The following is an excerpt from last week’s edition of the Alaska Political Report, written by Neil Steininger. You can click here for more information about the Political Report. A subscription is $1,299/year per organization. Discounted pricing is available for non-profits and government entities. Our coverage of the budget starts with the governor’s proposed budget in mid-December and we track everything in detail through the entire process. If you have any questions or would like to subscribe, please email email@example.com.
In recent legislative hearings the Director of the Legislative Finance Division (LFD) and the Alaska Permanent Fund Corporation (APFC) executive director have separately alerted the finance committees to a potential concern. Director Alexi Painter of LFD put it most succinctly; per his division’s analysis there is a 54% chance that the state will exhaust the Earnings Reserve Account (ERA) and fail to have the resources to cover state services in the next decade. APFC Executive Director Deven Mitchell expressed similar concerns in his testimony. The Alaska Political Report has examined this issue to determine how this problem came about, whether it is truly a significant concern for Alaskans, and what the Legislature or APFC can do to avoid it.
To investigate and understand the origins of this issue in an objective way, it’s important to put aside the social, political, and cultural legacies surrounding the ERA and Permanent Fund. At its most basic level, the Earnings Reserve Account (ERA) is a state savings account managed by APFC available for the Legislature to appropriate without any restriction. The Permanent Fund corpus was established in the Alaska Constitution by voters in 1976, while statute, initially drafted in the 70s and subsequently amended, directs the income to be transferred to the ERA. This follows the ‘income and principal’ structure that was in vogue in the 1980s when the fund was first established.
The constitution prohibits appropriations (spending) from the fund corpus. The corpus of the fund is made up of an initial 1977 deposit of $734,000, constitutionally obligated rents and royalties, and other ad hoc and optional appropriations into the fund made by the Legislature like inflation proofing, and additional royalty contributions. To ensure a stable real value of the corpus the Legislature annually makes an appropriation from the ERA to combat the effect of inflation on the fund value.
The Alaska Constitution does not prohibit the Legislature from making appropriations from the ERA; however, Alaska statutes include mathematical formulas to set a sustainable rate of draw from the fund. Since the early 1980s the formula for available draw was 21% of the most-recent five years of income deposited into the fund, with half of that draw designated to the Permanent Fund Dividend (PFD) program. In 2018 a formula was added defining the allowable distribution from the ERA as 5% of a trailing 5-year average of the value of both the ERA and corpus. This draw is commonly called the percent of market value (POMV) and follows modern endowment models.
The state has never exceeded either draw limit and, prior to 2018, the Legislature only appropriated the portion of the draw designated to the PFD program. The change in 2018 came as the state was forced to adapt to declining oil revenues and the need for another recurring source of revenue.
What if the Legislature never passed SB26, the POMV legislation, in 2018? Had the state simply followed the historical formula, and started spending the half not designated to the PFD, we would effectively spend all income of the fund and be exposed to the volatility of investment markets. The 1980’s formula protects the nominal balance of the corpus but, if fully drawn, the value of the fund will lose ground to inflation over time. The formula from the 80s was only a sustainable draw because the Legislature had the wherewithal to not spend more than half of the available funds.
To ensure that further use of the fund would be sustainable, the state implemented the POMV with SB26, calculated to protect the real value of the fund. However, when making that change rather than restructure the entire fund and statutes to align with the new model, the Legislature left intact the previous draw formula and fund structure.
This leaves us with the primary source of the concerns expressed by LFD and APFC, a fund structure and draw rules that are no longer aligned. In addition to that structural disconnect, changes in investment strategies over the decades have exacerbated the problem.
The way that APFC invests money is designed to protect fund principal and maximize returns, but are not specifically designed to generate income for deposit into the ERA. Over time APFC has moved investments away from liquid markets and into long-term, illiquid, investments that have reduced its ability to ‘churn’ investments in a way that generate spendable income for the state in the ERA. These longer-term investments have potential to deliver large returns to the state but may not see income for many years. As a result, projected deposits into the ERA are set to decline even though the fund may grow in value.
The POMV model, if followed, makes inflation proofing unnecessary. It does so by setting a draw rate set to projected earnings less projected inflation – in other words only drawing real earnings of the fund. Despite this APFC continues to advocate for the practice of inflation proofing, and the Legislature continues to make those appropriations annually. This is a legacy of the two-account structure where inflation proofing is necessary to ensure that money is protected from being available for appropriation. The concern of APFC and the Legislature is that absent these transfers, a future Legislature will make unsustainable draws and degrade the value of the fund. In a further effort to protect the Permanent Fund from overdraw, several appropriations have been made in recent years to transfer over $8 billion from the ERA to the corpus.
Concerns about overdraws are valid – in FY22, the Dunleavy administration proposed to draw an additional $3 billion from the ERA in addition to the POMV calculation, and the Dunleavy administration’s current 10-year plan implies overdraws starting in FY27.
When the individually prudent factors of an illiquid investment strategy that maximizes returns and protecting money in the corpus are combined, the likelihood that the ERA will decline in value to the point where it does not hold enough money to pay the annual POMV increases.
There are several ways that policy makers could avoid this risk:
- First and foremost, strict adherence to the statutory POMV draw limit is critical.
- Any draw in excess of the POMV will both work to erode future state revenues and will increase the likelihood the ERA balance is exhausted.
- Most robust, and advocated for by APFC, would be a constitutional amendment. This amendment would replace the current language that provides the Legislature access to spend 100% of fund income with language limiting access to the POMV calculation.
- There are many political challenges to implementing a constitutional amendment, like the high vote thresholds and the need for a statewide election. Political considerations also make it very challenging to address the account structure without also addressing the issue of the PFD program formula.
- There is potential that a statutory reform, redefining what constitutes permanent fund income, could be implemented. While not as robust as a constitutional amendment this would reduce the vote count hurdle. Current definitions of statutory net income are unique to Alaska and not based outside accounting rules; however, clever statutory solutions to constitutional problems don’t always fare well when tested in the courts.
- Limit the use of inflation proofing in the operating budget. Last year the Legislature put a cap on the amount of the inflation proofing transfer.
- The main challenge is that this strategy leaves excess balance in the ERA exposed to simple majority appropriation in future years, which is a risk some may not want to take given current budget proposals.
- The APFC board could instruct fund managers to consider the structure and state’s use of the fund in their investment decisions. This would effectively be instructing them to reduce the percent of fund assets allocated to illiquid investments.
- APFC warns that this would put at risk the level of long-term returns that the corporation could deliver for the state.
Luckily, so long as organizations like LFD and APFC continue to monitor and report to the finance committees on this concern, an ERA failure is something we will see coming years in advance. Unfortunately, the most robust solution is tied to a political quagmire that has seen countless failed attempts at resolution over the last decade. Alaska has the wealth and opportunity to support a robust system of government with a durable rules-based system, but only if we can resolve the social, political, and cultural legacies we set aside at the start of this article.