Caution raised, however, on new use of Permanent Fund earnings
With some luck – and higher oil prices – Alaska’s budget deficit may be significantly smaller than forecast this year. The state could even see a balanced budget. The newly-enacted Senate Bill 26 is in effect this year, bringing $2.7 billon of Permanent Fund earnings into the state general fund. About $1.7 billion of this will be available for the budget, with the remaining $1 billion spent for the $1,600 dividend for 2018. This supplements recurring state revenues, mostly from oil, which have suffered with the oil price decline.
Still, caution flags are being raised on some aspects of the new arrangement. The Permanent Fund dividend is now playing a central role in the 2018 governor’s race and proposals that are now being made by two of the three candidates for governor that could undermine the beneficial effects of SB 26. (See more discussion of this, page 8). Also, there are worries that recent stock market plunges foretell a new national recession. This could also undercut the new stability SB 26 has brought to state finances.
Oil prices are rising; deficit is shrinking
Earlier this year about $2.3 billion in recurring revenues, mostly still from oil, were predicted in the spring revenue forecast based on an assumed $63-per-barrel average oil price for FY 2019, the current budget year. That would have resulted in a $700 million deficit in funding an overall $4.7 budget (state funds only).
Oil prices are rising, however. State budget officials say that if prices average $73/barrel the budget balances, however. For the first four months of the fiscal year prices have been well above that and have been over $80 per barrel in recent days. If prices average $79/barrel there would be a $400 million surplus for FY 2019 but supplemental appropriations needed to cover higher costs of some state programs could reduce or even eliminate any surplus. Typically, state health and corrections (crime) costs are higher than estimated, requiring supplementals.
Oil prices are notoriously fickle, however. If they fall, the deficit estimated earlier could reappear, or even grow larger. In any event, for now the state’s dire fiscal dilemma, which saw multi-billion-dollar deficits over several years, has eased. The state’s late-2019 revenue forecast is due in December.
That is thanks to the first-ever use of some of the Permanent Fund’s earnings authorized in SB 26, however. Previously the only use of the Fund’s earnings was to pay annual citizen dividends although some earnings have traditionally been injected back into the principal of the Fund to offset effects of inflation. Inflation-proofing earnings reinvested in the principal is more an internal transfer, not an appropriation from the fund to pay other things
Nevertheless, Alaska has made a fundamental change in the way the state budget is financed, and that’s a big plus, community and business leaders say. Credit rating agencies agreed. As soon as SB 26 was approved last spring financial analysts upgraded their ratings on Alaska debt. Many laud this step as a healthy diversification of the fiscal structure away from oil, which is volatile, but there are now concerns that depending on the Permanent Fund’s earnings in financial markets, which can also be volatile, makes the state’s finances vulnerable in other ways. That’s partly because of the unusual way the payout mechanism from the Alaska Fund is structured, which is different than large endowments.
Dependence on volatile oil now joined by dependence on volatile financial markets?
For decades, since oil production began on the North Slope in 1977, the state has depended on oil royalties and taxes to fund most of its state budget. In 1981 the state personal income tax was repealed. Except for a state fuel tax – the lowest in the nation – there are no state taxes that citizens pay. What is unique in the world is that Alaska also pays its citizens the Permanent Fund Dividend, or PFD.
Through the same period, from 1977 onward, the Permanent Fund, the state oil revenue savings account has also grown steadily, to about $66 billion now. While oil revenues are still invested most of the Fund now consists of investment earnings, and investment income provides the bulk of the revenue on which state finances will now partly depend. In addition to the Permanent Fund the state saved about $18 billion in two state cash funds, the Constitutional Budget Reserve (CBR) and Statutory Budget Reserve (SBR), from 2010 to 2015 when oil prices were in the range of $100 per barrel or more.
