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A Publication of the Public Affairs Research Council of Alabama / Number 40 / Fall2000

    Proposed Changes to Alabama’s Trust Funds

        Large-scale production of natural gas from Alabama’s offshore waters began in the 1980s and is expected to last at least until 2022. Sales of drilling rights and continuing royalties from gas production have created over $1.8 billion in revenues for the State of Alabama thus far, with another $1.8 billion or more expected to follow.

        Fortunately, Alabama’s governmental leaders recognized that these are revenues from a depleting resource. They proposed, and voters adopted, constitutional amendments that created two large trust funds so that these revenues would be used for the continuing benefit of the state and its people.

        Four detailed constitutional amendments now govern the trust funds, which are scheduled to merge in 2001. Proposal 1 on the November 7, 2000 statewide ballot would make significant changes. This report looks at the proposal in detail. A companion report to follow will look at other proposed constitutional amendments on the November ballot.

         Alabama Heritage Trust Fund (AHTF). The Alabama Heritage Trust Fund (AHTF), approved by voters in 1982, captured the revenues from the first sale of offshore drilling rights in 1981. The Legislature was authorized to spend the income from this trust fund each year. Today this fund has assets valued at $466 million and provides about $50 million each year for legislative appropriation.

        At the same 1982 election, voters approved a legislative proposal to borrow $520 million for capital improvements to education, highways, inland waterways and Mobile harbor, prisons, mental health, and government buildings. In effect, the Legislature has used part of the AAHTF income to finance the annual debt service on these investments, with the remainder going to fund the activities of state agencies. The last bonds are scheduled to be retired in 2008.

        Alabama Trust Fund (ATF). The Alabama Trust Fund (ATF), approved by voters in 1985, captures the revenues from subsequent sales of offshore drilling rights and from royalties on the resulting gas production. The income from investment of this fund is allocated automatically for expenditure, as described below. The ATF has grown due to the annual infusion of production royalties, and today its assets are valued at $1,367 million. It provides about $84 million to fund state and local programs each year.

        The State’s General Fund. The Legislature allocates 100 percent of AHTF trust income to the state’s general fund each year, using some of the money for debt service and the rest to fund state agencies and programs. Thirty percent of ATF trust income has been allocated to specific purposes, described below, with the remaining seventy percent going to the general fund. The general fund’s net revenue from the two trust funds is about $110 million a year, 81 percent of all trust-fund distributions, making trust income its second largest source of support.

        Forever Wild Land Trust (FWLT). The original ATF amendment called for reinvesting a portion of trust income each year; the reinvestment would have grown to ten percent a year in 1999 and remained at that level thereafter. However, a 1993 constitutional amendment allocated this money to the Forever Wild Land Trust (FWLT), subject to an annual cap of $15 million. The FWLT now receives about $8 million a year; the $15-million cap will not be reached for several years.

        FWLT funds are used to purchase and manage lands for conservation, education, recreation, or aesthetic purposes, preserving Alabama’s natural heritage. Allocations to the FWLT will cease after 2012 unless the Legislature acts to continue them, except that 2.5 percent of ATF income will be allocated for stewardship of land in the trust until the Legislature decides that enough money has been set aside for this purpose.

        County and Municipal Government Capital Improvement Funds. The Legislature in 1986 decided that whenever ATF trust income reaches $60 million in a year, ten percent of the trust income will be distributed to a Capital Improvement Fund for counties and another ten percent to a similar fund for municipalities. ATF trust income reached $60 million in 1998 and has remained above that level in the years since; cities and counties now share about $16 million per year.

        The statutory allocations to municipalities and counties are to be used mainly for capital improvements such as local streets, roads, bridges, landfills, public utilities, and governmental buildings. Proposal 3 on the statewide ballot would give constitutional status to these allocations.

        The constitution calls for merging the two trust funds within ninety days after September 1, 2001. In this merger, the ATF will absorb the AHTF, and the distributions will be the same as those that now apply to the ATF. Two issues have arisen, and they are the basis for Proposal 1 on the November ballot.

