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We Build Alaska

Brad Keithley’s Chart of the Week: The real Permanent Fund reform that’s needed

Earlier this month, three groups – Alaska Common Ground, the Institute of the North, and Commonwealth North – co-hosted a forum entitled “Protecting the Permanent Fund: A Rules-Based Permanent Fund Endowment Model.” As it turned out, the forum was little more than a pep rally for a proposal by some to merge the Permanent Fund corpus and earnings reserve into a single account, a step that, as we’ve explained in previous columns, would open the door to draining the Permanent Fund.

Some claim that the step is justified by a “crisis” facing the Permanent Fund. As we’ve also explained in previous columns, however, the claimed “crisis” is entirely an artificial one created by some accounting gimmicks employed by the Permanent Fund Corporation (PFC) to restate the purpose of previous prepayments made by the Legislature for inflation-proofing. The real problem is the Permanent Fund’s recent failure to produce earnings on an ongoing basis sufficient to keep up with the Legislature’s annual percent of market value (POMV) draw.

Focusing on the latter, in our column two weeks ago, we examined the Permanent Fund’s recent performance compared to its self-selected benchmarks, as well as better-known public measures of investment performance, such as the Standard & Poors (S&P) 500, the Dow Jones Industrial Average (DJIA), and the Nasdaq 100. As we explained there, while the Fund’s performance seemed “sort of ok” compared to its self-selected benchmarks, the Fund appeared clearly to be “leaving money on the table” when the results were compared to the S&P 500 and other better-known public measures of investment performance. 

As we noted at the time, while we had more than enough information to analyze the Fund’s performance against various benchmarks, we lacked a recent update on the management fees paid by the PFC as part of its operations. Given the size of the Fund and the returns it generates, some have expressed concern that the fee level is excessive. We wanted to include these recent levels in our assessment of the Fund’s overall performance. 

Since then, the PFC has finally published the management fees it incurred for the first quarter (through September) of Fiscal Year 2025, three months after the fact. Perhaps explaining the delay in their publication, these fees raise significant concerns about the Fund’s performance.

One of the benchmarks used by the PFC—its “Passive Index Benchmark”—is intended to provide a baseline for measuring the “value added” by the Permanent Fund’s active management compared to the results that would apply if the Fund were only invested passively in various indices. Significant portions of the Fund’s active management are executed through advice and investments made by various entities, who are compensated through the management and incentive fees paid by the Fund. 

In this chart, we compare the actual returns realized by the Fund since FY2017 to those that would have been realized had the Fund instead been invested passively in the indices tracked by the PFC’s Passive Investment Benchmark. We then compare the difference—the “value added” by the Fund’s active management—against the management and investment fees paid over the same period in two ways. 

The first is through simple subtraction: what was the “value added” after considering the fees (the return is net of fees for FYY2021 and after). The second is a calculation of the realized return on the fees paid: what was the rate of return on the “investment” made through paying the fees, measured in terms of the “value-added” they provided.

As the chart demonstrates, in the early part of the period – through FY2022 – the management and incentive fees not only paid for themselves in terms of increased “value added” but, measured as an investment on their own, produced a significant positive return. While there were a couple of down years during that period, on average, over the period as a whole, the Fund’s actual return exceeded the Passive Index Benchmark by 3.55% per year. Again, on average, over the period, that resulted in a value-added after fees (which averaged 0.83% of the Fund’s value) of 3.08% per year, or an average return on the fees paid of 291% per year.

Those results have changed significantly over the last three years, however. For FY2023, FY2024, and the rolling 12 months through the end of the first quarter of FY2025 (September), the Fund’s actual return consistently has fallen below the Passive Index Benchmark. Put simply, the actively managed Fund has performed worse than if the balance had been left on auto-pilot in the funds included in the Benchmark.

The return the actively managed Fund realized over the latter period has averaged 6.70% less than the Passive Index Benchmark. The management and incentive fees paid to help produce those deficient returns have only added insult to injury. Again, on average, over the period, the fees have reduced the Fund’s return by an additional 0.96%, producing an average return on the fees paid of minus 795%. Put another way, measured by the management and incentive fees paid, actively managing the Fund has pulled the Fund’s returns down by an annual average of 6.70% rather than adding to them.

These negative results have all but wiped out the gains realized from active management during the previous part of the period. Over the entire period, the PFC’s average actual return has only exceeded that of the Passive Index Benchmark by 0.13%. After factoring in the amounts paid for management and incentive fees (which have averaged 0.87% per year over the entire period), the Fund has actually lost 0.18% per year on average, producing an average return on the fees paid of minus 71%.