For years healthy oil production created a happy arrangement, although there were periodic dips in oil prices. Alaska has no significant citizen taxes, an annual PFD and a muscular savings account – the Permanent Fund and the CBR and SBR cash reserves. There are weaknesses, however. One weakness is that oil production is declining from over 2 million barrels per day in the 1980s to about one-fourth of that now, or just over 500,000 barrels per day. For years the production decline averaged about 6 percent per year. In the last three years new oil exploration and new discoveries have resulted in enough new production to stabilize production. Many now hope new discoveries, for example in the National Petroleum Reserve-Alaska and the Arctic National Wildlife Refuge, could increase production. But the days of 2 million barrels a day are in the past.
There is, however, a well-known volatility in oil prices. For several years Alaskans enjoyed the benefit of prices above $100 per barrel but in late 2015 prices unexpectedly dropped to below $40 per barrel. Over three years they have gradually recovered to about $80 per barrel but the huge 2015-2018 deficits in the state budget had to be covered by huge withdrawals from state cash reserves, the Constitutional Budget Reserve and Statutory Budget Reserve.
From 2016 through 2018 about $15 billion was withdrawn from these reserves bringing these funds from $18 billion in 2015 to about $3.5 billion now.
Forcing the issue in 2018: Running out of liquid assets
Using part of the Permanent Fund earnings for the budget had been discussed for years but because of political sensitivities the Legislature had not actually done it. What forced the issue in 2018, resulting in SB 26, was that the reserves remaining in the two cash accounts would not be sufficient to cover the projected FY 2019 deficit (then estimated at $700 million) or to provide a needed liquid cash reserve to meet the state’s needs through the year, such as for payroll. Fortunately, the Permanent Fund’s earnings, typically at $3 billion a year, were robust because of strong financial market, exceeding $5 billion last year. That gave legislators more courage to make the change to use earnings of the Fund.
Senate Bill 26, enacted this year, establishes an annual draw using a percent-of-market-value, or POMV, mechanism similar, but different in important ways, to those used for large charitable and university endowments. SB 26 provides for a 5.25 percent annual draw for three years, for FY 2019 through 2021, which drops to 5 percent in FY 2021 and thereafter. The bill requires the percentage and payment to be based on Fund market values averaged over the previous five years. When it approved SB 26 the Legislature assumed investment returns in the Fund’s historical ranges of 8 percent. Backing out assumed inflation of 2.5 percent leaves a 5.5 percent real, or inflation-adjusted, return. In theory, this allows the Fund to retain enough earnings to account for inflation, keeping it sustainable. (To be prudent lawmakers set the POMV at 5.25 percent and then 5 percent, and then provided the five-year averaging on the actual withdrawal.)
Are the 5.25 percent and 5 percent withdrawal rates too high? Some financial advisors have suggested that. When they passed SB 26 legislators assumed an approximate 8 percent return, believing it a comfortable assumption. (It has been 8.86 percent since the Fund’s inception; 8.9 percent over the last five years and 7.96 percent in the last three years.) One or more bad financial years could affect this, however. In 2009, a bad financial year, the Fund suffered, as an example.
Being cautious, Callan Associates, the Permanent Fund’s long-term advisors on markets, has estimated a 6.5 percent return on capital market investments over the next 10 years. Factoring in assumed inflation at 2.5 percent, this brings the real return to 4 percent. If Callan is correct the Fund will not be retaining sufficient earnings under the POMV to account for inflation, reducing the Fund’s value.
There is also the possibility that inflation could rise higher than 2.5 percent. The low inflation of recent years has softened memories of high inflation, in the 10 percent range, in the early 1970s. Legislators can always adjust the withdrawal rates, but this means cutting into the POMV payment and reducing revenues to the general fund, requiring either spending cuts or taxes. The retained earnings in the POMV draw keeps money only in the Earnings Reserve Account, from this money can be spent. It does not constitute money deposited in the principal of the Fund, which is constitutionally protected. Historically the Legislature has made annual inflation-proofing appropriations of earnings to the principal, allowing the protected portion of the Fund to grow over time. SB 26 authorizes the Legislature to make an inflation-proofing appropriation to the principal, but this is outside the POMV, and is only optional.