        How to increase the trust-fund payout. The coming merger will reduce the net trust-fund revenue going to the state’s general fund from 81 to 70 percent of all distributions. The total amount of trust fund income also is likely to fall at the same time, because high-yielding bonds bought many years ago are scheduled to mature. Fixed-income investments in today’s low-inflation environment will not replace the revenue that will be lost. The combination of these two factors will create an annual loss to the state’s general fund of about $30 million beginning in fiscal 2002, unless something is done. This fund, which supports prisons, medical assistance, mental health institutions, courts, public safety, and other state services, has no sources of growth to offset the loss.

        How to finance necessary investments in the state’s infrastructure. Alabama cannot prosper economically without strategic investment in the human and physical capital that underpins its economy. This is the major conclusion of the Alabama Commerce Commission in its report issued earlier this year, yet the funds for such investments are lacking. For example, $75 million in state bonds for educational and research facilities, authorized by the people two years ago, have not been sold because there is no money to pay debt service; about 1,900 county bridges are structurally unable to carry even school bus traffic, yet many counties lack the capacity to match available federal road and bridge funds; and a master plan being developed for the state docks, calling for a public-private partnership to improve this statewide asset, lacks a source of public money. Proposal 1 attempts to resolve these issues.

        Alabama’s trust funds, soon to be merged, are a constitutional endowment that exists "for the continuing benefit of the state of Alabama and the citizens thereof." A successful fund of this type should grow to maintain its purchasing power, and it should have sound distribution rules to ensure that the benefits paid out are not only high but sustainable over the long run. Alabama’s endowment has neither of these fundamentals in place today. Two changes are necessary to create the greatest possible "continuing benefit" from this endowment.

        1. Alabama’s endowment should be invested for growth as well as current income. Alabama’s trust funds have been invested exclusively in fixed-income investments such as U.S. Treasury bonds, obligations of federal agencies, federally guaranteed mortgage loans, and corporate securities. These investments are held for the current income and stability they provide, not for growth, and all of the income is appropriated each year. The only source of trust fund growth is royalty income from offshore oil and gas production. Proven reserves are expected to be depleted as early as 2022. At that point, growth in the endowment will cease.

        Other large public endowment and retirement funds have more diversified investments designed for continuing growth as well as current income. Growth is necessary because inflation reduces the purchasing power of an endowment over time; growth is also desirable to increase the benefits provided by the endowment. To create a continuing source of growth, many endowment and retirement funds have invested significant percentages of their assets in equities, or stocks – including, for example, the Texas Permanent School Fund (69 percent), the Alaska Permanent Fund (54 percent), the average university endowment fund (64 percent), and the Retirement Systems of Alabama (50 percent).

        History has shown that, over the long run, stocks produce a higher return than bonds or other fixed-income investments. Ibbotson Associates, one of the nation’s best-known financial forecasting firms, has estimated that over the next 25 years large-company stocks will yield median annual returns of 11.6 percent, compared to 5.4 percent for long-term government bonds. If this turns out to be true, an investment of $1.00 in stocks today would grow to $15.55 by 2025, while the same investment in bonds would grow only to $3.72. However, with this great advantage in long-term yield comes short-term risk: stocks will produce very high returns in some years and very low or negative returns in others. The annual return on the S&P 500 index of U.S. stocks was negative in 20 of the last 74 years. The wise course for stability and growth is to invest in a diversified mix of stocks, bonds, and other kinds of investments.

        The important point to recognize is that failing to diversify the investments of Alabama’s endowment will impair its ability to grow so that it maintains purchasing power and provides maximum benefits over the long run. A number of years ago, Alabama’s voters approved a constitutional amendment that allows this kind of investment diversification. However, the distribution rules for Alabama’s endowment are biased against diversified investments.

