VALUE
JUDGEMENTS ASSOCIATED WITH THE STUDY
Investment
consultants look at permanent funds as an endowment, not a “rainy day fund”.
This is an important distinction because it implies that the current
generation is obligated to pass the fund on to future generations intact. This
notion is often referred to as “inter generational equity”. Specifically, it
means that the inflation adjusted purchasing power of the distributions should
not be diminished. Alternately, it means that the present value (a way of
adjusting for the time value of money) of the funds’ corpus and distributions
should not be impaired. Implicit in this standard is the assumed trade-off between
the value of a dollar today and in the future (known as the discount rate). A
lower rate makes future dollars more attractive; conversely, a higher rate
implies that today’s distributions have a higher value than tomorrow’s
increased fund balances. Experts note that the discount rate in these studies
has typically ranged from a high of 15 percent to a low of 5 percent.
These
explicit standards are of recent origin. In the past, both funds were mainly
invested in bonds whose returns were insufficient to compensate for inflation
and current income needs. Furthermore, as noted above, the STPF was
specifically a “rainy day” fund rather than an endowment. Until the 1982
amendment, the legislature had the option of appropriating from the corpus.
Another
value judgement has to do with contributions to the funds from energy related
revenues; including these contributions will raise the permissible distribution
level. One camp would argue that contributions should not be included in a
distribution study; the point of a permanent fund was to capture the value of
the resource base in perpetuity. Another point of view would note that it is
sufficient to pass on the endowment unimpaired; current generations are not
required to sacrifice so that future generations will have increased wealth.
By
far the most important value judgement underlying this study is the supposition
that the maintenance of the endowment is of greater good to society than any
alternative investment. As the attached Wall Street Journal article shows, many
trustees have and do question this principle. The article’s most poignant
argument for the spend-it-all approach comes from 1913; Julius Rosenwald,
chairman of Sears, Roebuck and Co., declared, "Permanent endowment tends
to lessen the amount available for immediate needs, and our immediate needs are
too plain and too urgent to allow us to do the work of future generations. "The article goes on to note that “In
the first half of the century, Mr. Rosenwald's fund gave away the equivalent of
more than $700 million in today's dollars.
Among many other projects, Mr. Rosenwald contributed to the construction
of nearly 5,400 schools for black children in the South. In the years following
World War I, an estimated 60% of American blacks who had completed primary
school had been educated in Rosenwald schools”.
The
point here is that the quantitative measures presented in these studies are
still governed by subjective influences; they are not “scientific” nor are they
sufficient information on which to make an informed judgement. The investments
that depleted the Rosenwald endowments had dramatic returns to society but
would probably fare quite poorly by the present value and inflation statistics
presented in this study. In the end, policy makers must make their own
judgements as to what expenditures have the highest return for society.
HOW
DISTRIBUTION STUDIES ARE PREPARED
The
key determinant in these studies is the allocation of the funds’ assets. Each
class of assets will have a different expected rate of return and a different
range of return variability (risk). Investment consultants find it critical to
model both, and the recent performance of the stock market underscores this
point of view.
Analysts
use random samples and statistical modeling to incorporate the riskiness of
each asset class’s return. This means that the projected return will vary
significantly from the average return (and could well be less than the average
return). For example, in the 2001 study, US equities have an average return of 8 percent, but
there is a significant chance that their return might vary by as much as plus
or minus 17 percent. Alternatively, the
expected return on Treasury bills is only 4.75 percent, but the significant
chance of variability in the return is only plus or minus 1 percent.
The
investment return and fund balance “ forecasting”
process then works as follows:
In year 1 the annual return on an asset class
such as stocks is randomly generated given its risk profile. If stocks are 50
percent of the portfolio and yield 8 percent, then 50 percent of the
endowment’s return is 8 percent. The remaining return is prorated by the yield
on each constituent asset class. It should be noted that the consultant does
not add annual contributions from energy revenues into the calculation; he only
deducts distributions. This calculation yields the beginning balance for year
2.
The process is then repeated to generate a
twenty-year horizon.
RESULTS
The
consultant ran scenarios that increased the distribution from 4.7 percent to
5.45 percent. Table 1 summarizes the results of these scenarios in inflation
and time-adjusted terms. The first row shows the combined market value of the
LGPF and STPF as of December 2001. The second row shows the inflation adjusted
value twenty years into the future assuming an inflation rate of 3.25 percent.surprisingly, the inflation adjusted value of the
fund is largest under the current level. This is because the distributions are
the smallest; the inflation adjusted value would be maximized if distributions
were eliminated. More meaningful is the test as to whether the real value
of the fund is diminished; this is the implication of row marked “Difference”.
It should be noted that even the present spending policy is projected to diminish
the real value of the fund. This is a significant change from last year’s study
and is principally due to a much more sober forecast of equity market performance.
Table 1
Inflation and Time
Adjusted Effects of Different Spending Scenarios
(dollars in billions)
|
Distribution Level |
4.70% |
4.95% |
5.20% |
5.45% |
|
Current Value of Funds* |
$10.92 |
$10.92
|
$10.92
|
$10.92
|
|
Inflation-Adjusted Value at Year 20 |
$10.56
|
$10.24 |
$9.75 |
$9.27 |
|
Difference |
($0.36) |
($0.68) |
($1.18) |
($1.65) |
|
Total Present Value of Spending Policy** |
$15.74 |
$15.64 |
$15.54 |
$15.43 |
*
December, 2001 values
**
Assumes 5% discount rate
The tradeoff between spending and inflation is illustrated in Figure 1. The values on the x-axis are spending policies. The values on the y-axis are the total loss in real value from increasing spending. For example the loss from moving from a 4.7 percent to a 4.95 percent distribution is a cumulative 6.2 percent of the funds’ real value.
OTHER SUBSTANTIVE ISSUES
There are currently 2
Joint resolutions that would increase distributions from the LGPF:
·
Senate Joint Resolution 6
proposes to amend the New Mexico Constitution to increase the annual
distribution from the LGPF from 4.7% to 5.5% of a five-year average market
value.
·
House Joint Resolution 6
proposes to amend the New Mexico Constitution to increase the annual
distribution from the LGPF from 4.7% to 5.5% of a five-year average market
value.
The row marked “Total
Present Value of Spending Policy” in Table 1 shows the time adjusted effects of
different spending policies. The purpose of this table is to put the future
value of the corpus of the funds (a stock) on an “apple to apples” basis with a
set of annual distributions over time (a flow) by using the financial concept
of the time value of money, or “present value”. This figure is the sum of
discounted distributions and the initial corpus value. As noted above, present
value calculations are extremely dependent on the discount rate used. A higher
rate will favor current expenditures while a lower rate will favor future
distributions (and a higher fund balance). As the table shows, the current
formula has the highest present value but it can be increased even more by
eliminating the distributions altogether.
Mathematically this is because the discount rate is less than the
median yield of the portfolio (roughly 8 percent). At a discount rate higher
than the portfolio’s return, present value is maximized by depleting the trust
immediately.
The
point of this math exercise is not to belittle the value of quantitative measures, it is simply to emphasize the subjective nature of
these studies. If there is a spending alternative that has a return greater
than the yield on the portfolio, then that alternative is the better use of the
money. Unfortunately, this often is not measurable and is best left up to the
judgement of policymakers and voters.
FISCAL IMPLICATIONS
The fiscal
implications relate to the costs to conduct the task force meetings. It is expected these costs can be absorbed by
the existing agencies budgets.