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ED 9
Increase the Efficiency of the Permanent School Fund; Increase Distributions to the Available School Fund

Summary

The Texas Constitution of 1854 does not allow any portion of the principal of the Permanent School Fund (PSF) to be used to support public education. This has led to an income-based spending policy where only interest, dividends and certain land income can be contributed to the Available School Fund (ASF) for distribution to school districts. Virtually all other college and university endowment funds use a total return management policy that allows a portion of market value increases to be distributed. The Texas Constitution should be amended to allow the PSF to use a total return management policy, which would allow the PSF to grow faster and provide larger distributions to the ASF.

Background

The Texas Constitution authorized the creation of the PSF to support public education. The principal of the PSF may not be spent and is derived from lease rentals, bonuses and royalty payments generated from lands dedicated to the fund. The market value of the PSF principal, or corpus, was $18.8 billion on March 31, 2002. PSF income is deposited in the ASF, from which it is distributed to local school districts.[1]

The State Board of Education (SBOE) gives general guidance for the oversight of the PSF, acting much like the board of directors of a corporation. The Texas Education Agency (TEA) has a division that makes the day-to-day trades and provides accounting and administration for the fund. There are several external managers who also manage portfolios that make up part of the PSF corpus.

The Texas Constitution requires the managers of the PSF to use an income spending policy. The constitution prohibits distributing any portion of investment gains in market value. Cumulative investment gains and oil and gas income from PSF land remain part of the PSF and cannot be placed in the ASF. The constitution requires the distribution of all current income, including interest, dividends and certain land income to the ASF. The Texas Legislature’s biennial appropriations bill mandates minimum distribution amounts from the PSF to the ASF.

Over the last five to 10 years, however, most endowment funds and perpetual governmental funds have adopted a “total return” concept for managing fund assets. Barron’s financial guides define total return as “the annual return on an investment including appreciation and dividends or interest.”[2] Under the total return spending policy, a certain amount of the total annual return is held in the corpus of the fund to offset inflation and other factors; the remainder of the return is paid to the funds’ beneficiaries after management expenses are paid. This policy, then, makes a portion of the annual growth in the fund’s total market value, as well as its income, available for distribution. This gives fund managers the ability to distribute some portion of each part of an investment’s total return—interest, dividends and market value increases.

In 2001, the National Association of College and University Business Officers (NACUBO) performed a study of endowment funds used to finance education. The NACUBO study reported that only 2.5 percent of the funds responding used an income-based spending policy. The remaining 97.5 percent used some form of total return spending policy. No college or university endowment fund with assets of more than $500 million used an income-based spending policy.[3] Looking at other major state of Texas funds, a constitutional amendment approved in November 1999 led to Texas putting the Permanent University Fund on a total return spending policy. In addition, Texas manages the funds from the tobacco lawsuit settlement and higher education and health trust funds created by the 1999 Legislature under a total return spending policy.

According to a TEA analysis, the PSF corpus grew relatively slowly during the 1990s due to the income spending policy.[4] In March 1995, the SBOE began to allocate a larger portion of the PSF’s assets to stocks and a smaller portion to bonds. Due to constraints produced by the income spending policy, the change was not completed until 1999. The PSF must produce a minimum cash income set in the appropriations bill.

Bonds earn a cash income of about 4 percent to 6 percent more per year than stocks. If the income reduction of $173 million per year due to increased stock purchases had occurred at one time, the PSF would have failed to meet the cash income mandate, but by gradually switching from bonds to stocks, the income reduction of $173 million per year was made incrementally, and for 1996-97, the income mandate was adjusted to allow the $173 million per year decrease in income.

This gradual switch could have been avoided if the PSF had been under a total return distribution policy. The increased earnings from stocks would have allowed the PSF to meet the minimum cash income mandate more quickly. This delay cost the state about $1.9 billion, the amount that could have been added to the PSF corpus by August 31, 2000 if the switch had been made in August 1995. It should be noted, however, that the PSF would not have increased by $1.9 billion if this had been the case, because a portion of that money would have been distributed to the ASF.

Investment professionals say it normally would take about four to five months to make a cost-effective change in asset allocation under a total return spending policy. It also normally takes four to five months to cost-effectively sell and buy $3.5 billion in bonds and stocks. Trying to sell $3.5 billion in bonds in a few weeks would flood the market and lower the price. Likewise, purchasing $3.5 billion in bonds over a short time would increase the price. More gradual transactions are more cost-effective.

An income spending policy imposes certain constraints on portfolio management. Stocks can produce drastically more growth in the market value of the investments, and thus the PSF, than bonds can. Should the value of the stock portfolio decline and the value of the bond portfolio rise, it might be advantageous to move funds from the bond portfolio to the stock portfolio to take advantage of market conditions. Under an income spending policy, funds sometimes cannot be moved because the fund is under the income production constraint specified in the appropriations bill. Removing this constraint by switching to a total return policy would free the PSF’s managers to maximize the funds earnings and distributions to the ASF by allowing them to invest in the most effective manner at the most advantageous time.