In sum, using the management level and incentive fees as a measure of the cost of active investment, the Fund has lost value on average over the last nine years due to active management rather than gained from it.

Given our past discussion, we anticipate some will ask what the results would have been over the same period if we had used the S&P 500 index instead of the PFC’s self-selected Passive Index Benchmark to measure the passive alternative.

Here are the results through the end of FY2024.

 

Under active management, the Permanent Fund has realized an average annual return of 9.14%, while the S&P 500’s annual return over the same period has averaged 16.16%. Had the Fund been passively managed by investing in the S&P 500 over the period, it would have earned, on average, approximately 7.02% more annually than it did by being actively managed.

That difference widens after considering the management and incentive fees paid over the period. After deducting the amounts paid for the management and incentive fees associated with active management (which averaged 0.86% over the period), the Fund would have earned approximately 7.37% more annually than it did by being actively managed. Put differently, by actively managing the Fund rather than passively through investing in the S&P 500 index, the Fund generated an average negative return on the investments made in management and incentives fees of minus 1048% per year.

In our previous discussion of the management and incentive fees paid by the PFC, we included a chart comparing that level to those incurred in managing Norway’s bellwether Government Pension Fund—Global (GPFG). For those interested, here’s the most recent update of that chart.

It shows that, as a percentage of assets under management, the PFC continues to incur management and incentive fees that are more than double the level incurred by Norway’s GPFG.

These charts emphatically demonstrate that the Permanent Fund’s problem is not, as the presenters at the Alaska Common Ground forum and others would have Alaskans believe, the Constitutional barrier to overdraws created by maintaining a separate earnings reserve.

The Permanent Fund’s problem is that it is not earning enough even to pay for the management and incentive fees the PFC is incurring, much less a return sufficient to cover the draws the Legislature wants to maintain.

The solution is not to eliminate the Fund’s overdraw protections, which are included in the Constitution, but to reform the PFC in ways designed to increase its returns.

In a previous column, we outlined three steps the Legislature should take to reorient the PFC in that direction. For the reasons we explained there they are:

  • First, the Legislature should restructure and professionalize the Board.
  • Second, the Legislature should reevaluate whether the 5% draw is the right level.
  • And third, the Legislature should indefinitely postpone any consideration of merging the principal and earnings reserve accounts into a single fund.

In retrospect, the only one we would change now is the third. The Legislature should permanently discard the proposal to merge the principal and earnings reserve accounts into a single fund. The discussion at the Alaska Common Ground forum convinced us the fiscal appetite unleashed by eliminating the Constitutional protections poses too much risk to the future permanence of the Permanent Fund even to be left on the table.

However, we continue to believe that the first and second steps are not only the right ones but also necessary if the Permanent Fund is to return successfully to its intended twin purposes of providing income to current generations and building wealth for future ones.

Looking at the recent level of management and incentive fees against the performance they have produced, it is clear that the PFC has become no more than a self-serving bureaucracy, generating only enough earnings to cover the fees it is paying. 

That needs to change. Restructuring and professionalizing the Board is the first step. Regearing the portfolio toward producing earnings – likely at least in part through the use of more passive mechanisms – and resetting the draw rate at a realistic level remains the second.

Brad Keithley is the Managing Director of Alaskans for Sustainable Budgets, a project focused on developing and advocating for economically robust and durable state fiscal policies. You can follow the work of the project on its website, at @AK4SB on Twitter, on its Facebook page or by subscribing to its weekly podcast on Substack.

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Mark
14 days ago

Thank you, Brad, for continuing to illuminate these performance issues and the risks associated with collapsing the fund into one account from the perspective of the Gov/Leg. As a former CFO of a large public enterprise, I concur that there is considerable value in maintaining two accounts to provide a speed bump for those leaning toward draining, rather than sustaining, adequate reserves,

Larry Smith
13 days ago

Brad, Your thorough examination is needed and you should be heeded. The ERA has morphed from origin as a savings account for unspent increments into a spending account subject to appropriation. It serves today as something of a buffer which can protect the corpus of the Fund. Although that to has not deterred administrations and legislatures from creative maneuvers. Trustee Paper #10 places most blame on inadequate inflation proofing, pressure to increase realized earnings by ad hoc sales of assets, refusal to appropriate latter times royalty share, and too high POMV cap at 5%. Correcting these artful manipulations and reducing… Read more »

Matthew Bucklin
12 days ago

A lot of funds are looking to the liquid alternatives now that the illiquidity premium is gone, at least for now. A series of ETFs from funds like Tema and Innovator work. There is Endowment ETFs