Improve the Formula Used to Distribute Permanent School Fund Revenue

Summary

The State Board of Education (SBOE) manages the Permanent School Fund (PSF) according to trust law principles, which require net realized capital gains to remain with the corpus of the fund. Corporate law principles, on the other hand, allow the spending of net realized and unrealized capital gains. The SBOE should adopt a distribution policy based on corporate law principles.

Background

The Texas Constitution of 1854 created the Permanent School Fund (PSF). 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. Income derived from fund investments (dividends from stocks and interest from bonds and money market instruments) may be spent. This revenue flows from the PSF into the Available School Fund (ASF) and then is distributed to local school districts.[1]

Until the late 1960s, American fund managers followed trust law principles, which require net realized capital gains to remain with the corpus. Currently, most endowment managers follow corporate law principles, which allow the spending of net realized and unrealized capital gains. A capital gain is the difference, if positive, between an asset’s purchase price and its current market value. A capital gain is unrealized until the asset is sold, at which point it becomes realized.

In recent years, many states and funds have adopted a “total return” concept in managing and administering fund assets. Barron’s financial guides define total return as “annual return on an investment including appreciation and dividends or interest.”[2] Along with the total return concept, fund managers may adopt a “spending rule.” Under a spending rule, a certain amount of the total return is held in the corpus of the fund to allow for inflation and other preset allowances. The remaining balance of the total return is paid to beneficiaries of the fund after fund management expenses are paid.

Presently, the PSF is managed by trust law principles. Net realized capital gains from the sale of equity and debt securities are returned to the fund’s principal. In August 1986, a House Joint Resolution proposed spending net realized capital gains as long as the current income of the fund keeps the fund balance growing with inflation; this measure did not become law.[3]

In 1989, Texas adopted the Uniform Management of Institutional Funds Act.[4] At this writing, 45 of the 50 states have adopted some variation of the act, which authorizes the use of net realized and unrealized capital gains to meet current obligations, subject to a standard of business care and prudence.[5] The 1989 Texas act prohibited institutions of higher education and other governmental entities from using PSF net realized capital gains for current obligations.[6] A 1993 amendment to the Texas act removed the prohibition for governmental entities.[7] This amendment allows the PSF to use realized and unrealized capital gains for current obligations. The Texas Constitution, however, overrides the act and prohibits spending any of the PSF corpus.

Texas passed a constitutional amendment in November 1999 that put the Permanent University Fund on a spending rule. The tobacco lawsuit settlement revenues, which Texas began to receive in 1999, also are being managed under a spending rule.

Exhibit 1

Permanent School Fund Revenue Growth

(In millions)

Fiscal Year	Beginning Balance (Book Value)	Mineral Income	Realized Capital Gains	EndingBalance(Book Value)	Yearly Percent Increase	Percent Increase Excluding Realized Capital Gains
1990	$ 6,780	$178	$ 270	$ 7,228	6.6%	2.6%
1991	$ 7,228	$176	$ 175	$ 7,579	4.9%	2.4%
1992	$ 7,579	$145	$ 343	$ 8,067	6.4%	1.9%
1993	$ 8,067	$148	$ 416	$ 8,631	7.0%	1.8%
1994	$ 8,631	$151	$ 236	$ 9,011	4.4%	1.7%
1995	$ 9,011	$123	$ 284	$ 9,418	4.5%	1.4%
1996	$ 9,418	$153	$ 566	$10,140	7.7%	1.7%
1997	$10,140	$199	$ 324	$10,622	4.8%	1.6%
1998	$10,622	$211	$1,645	$12,535	18.0%	2.5%
1999	$12,535	$163	$1,450	$14,141	12.8%	1.2%

Sources: Texas Education Agency and US Bureau of Labor Statistics.

Exhibit 1 presents PSF data for the past 10 years. During this period, the book value of the PSF increased by 108.6 percent, from $6.8 billion to $14.1 billion. Inflation over the same time period was 35.1 percent. Alone, unrealized capital gains and land-related mineral income would have allowed the fund to grow at a higher rate than inflation.

Recommendation

A. State law and the Texas Constitution should be amended to adopt the total return concept for the Permanent School Fund (PSF), and establish a spending rule distribution policy.

This change in distribution policy would require a constitutional amendment that could be submitted to the voters in November 2001. The amendment should specify a permissible distribution range of 3 to 6 percent of the beginning annual market value of the PSF. The distribution would be established initially at 5 percent for fiscal 2002 and 2003. Beginning in fiscal 2004, the distribution percentage could be changed within the permissible range, subject to a two-thirds majority vote of the State Board of Education.

The spending rule would protect the corpus from inflation, add an annual cushion amount, and allow for payment of management expenses each year. The balance left would be used to support public education.

Fiscal Impact

Adopting the total returns concept for the PSF would provide more money to support public education. This money might be used as an initial payment toward establishing a fund for teachers’ health insurance.

As stated earlier, earnings from the PSF flow to the ASF and are distributed to individual school districts within the state. Any needs not met by the ASF are matched dollar-for-dollar from the General Revenue Fund. Any increase to the ASF has a direct effect on the General Revenue Fund.

Fiscal

Year

Savings to the

General Revenue Fund

(Loss) to the Permanent

School Fund

2002

$343,000,000

($343,000,000)

2003

$336,000,000

($336,000,000)

2004

$327,000,000

($327,000,000)

2005

$320,000,000

($320,000,000)

2006

$314,000,000

($314,000,000)

Endnotes

[1] Vernon’s Ann. Tex Const. Art. 7, §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 H.J.R. 11, 69th Leg., 2nd Called Sess. (1986).

[4] V.T.C.A., Property Code §163.000.

[5] Uniform Management of Institution Funds Act, Uniform Laws Annotated Business & Financial Laws, Cumulative Annual Pocket Part, Vol 7A (St. Paul, Minnesota: West Publishing Company, 1985), p. 194.

[6] Texas S.B. 1081, 71st Leg. Reg. Sess. (1989).

[7] Texas S.B. 709, 73rd Leg. Reg. Sess. (1993).

e-Texas is an initiative of Carole Keeton Rylander, Texas Comptroller of Public Accounts
Post Office Box 13528, Capitol Station
Austin, Texas

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