What draw rate should we use with a POMV approach?

One of the issues that has received some, but relatively little attention compared to others during the current fiscal debate is what the so-called draw rate should be if we start using a percent of market value (POMV) approach to establish the flow of cash from the Permanent Fund.

There have been various proposals. SB 26 (the Senate's version of a fiscal plan) uses 5.25% for a couple of years at the start, then reduces it to 5%. The Governor's most recent proposal uses 5% from the start. The House's proposed Constitutional Amendment (HJR 23) was originally 5%, but in the course of redrafting was lowered to 4.75%.

The rate used makes a difference.  The Permanent Fund has a current market value of roughly $60 billion. A draw rate of 5.25%, results in an annual draw of roughly $3.15 billion; a draw rate of 4.75% in an annual draw of roughly $2.85 billion, $300 million less. 

If split 50/50 between the PFD and government (as it should be), the use of the lower draw rate translates into $150 million less to the PFD, or, using last year's number of recipients, roughly $250 less per PFD. 

A lower contribution to the government also means increased pressure for the use of other options, such as taxes or a PFD cut.

The difference between a higher and lower draw rate increases with the size of the Permanent Fund. At a market value of $80 billion, for example, the difference between a 5.25% and a 4.75% draw rate would be $400 million, compared to the $300 million difference at a market value of $60 billion.

Generally speaking the draw rate is intended to equal the so-called "real" rate of return anticipated to be generated going forward from the investments made by the Permanent Fund. The "real" rate is equal to the overall rate of return, including inflation (the so-called "nominal" rate of return) anticipated to be generated by the Fund, less the rate of inflation.

Using the "real" rate of return is simply another (and in our view, better than the current) way of inflation proofing the Fund.

To this point in the discussion, all of the numbers have been based on the anticipated real rate of return -- that is the real rate of return anticipated to be earned in the future. That requires projections not only of the future overall rate of return that will be earned on the Permanent Fund, but also future inflation rates as well.

Generally speaking, the reason that projections are used under the POMV approach is because the goal of using a real rate of return is to keep the relevant fund protected against inflation into the future.  Thus, projections of future rates (both of return and inflation) are perceived to be more relevant than past experience.

But there also is a problem with using projected returns and inflation rates.

In a nutshell, that problem is that the future may not turn out as anticipated. Overall returns may turn out to be more or less than projected, and inflation rates may turn out to be more or less than projected.

For example, rather than the 7.5% overall return and 2.5% inflation rate anticipated by those who recommend using a 5% draw rate, the future may result in an 8% overall return and a 2% inflation rate, or a 7% overall return and a 3% inflation rate.

In the first case (8% overall, 2% inflation), a 5% draw rate will understate the 6% draw rate that actual experience demonstrates could have been used, leaving money "on the table" (i.e., in the Fund) that could have gone to support the current generation through higher PFD's and government support without penalizing those that come after.

In the latter case (7% overall, 3% inflation), a 5% draw rate will overstate the 4% draw rate that actual experience demonstrates should have been used, distributing money to the current generation that, instead, should have been retained in the Fund to protect future generations.

Normally, endowments and other institutions that use a POMV approach do not worry that much about inaccurate projections. As conditions change proving the original projection wrong, the boards of the relevant institutions simply change the draw rate to better reflect revised projections.

But the potential (even likelihood) that the future does not match projections creates a special challenge for establishing a draw rate for the Permanent Fund.  Especially if the draw rate is "constitutionalized," as proposed by HJR 23, for example, it may be hard, if not impossible, to make adjustments as conditions change, locking in permanent over or under draws and with it, potentially significant intergenerational consequences.

As a result, the more we have thought about it the more we have come to the conclusion that the better way to set a draw rate for the Alaska Permanent Fund is to use past experience, rather than a projected look. 

Using actual, past experience protects against over- or under-stating the amount which each generation may draw without impairing others. If the investment policies of the Permanent Fund Corporation result in higher than the anticipated real rate of return, as they have at many times in the past, both current and future generations will share in the resulting benefit, rather than shifting all of the benefit to future generations (and potentially leaving the current generation with higher tax rates than necessary).

If, on the other hand, those investment policies result in lower than the anticipated real rate of return, both current and future generations will share in the resulting burden, rather than shifting all of the burden to future generations.

One legitimate question about such an approach is what past period should be used in calculating the realized real rate of return. Actual real rates may vary substantially from year-to-year depending on a variety of circumstances. As with statutory earnings used in the current calculation, it is better to use an average calculated over time to smooth those out.