        2. The distribution rules for Alabama’s endowment should promote high, sustainable payout. A primary reason for the lack of progress in diversifying the investment of Alabama’s trust funds is that the state constitution creates a very strong incentive to place every trust-fund dollar in fixed-income investments. It does this by defining payout solely in terms of annual trust income, limiting distributions to interest and dividends. If the trust funds are invested in stocks or other assets that produce capital gains, these gains are not considered in the distribution – whether they are reinvested or the asset is sold. Thus, in the short run, a diversified fund would generate returns that could not be counted in the payout calculation, and it would give up interest income that could be counted. Diversifying the endowment to increase its growth potential would immediately reduce its payout to the general fund.

        The recent experience of the Texas Permanent School Fund, which operates under similar payout rules, illustrates this dilemma. As oil and gas income began to decline in the 1990s, this fund was shifted away from fixed-income investments and into equities. As a result, the value of the fund more than doubled during the decade – yet its payout to Texas’ public schools was actually lower in 1999 than it had been in 1990. The Texas fund faced no intense pressure to maintain current appropriations, but in Alabama the trust-fund payout is too important as a source of general fund revenue to allow this kind of result.

        One way to correct this problem is to broaden the kinds of trust-fund revenue that can be appropriated for expenditure. This is what Proposal 1 would do, as shown in the table to the right. Currently, only interest and dividend income can be appropriated. The proposal would give the ATF board of trustees the discretion to transfer for expenditure up to 75 percent of capital gains each year, whether realized through sale or retained as growth in the fund.1 In addition, the proposal would require the transfer of a portion of oil and gas royalty payments into two new earmarked trust funds. One of the new trust funds would receive 28 percent of royalties, to be invested for providing income to the state general fund. However, the Governor could recommend and the Legislature appropriate money out of this account for demonstrated capital needs. The other new trust fund would receive 7 percent of royalties, which could not be appropriated but would be invested for providing income to cities and counties.

    As the table shows, the amount of revenue that could be appropriated under Proposal 1 would not exceed 100 percent in any category, and in some categories would be less than 100 percent. The endowment would continue to grow even without royalty income, and with investment diversification it would tend to grow faster. If we assume Ibbotson’s projected investment returns, appropriations at the maximum allowed, and gradual diversification to 50 percent equity investments, the ATF in 2025 would pay out over 60 percent more money and have a fund balance 10 percent larger under Proposal 1 than without any changes.

        However, the actual amount of growth in the fund and its payout would depend on the results of the investment strategy chosen by the ATF board of trustees, and on the appropriation policies chosen by that board as well as the Governor and Legislature. These decisions are important because as the fund is diversified, its results will vary from year to year. The chart to the right shows the actual returns of the Teachers’ Retirement System of Alabama for equity and fixed investments during the 1990s. Equities outperformed fixed-income investments substantially, but the returns also were much more volatile, exceeding 30 percent twice and turning negative twice. Can we be sure that this kind of variation will not create opportunities to "raid" the trust fund?

        Proposal 1 does not specify what the investment and appropriation decisions will be – but in conjunction with the existing constitutional language governing the ATF, it creates a framework for them. The issue is whether that framework is adequate to protect the public interest. The following features are significant.

        Composition of the ATF board. The ATF board of trustees consists of nine members. These include the Governor, State Treasurer, Finance Director, three members appointed by the Governor, two members appointed by the Lieutenant Governor, and one member appointed by the Speaker of the House. The Governor serves as chairman and presiding officer. Each of the six appointees serves a six-year term, must have "recognized competence and experience in the evaluation and management of investments," and must be confirmed by the State Senate. The six appointees with professional investment experience constitute two-thirds of the board.

        Powers of the ATF board. The ATF board of trustees has the power to decide how to diversify the trust fund’s investments. Under Proposal 1, the ATF board of trustees also would make the decision each year about what percentage of capital gains could be appropriated by the Legislature, up to the limit of 75 percent. (All interest and dividends are automatically distributed for appropriation, under an existing constitutional provision.)

