Wednesday, February 7, 2018

Hmmm, a POMV approach may produce a higher PFD than the current statute after adjusting for inflation proofing

Recently, we wrote a piece in which we explained that the current formulation of the PFD is not entirely as Governor Hammond intended, once the state starts using the "other half" of the earnings stream for "essential government services." See "Is the current formulation of the PFD what Governor Hammond intended?" (Jan. 2018).

Our point was that due to how the so-called "inflation proofing" provisions work, under the current statute the earnings available after inflation proofing are not split 50/50 between residents (through the PFD) and government (through the earnings reserve) as Governor Hammond intended.

Instead, using FY 2016 as an example, we demonstrated that while residents receive 50% of the current distributions, government received only 27%. The remaining 23% was available to neither residents nor government but instead reinvested in the Permanent Fund corpus.

As a result, between the portion split between residents and government, residents received roughly 65% of the earnings made available for distribution and government 35%. This departs from Governor Hammond's vision, expressed in Diapering the Devil, that once the "money wells" created by the Permanent Fund started pumping,

Each year one-half of the account’s earnings would be dispersed among Alaska residents …. The other half of the earnings could be used for essential government services.

While not our principal point, in the course of writing the piece we commented, based on some prior work, that in addition to imbalancing the split between residents and government, the current statutory inflation proofing mechanism also appeared to overcompensate for inflation. We speculated -- as we had also in an earlier November piece -- that the percent of market value (POMV) approach favored by some to calculate distributions from the Permanent Fund might actually result in a more accurate assessment, and thus a better net result.

In response, some readers of the January piece appropriately challenged us to prove that latter statement. Over the course of the past couple of weeks we have worked to analyze the results under the two approaches.

It turns out, based on what we believe is an appropriate methodology for comparing the two, the POMV approach, in fact, results in a higher overall level of net distribution after inflation proofing than the current approach.

Put another way, assuming a 50/50 split in distributions between residents and government, PFD's would be higher under a POMV (5%) approach than under the current statute, once adjusted to reflect an equal split of the earnings remaining after current inflation proofing.

Largely because of the lingering effects of FY 2009 on Statutory Net Income (when SNI was a -$2.51 B), looking back over the last 5 years (FY 2014-2018) the difference would have been significant. The annual distribution net to the PFD would have averaged roughly $245 million higher under POMV (5%) than under the current statute, once adjusted to reflect an equal split of the earnings remaining after inflation proofing.

Going forward the projected differences are not as significant. Using Permanent Fund Corporation (PFC) projections, for example, over the 10-year period between FY 2019 and 2028 (a copy is available here), the difference between the two, net to the PFD, would average roughly $60 million per year (or, at 650,000 applicants, a little less than $100 per PFD check).

But the fact there is some difference both demonstrates that the current methodology likely is, in fact, overcounting for inflation and that, far from being adverse to the PFD, the use of POMV may actually be helpful, if the split remains as intended by Governor Hammond and other founders, equally between residents and government.

Of course, the results depend on the approach taken.

In calculating the POMV distribution we largely adopted the approach reflected in SB 26, using a rolling five year average of the market value of the Permanent Fund as the base, with a draw rate of 5.25% for 2019 and 2020, and 5% before (for the lookback) and thereafter. We calculated the average value of the Permanent Fund using the PFC's most recent estimates for such balances between now and 2028. The average for each year was calculated by averaging the end of the previous year and the end of the current year.

In calculating the distribution under the current statute we used the PFC's most recent estimate of Statutory Net Income (SNI) and Inflation Proofing (IP). To determine the net available for distribution after inflation proofing we subtracted the number for Inflation Proofing from Statutory Net Income. To avoid timing distortions, we used the five year rolling average for each, as the current statute requires for the calculation of the PFD.

As should be expected, the results are heavily influenced by the POMV draw rate used. As noted above, we used the 5% rate included in SB 26. Using a 4.5% rate reverses the results, with the current approach producing a better result, even after subtracting the inflation adjustment.

But at a 5% draw rate a POMV approach produces a higher PFD than under the current statute, once adjusted to reflect an equal split of the earnings remaining after inflation proofing.

We believe that is a significant fact to keep in mind as we continue the current discussions.

For those interested, the detailed calculations are available at the spreadsheet below, or available also for download here.