Changes in averages determined over time also tend to be gradual, providing the Permanent Fund Corporation with more predictability about what the draw is likely to be -- a key argument behind the use of a permanently fixed rate -- and government and residents receiving the PFD also with more predictability about what their receipts are likely to be.

In the following chart we have calculated, by year, the actual real rate of return realized by the Permanent Fund in every year since its inception, along with a rolling 5-, 10-, 15-, 20- and 25-year average.

Two things leap out (to us, at least) from charting the results in that way. The first is that the longer the time period over which the average is calculated, the smaller the year-to-year changes and the smoother the adjustments. 

The second is that every measure -- 5-year, 10-year, 15-year, 20-year, 25-year and full life (some 40 years) -- averages out to an actual, real rate of return of somewhere in the 6+% range. To us, the second point is important and raises significant questions about the substantially lower percentages (4.75 - 5.25%) that have been proposed in the current round of discussions for use in connection with the Permanent Fund.  

Recall that the lower the percentage, the lower the PFD and government draw (and the greater the potential need for finding other sources of "new revenues"). Given the intergenerational issues resulting from using a draw rate significantly lower than the actual real rate of return, to us these results add even more weight to our proposal to use a draw rate based on the actual real rate of return realized over some period of time, rather than one based on anticipated future real rates of return.

Because it generates the least amount of change year-to-year, we believe the 25-year average is the best approach, but likely could be convinced as well of the suitability of the 15- or 20-year averages. Looking at the results, we are concerned that the use of 5- and 10-year averages could generate an unnecessary amount of year-to-year change.

But at the end of the day we believe that the use of some sort of averaged actual rate of return is more appropriate than the use of anticipated rates.  The potential for significant intergenerational problems resulting from the use of a constitutionally or even statutory fixed rate is too great.

Just who is the Alaska Senate Majority trying to protect?

In an article in this Sunday's edition of the Anchorage Daily News ("New forecast of Alaska oil revenue takes chunk out of state’s deficit"), the Senate Majority's fiscal position is summarized this way:

The Senate majority ... favors lower [Permanent Fund] dividends ... Senate leaders have said taxes would hurt Alaska's economy and aren't needed ....

But the Senate isn't really concerned about the overall Alaska economy; if it was, its position would be the reverse.

According to a study from the University of Alaska-Anchorage's Institute of Social and Economic Research (ISER) last March, "the PFD cut ... has the largest adverse impact on the economy" of all of the so-called "new revenue" sources it analyzed, including sales, income (progressive and flat) and property taxes. If the Senate was truly concerned about the overall economy, cutting the PFD would be the last option taken, not the first, and certainly not ahead of taxes.

The Senate also isn't really concerned about Alaska families.  According to a second study from ISER in early 2017, a "cut in PFDs would be by far the costliest measure for Alaska families."  As in the earlier study, the analysis included also sales and income taxes. If the Senate was truly concerned about Alaska families, cutting the PFD would be the last option taken, not the first, and again, certainly not ahead of taxes.

The Senate also isn't really concerned about the amount of money Alaskans are required to pay to support government. As both the first and second ISER studies make clear, "[n]on-residents would pay a share of any of the potential taxes, reducing the burden on Alaska households." Because PFDs are only paid to residents, however, "the impact of the PFD cut falls almost exclusively on residents." 

Using ISER's numbers we have estimated that Alaskans will be required to pay more than $500 million more overall under PFD cuts over 10 years than would be the case under any of the tax cases. Again, if the Senate was truly concerned about limiting the amount of money Alaskans are required to support government -- and optimizing contributions from non-residents receiving income in the state -- cutting the PFD would be the last option taken, not the first, and again, certainly not ahead of taxes. 

So, if the Senate doesn't really care about the overall Alaska economy, Alaska families or limiting the amount of money Alaskans are required to pay overall to support government, what does it care about. 

Put another way, just who is the Senate trying to protect by putting PFD cuts ahead of taxes.

To analyze that we compared the effect of PFD cuts with that of a flat tax on a family of four. We have previously discussed the type of flat tax we envision. ICYMI: Designing a Flat Tax (Sept. 2017).

To identify just who the Senate is trying to protect we calculated the crossover point at which a flat tax would take more from a typical family of four than the Senate's proposed PFD cuts.

Those below that point would fare better under a flat tax. Those above fare better under a PFD cut; as a result, they are the ones the Senate's actions are protecting. Our analysis is here (the crossover point by year is in the yellow column):

The answer was higher than even we guessed off the top of our head; roughly, those with incomes above $160,000-$170,000.  