        The constitution requires the board to exercise the judgment and care of a prudent institutional investor and to invest and manage the trust "for the permanent generation and disposition of funds." By adopting the legal standard called the "prudent investor rule" and specifying the purpose toward which it is to be applied, the constitution has created legal obligations for the ATF board. One of these is to diversify investments so as to reduce uncompensated risk; another is to "act with undivided loyalty to the beneficiaries and with impartiality among them."2 The ATF’s beneficiaries are Alabamians of today and tomorrow. Placing the fund at risk, either through investment or appropriation decisions, would violate the trustees’ duties.

        Relationship of the ATF board’s powers to those of the Legislature. Proposal 1 would have the ATF board, which is bound by the legal duties of trusteeship, serve as a gatekeeper for the appropriation of the endowment’s capital gains by the Legislature. However, the ATF board has no control over the Legislature’s appropriation decisions.

        The ATF board would need the active cooperation of the Legislature because equity returns are volatile, as illustrated in the chart above. Appropriating the same percentage of capital gains each year eventually would produce big swings in the trust-fund payout to the general fund and other accounts. In some years, there would be no capital gains to appropriate; in other years, the amounts would be unusually large. Smoothing out the extremes would require the Legislature to create a reserve fund and cooperate with the ATF board of trustees in allocating capital gains appropriations for current and future use. This would amount to averaging, a policy that America’s universities have found helpful in managing their endowments.3

        In enacting Proposal 1, the Legislature declared the need for a dedicated source of money to finance state and local capital improvements. The proposal would accomplish this goal by earmarking portions of the existing royalty income flowing into the ATF.

        Research indicates that infrastructure investments can produce substantial economic returns for a state. For example, seven out of every eight new and expanding firms in Wisconsin from 1990 to 1996 located along its targeted highway investment corridors. A $100-million expansion of the Port of Charleston allowed it to pass Seattle and Oakland in 1997, becoming the fourth-busiest container port in the country. Studies showed an annual return of eight percent on investment in the Appalachian Development Highway System, and a reduction of 17 cents in private production costs for every dollar invested in Maryland highways.

        Two new infrastructure funds. To finance state-level infrastructure projects, Proposal 1 would create the Alabama Capital Improvements Trust Fund (ACITF), which would receive 28 percent of the trust-fund royalty payments. This would amount to about $35 million a year. To finance local projects, it would create the County and Municipal Government Capital Improvements Trust Fund (CMGCITF), which would receive 7 percent of the trust-fund royalty payments or almost $9 million a year.

        In the absence of special legislative action, these trust funds would function as if they were earmarked portions of the ATF. Royalties would flow into the funds for investment by the ATF board; the trust income from the ACITF would be deposited in the state general fund, and the trust income from the CMGCITF would be allocated to municipal and county governments according to existing statutory formulas.

        However, the Governor could recommend in his annual budget that the Legislature appropriate funds from the ACITF for specific capital improvements, and the Legislature by recorded majority vote in each house could appropriate ACITF money for capital improvements. These appropriations would be alternative investments for the royalty income that has built the trust funds, and it would be important to develop an annual accounting of the results achieved, as a part of the appropriation process.

        General obligation bonds. Proposal 1 contains the first of these alternative investment authorizations. It would authorize $350 million in general obligation bonds for improvements in county roads and bridges, municipal infrastructure, the State Docks, and economic development projects. It would appropriate money out of the ACITF to pay the debt service on these bonds, and on $75 million in bonds authorized by prior constitutional amendments.

        Prior bond authorizations. The proposal would provide the funding source that has been lacking for three prior bond authorizations. The first of these would make available $52 million to finance twelve specific projects for agriculture, forestry, and veterinary services and research at three Alabama universities. The second would provide $5.7 million for research facilities in textiles and apparel technology. The third would provide $17.5 million to update the state’s crime laboratories, which are inadequate to meet the needs of law enforcement and the courts. There are long backlogs for the testing of evidence, and the labs are in danger of losing accreditation.