Will inflation-proofing of the principal be continued?
In FY 2017 and 2018, years of financial stress, the Legislature did not make inflation-proofing appropriations to the principal, although it did so in FY 2019. This does not affect the overall value of the Fund, of course, because it is just a transfer from the Earnings Reserve to the principal. It does reduce the earnings account, however. Since this is the account from which the POMV deposit is made, legislators will watch its value. However, to truly grow the permanent part of the Permanent Fund (the principal) over time, the Fund’s trustees urge that these payments be made. Whether they are made is up to the Legislature.
The structure of Alaska’s Permanent Fund is unique because the state Constitution requires that payments of earnings to the general fund to support the budget or pay dividends be realized, or cash, earnings from bond interest, sales of assets like stocks, real estate rent, or other cash income. Because no earnings have been disbursed except to pay the PFDs the Fund’s earnings over time have accumulated. The Legislature created the Earnings Reserve account in the general fund to hold them, an accounting measure.
However, now that the Permanent Fund is a major source of revenue to the general fund the payment structure is attracting some attention. If by chance the earnings reserve does not have enough money to make the annual POMV (which includes the PFD) the POMV cannot be paid. Any change of this would require a constitutional change, however.
Comfortable balance now in Earnings Reserve
At this point, however, the Earnings Reserve account has a comfortable balance over $16 billion, a big cushion against some reverse in financial markets. If markets remain strong the earnings account will grow because of the “automatic” inflation-proofing built into the POMV (the 2.5 percent retained in the earnings reserve). The reserve account grows 2.5 percent because of the retained earnings, but this would be offset, at least for the reserve account, if the Legislature appropriates the funds into the principal, which the trustees have urged. This, of course, really amounts to a transfer within the Fund – earnings account to the principal. The overall value of the Fund would be stable.
However, the need to ensure there is adequate cash in the reserve account to pay the POMV and dividend raises another issue. All of the Permanent Fund, the principal and retained earnings in the reserve account, are invested for long-term gain. With other state reserves where liquidity is required funds are invested for the short-term, out of the knowledge they will needed within a relatively short period of time. With the POMV obligation in SB 26 an annual payment close to $3 billion will be made to the General Fund.
The Fund trustees and managers must now ensure adequate cash will be in the earnings reserve when the POMV payment is due. Previously the trustees and managers only had to worry about having enough in the reserve for the PFD payment, which involved much less money.
This obligation could, however, result in assets being liquidated to generate cash before the optimum time. This is a theoretical possibility with a Fund as large as Alaska’s but if there were one or two bad financial years the earnings account could be depleted to the point that it could happen. For now, the account is healthy. Let’s keep our fingers crossed that it remains so.
A threat to stability of SB 26 system: “Fully funding” the dividend
The bigger threat to stability under the new fiscal system is if either Mike Dunleavy or Mark Begich, the Republican and Democratic governor’s candidate, emerge victorious in the November election and can follow through on their campaign promises to “fully fund” the dividend. This refers to payment under a state statute that sets out how the dividend is calculated, if a dividend is paid. Keep in mind that there is no constitutional requirement to actually pay a dividend – that choice, and the amount, is left to the Legislature, which is the appropriating body. However, the PFD is such a long-standing and popular practice that may citizens have come to assume it is an guaranteed entitlement, which it is not.
Gov. Walker was criticized for vetoing part of the PFD appropriation in 2015 during the state’s financial crisis, resulting in a payment below the formula amount set out in statute. Although many have complimented the governor for showing political courage, Walker is now suffering in his campaign for reelection beause of the PFD action. Voters forget that the Legislature, including the Republican-led Senate, similarly appropriated below the formula amount in 2016 and 2017 as a part of their annual budget approvals.
In promising to “fully fund” the dividend, Begich and Dunleavy do not explain the full consequences of this. The statute allows the payment to be based on half of the Fund’s realized earnings. The problem is that the POMV payment, at 5.25 percent of 5 percent of market value, has to fund both the PFD and funding for the budget, and SB 26 has no specific allocation for either. The allocation is left to the Legislature. For 2018 the Legislature arbitrarily set the PFD at $1,600 (it was $1,100 in 2017).