Only those receiving above that amount would pay more under a flat tax; all those receiving less than that amount lose more under the Senate's proposed PFD cut plan.

So, using a family of four as the measure, who is the Senate trying to protect?

The answer: families with incomes greater than $160,000 - $170,000, about the Top 10%.

At whose expense? Families earning less than $160,000 - $170,000 -- the Remaining 90%.

Let that sink in -- in order to save the Top 10% of Alaska families from paying a bit more under a flat tax, the Alaska Senate Majority is prepared to hurt the overall Alaska economy, the Remaining 90% of Alaska families, and make Alaskans pay more for government overall.

Just wow.  Their upper income donors must be so proud. The Remaining 90% of Alaska families? Not so much.

Maintaining the PFD is important to achieving real spending cuts ...

Some ask why we are so focused on preserving the PFD. 

There are a number of reasons -- the significant adverse effect of cuts on the overall Alaska economy & families, its critical role in protecting against raids on the corpus, its role in creating a private sector economy similar to those in other oil producing states.

But another, similarly important reason is the significant role maintaining the PFD plays in restraining government spending to long-term sustainable levels.

Because PFD cuts largely don't affect their donor class, some legislators from more affluent parts of the state (or more affluent themselves) have made clear that they have no problem cutting the PFD to zero. Their willingness to do so enables them to avoid focusing on the hard work of constraining spending.

As Governor Hammond well understood, "the best therapy for containing malignant government growth is a diet forcing politicians to spend no more than that for which they are willing to tax." Diapering the Devil at p. 31. Cutting the PFD enables the legislators to put off the date they have to do so even longer. 

It provides a cushion of an additional $750 million - $1 billion (and growing) in revenue before they have to begin confronting the need for taxes. They can continue to say "yes" to their constituents -- particularly including those corporations tied to government spending which make up a significant part of their donor class -- to a much greater extent and for a lot longer than if they were confronted instead with the need to raise new revenues through taxation now.

That delay has significant, long-term adverse consequences to Alaska, however. As is the case at the federal level, all that resulting increase in spending ultimately will do is bring Alaska closer to economic peril. 

Enabling spending to increase up to the level it can be funded through current revenues plus conversion of the PFD to government revenue will put the overall Alaska economy at even greater risk the next time oil revenues decline or, once we start relying on that source of revenues, investment returns drop.

A significant portion of the Alaska economy is already built on a somewhat artificial base of free government services funded by oil revenues. We have seen the last four years how unreliable that is.

Expanding spending to include the PFD simply will double up on that artificial base by including free government services dependent on projected investment returns. Those with long-term experience and a long-term perspective in financial markets know how unreliable those are as well. See, e.g., Financial Times, "Norway’s oil fund could lose over $420bn in next big market crash" ("The $1tn fund said that it could lose more than 40 per cent of its value in a single year because of a combination of a plunge in stock markets as well as a potential strengthening in the Norwegian krone.")

From our perspective it is important to draw a line in the sand on state spending now. We may need more than our current revenue base can sustain, but as Governor Hammond said, the revenues to fund any addition should only come to the extent "politicians ... are willing to tax." 

Going beyond that -- by converting the PFD to government revenue -- only walks Alaska's economy farther out on thinning ice, so that Alaska is over deeper water and farther from shore when the ice inevitably fails. It also removes the safety net that the PFD provides to the Alaska economy and Alaska families during challenging economic times, making the economy and those families entirely dependent on government when those times come.

That, inevitably, will lead to an even larger crash and burn for the overall Alaska economy and Alaska families than if we start to face up to the hard work of reigning in spending now.

The Alaska Senate started hearings yesterday on SB 196, a bill that would purportedly impose statutory limits on spending. They will tell you that approach is the solution to Alaska's spending binge. 

But as we have seen with the PFD, Alaska statutes dealing with fiscal issues are nearly as worthless as the paper on which they are written. They don't even have to be repealed; they can just be ignored.

What we need instead are hard, real world limits on spending. 

As Governor Hammond wisely understood, those are only created when government spending is put on a "diet forcing politicians to spend no more than that for which they are willing to tax." Cutting the PFD enables them to dodge that diet yet again, allowing them to continue to fatten government spending, putting the Alaska economy and families at even greater long term peril.

We have the opportunity to stop that now by preserving the PFD, and from the perspective of building a sustainable economy and budget that is exactly what we should do.

We would suggest the results of the Governor's and legislature's proposed spending levels would look much different if we do. Regardless of what the Alaska Senate tries to tell you about SB 196, we doubt it will if we don't.