        County road and bridge improvements. Alabama has a large number of deficient bridges – including 1,900 county bridges that cannot carry school buses – and spends below the southeastern average on its roads. Federal funds are available but must be matched by state or local money, which is lacking in many areas. Proposal 1 would appropriate $50 million from the $350-million bond issue to be used as local match for high-priority county road and bridge projects. With this matching money, counties could undertake projects valued at $250 million, with federal reimbursement providing the balance. From the $250-million total, most counties would receive an allocation of $3.25 million. The largest counties would receive more (e.g., Jefferson $14 million, Mobile $9 million, Madison $7 million, Montgomery $5 million, Tuscaloosa $4 million). Each county would submit plans based on two priorities: (1) repairing all structurally deficient bridges, beginning with those that cannot carry school bus traffic, then turning to those with lesser deficiencies; and then, if funds remain, (2) undertaking road resurfacing projects that are eligible for federal matching funds.

        Municipal infrastructure improvements. Proposal 1 would appropriate $15 million from the $350-million bond issue for allocation to municipalities for infrastructure improvements such as streets and municipal facilities. These funds would be allocated to all municipalities in the state through the existing statutory formula bywhich they receive trust-fund distributions. A $15-million allocation would provide about $1 million each for the four largest cities and $200 to $400 thousand each for the next five in size.

        Improvements at the State Docks. The Alabama State Docks were started in 1928 with a $10-million capital appropriation from the state; today the facilities are valued at about $600 million. They include a coal handling and storage facility, wharves and warehouses, a bulk cargo handling and storage facility, and a terminal railway; other facilities are under development with public and private funds. In fiscal 1999, the Docks handled 6.6 million tons of coal, 2 million tons of forest products, and 1.8 million tons of iron ore, among other products. A study by the Center for Business and Economic Research at the University of Alabama showed that the 1999 activities of the Alabama State Docks were responsible, directly or indirectly, for more than 10,000 jobs throughout the state. 

        To increase its share of the shipments that are important to Alabama industries, serve customers better, and provide a better base for statewide growth, the Docks Department is developing with consulting assistance a master plan that calls for (1) building a container facility with rail intermodal connections, (2) adding warehouse capacity for forest products, (3) adding storage capacity for the metal industry, and (4) upgrading the bulk facility and terminal railway tracks. The plan calls for financing these improvements with a combination of federal, state, and private funds as well as cash flow from the Docks. The state’s share has been estimated at $100 million, with another $50 - 100 million from federal and private sources. Proposal 1 would authorize the allocation of an unspecified part of the $350-million bond issue for this purpose. The Legislature would decide the amount when it appropriated ACITF funds to repay the bonds.

        Economic development projects. The county, city, and docks projects specified thus far total an estimated $165 million, leaving a balance of $185 million from the $350-million bonding authorization contained in Proposal 1. In actuality, the total amount of bonds issued would be limited by the royalty revenue available to support debt service. Estimates published by the State Oil and Gas Board indicate that the proven, recoverable reserves of natural gas remaining in Alabama offshore waters total about 3.5 billion cubic feet. This is twice the volume of natural gas that has been produced thus far, and the Board has indicated that production should last at least through 2022. Natural gas prices are expected to rise during this period, which will increase the royalty revenue and possibly gas supply estimates as well. In addition to the kinds of projects discussed above, the ACITF money could be used for economic development costs such as site preparation, infrastructure improvements, training facilities, and worker training and education.

1. Capital gains were defined in terms of the increase in value that has occurred since the end of the prior fiscal year, to prevent counting the increased value from earlier periods.

2. American Law Institute, Restatement of the Law, Trusts: Prudent Investor Rule, 1990, p. 8.

3. The most common policy of university endowments is to pay out a fixed percentage of the average fund balance, calculated over several fiscal periods to smooth out variations in investment results. A good description of the lessons learned by university endowment administrators can be found in the recent book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, by David F. Swensen, Chief Investment Officer of Yale University.