose of saving money in the past was to have the ability to use it in the future (to fund government and pay dividends).

Fund growth is not a goal in its own right. It’s a means to an end.


This is a complex issue, with lots of moving pieces. The answer is dependent on wildly unpredictable factors (like stock markets and oil prices). So, we need to use some sophisticated tools to solve it.

I don’t think we are there yet.

There may be very good reasons why we still need the fund to grow. If that is the intent behind the lower POMV number, great. We can make budget cuts and tax ourselves in order to leave money in the bank. But, let’s do that strategically, with an end goal in mind.

However, if we are making sacrifices based on a number that is artificially low, we have a different problem.

If that’s the case, we probably could have afforded the full PFD over the last three years. In fact, the whole “fiscal crisis” may not be as bad as we think.

Some fiscal discipline and a solid long-term strategy may be all we need to solve it.


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