This requires a payout of about $1 billion. The POMV draw was $2.7 billion (the 5.25 percent draw). Subtracting the $1 billion for the PFD left $1.7 billion for the budget support. However, if the 50 percent of earnings formula were followed there would be more money for the PFD, and a higher dividend, and less for the budget. The reduction of money for the budget would require cuts in spending or new revenues from other sources, such as taxes. Oil and gas companies worry that this calculus could fuel new calls for oil tax increases.
“Fully funded” PFD would have increased payout to $2,900 this year
A “fully funded” PFD, following the formula in statute, would have created a PFD of about $2,900, Juneau economist Ed King has calculated. That would raise the PFD payout, and its cost, by another $800 million or so. The effect would be to reduce the contribution to the budget this year to about $900 million compared with $1.7 billion, and causing the deficit to increase to $1.5 billion. The problem with this is that we’ve depleted funds in the state’s main ready reserve fund, the Constitutional Budget Reserve, to the point that we could not have funded the deficit at that amount. The only alternative would be to cut the budget by about $800 million, or raise other revenues, most likely through taxes.
Of course the burden of a lower PFD is more on lower-income Alaskans but that’s also true with certain other revenue instruments, such as a state sales tax. A personal income tax tends to tap higherincome Alaskans, in contrast. However, one important difference between a sales or income tax and the PFD is that nonresident workers will pay a share of an income and sales tax, as will tourists with a sales tax. A reduction in the PFD is felt only by Alaskans, in contrast.
Current system, budget vs. PFD, a proxy for traditional political dynamic
What’s interesting about the current framework under SB 26 is that because the shares of the POMV payment for the budget and the PDF are not specified, and are set annually by the Legislature, the tension between the dividend and the budget is a kind of proxy for the normal dynamic, in other states, between spending and taxes (Alaska has no state taxes paid by citizens, essentially). Elsewhere the tradeoff between more money for public services is typically higher taxes. In Alaska, the tradeoff is now more money for public services and a lower PFD (a kind of reverse tax). By proxy we have injected a traditional political dynamic back into Alaska’s fiscal system, where citizens will help pay for any increased spending but through lower dividends. The fully-funded PFD promise upends that.
However, just because Begich and Dunleavy are promising this it doesn’t mean it will happen. The Legislature will still make the final appropriation decision and a choice between money for schools and the PFD, as an example, will still be painful no matter who is governor.
Governor candidate Mark Begich argues the PFD should be put into the Constitution just to take this divisive issue off the table, to be one less annual fight in the Legislature. This raises other issues, however. Legislative attorneys have argued that having the PFD in the Constitution in effect gives the dividend payment a priority over other constitutional mandates, for public education and public safety, for example. That happens because a PFD guarantee would be for a specific amount where the other mandates say the Legislature shall provide, for education and public safety for example, but leaving the amount to be provided to the Legislature.
Of course, the same could be done for the PFD, allowing that a PFD may be paid but letting lawmakers make the appropriation and set the amount. This would leave all the constitutional mandates on equal footing. That’s not what advocates of PFD-in-the-Constitution really want, however, because there is no real guarantee of a dividend.
Permanent Fund: The numbers
• Total value, June 30, 2019: $64.9 billion ($46 billion in principal; $18.9 billion in Earnings Reserve)
• Contributions since inception (1978):
Deposits of mineral royalties required: $16.9 billion
Transfer to principal from Earnings Reserve for Inflation-proofing: $16.2 billion
Special appropriations from the General Fund: $7.1 billion
• Fund’s return on investment:
FY 2018 – 10.74%
` Last three years – 7.96%
Last five years – 8.91%
Since inception – 8.86%
• POMV payment to General Fund
FY 2019 – $2.723 billion
FY 2020 – $2.933 billion•
FY 2024 – $3.64 billion•
* Projected by the Permanent Fund)