When equity markets are doing well, earnings from a stock portfolio should be periodically reallocated to the bond portfolio to mitigate risk. However, the SBOE could elect not to do so if a reduction would produce more income than necessary to meet the cash income mandate. The money not reallocated to bonds could increase the value of the corpus if it remained invested in stocks.

Some members of the SBOE have also said that additional cash income does not increase the amount of money available for public education. They contend that since an increase in the PSF contribution to the ASF reduces the amount of general revenue the state must spend on public education, keeping the money in bonds does not provide any additional money for education. But it does make more money available for general revenue spending.

Under the current income spending policy, appropriation riders often force the PSF into holding a higher allocation of bonds than a portfolio designed to maximize total return would contain. A supplemental appropriation made in TEA Rider 90 to the 2001 General Appropriation Act required the SBOE to make changes in the PSF investment strategy that would result in an additional $150 million in earnings in the 2002-03 biennium. Callan Associates, the lead investment consultant to the PSF, says putting 65 percent of the fund’s investments in stocks would ensure the best results.[5] To generate the additional income required by rider 90, the SBOE adopted an asset allocation that has only 55 percent of the PSF in equities and the remaining 45 percent in fixed-income assets. A total return spending policy would allow the PSF to own equities in whatever amounts it believes would best help increase the value of the PSF.

Some observers believe that a total return spending policy would encourage the PSF to pay more to the ASF than is prudent. The history of the PSF suggests otherwise. In 1991, the PSF paid earnings worth 7.8 percent of the fund’s value to the ASF; in 1992, it paid earnings of 7.2 percent of its value, and in 1993, 6.7 percent. Not until 1998 did the percentage paid out fall below 4.5 percent of the value of the fund. The average earnings payout from 1991 through 2001 was 5.6 percent.[6]

Recommendation

State law and the Texas Constitution should be amended to adopt the total return concept for the Permanent School Fund and to establish a total return spending policy instead of the income spending policy that the PSF currently follows.

This change would require a constitutional amendment that could be submitted to voters in November 2003. The amendment would specify a maximum distribution percentage to the ASF of 4.5 percent of the value of the PSF corpus at the beginning of each year.

The total return spending policy would protect the corpus from inflation and allow the PSF to pay annual management expenses each year. Managing the fund on a total return basis would allow the fund to grow at a faster rate and would allow larger distributions to the ASF when the PSF’s value increases.

To protect the PSF corpus from inflation, if upcoming biennial distributions would cause a decline of the corpus compared with the previous 10 years, the distribution percentage should be reduced to a level that would maintain the value of the corpus at that time.


Fiscal Impact

The total return concept and a distribution policy for the PSF would provide more revenue to support public education. If the PSF was allowed to structure its portfolio to maximize total return, as much as 65 percent of the corpus could be invested in stocks.

Earnings from the PSF are distributed to the ASF and then to individual school districts. Any increase to the ASF would reduce by almost the same amount the contribution required from the General Revenue Fund for education.

Fiscal Year Gain to General Revenue Additional Amount Available to Budget Balanced School Districts Gain/(Loss) to the Permanent School Fund Corpus
2004 $24,117,000 $1,839,000 $36,521,000
2005 $58,973,000 $4,496,000 ($3,338,000)
2006 $80,616,000 $6,146,000 ($24,661,000)
2007 $87,065,000 $6,638,000 ($31,272,000)
2008 $97,970,000 $7,469,000 ($43,123,000)


Endnotes

[1] Tex. Const. art. VII, §5(a): and Texas Education Agency, Texas Permanent School Fund 1999 Annual Report (Austin Texas, February 14, 2000), p. 6.

[2] John Downes and Jordan Elliot Goodman, Dictionary of Finance and Investment Terms, 5th ed. (Hauppauge, New York: Barron’s Educational Series Inc., 1998), p. 654.

[3] Texas State Auditor’s Office analysis of a 2001 National Association of College and University Business Officers endowment study, in the presentation Total Return Investment and Spending Concepts Related to the Permanent School Fund before the House Select Committee on Constitutional Revision (Austin, Texas, May 31, 2002), p. 16.

[4] Texas Education Agency, Spending Policies, a presentation before the State Board of Education, Committee on School Finance/Permanent School Fund (Austin, Texas, March 29, 2001), pp. 16-19.

[5] State Board of Education, Texas Permanent School Fund Asset Allocation Analysis, by Callan Associates (Austin, Texas, June 21, 2000), p. 29.

[6] Texas Education Agency, Texas Permanent School Fund 2001 Annual Report (Austin, Texas, January 4, 2002), p. 34; and Texas Education Agency, Texas Permanent School Fund 2000 Annual Report (Austin, Texas, February 28, 2001), p. 35.