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F I S C A L I M P A C T R E P O R T

…..

SPONSOR Varela

DATE TYPED 3/3/05

HB 389/aHAFC

SHORT TITLE Permanent Fund Investment Limitations

SB

ANALYST Geisler

REVENUE

Estimated Revenue

Subsequent

Years Impact

Recurring

or Non-Rec

Fund

Affected

FY05

FY06

$42,000.0 Significant. See Narrative Recurring Pension and Trust

Funds

(Parenthesis ( ) Indicate Revenue Decreases)

Relates to: HB 55, SB 60

Duplicates: SB 392

SOURCES OF INFORMATION

LFC Files

State Investment Council (SIC)

Educational Retirement Board (ERB)

Public Employees Retirement Association (PERA)

Attorney General (AG)

SUMMARY

Disclosure of Bill Language Issue

Legislative Council Service staff has identified an issue with Section 8. Act Not Severable. The

current language of section 8 reads: “If any part or application of this act is held invalid, the re-

mainder or its application to other situations or persons shall likewise be invalid. The provisions

of this act are not severable.”

Council service staff indicate that the language as written might not ensure failure of the whole

bill if it does not receive 75% of the votes as required to amend the portions of the bill applying

to the land grant permanent fund statutes. If a 75% vote requirement to pass the entire bill is de-

sired, consideration should be given to amending section 8 of the bill to clarify this point. If the

intent is for the provisions of the bill to apply to ERB and PERA if more than 50%, but less than

75% of the votes are received, consideration should be given to amending the bill to strike Sec-

tion 8.

House Bill 389/aHAFC -- Page 2

Synopsis of HAFC Amendment

The House Appropriations and Finance Committee amendment to House Bill 389 clarifies that

the Uniform Prudent Investor Act and generally accepted accounting standards apply to the State

Investment Council’s differential rate investments. (Differential rate investments are those tar-

geted to NM economic development, such as the film program and regional private equity.)

Synopsis of Original Bill

House Bill 389 is Legislative Finance Committee sponsored legislation that would eliminate the

current “legal list” of permissible investments and replace it with the guiding principles of the

Uniform Prudent Investor Act (“UPIA”) for the Public Employees Retirement Association

(PERA), Educational Retirement Board (ERB), and the State Investment Council (SIC). House

Bill 389 also requires investing agencies to report quarterly to the Legislative Finance Commit-

tee and Department of Finance and Administration on investment performance and annually on

any changes in written investment policies.

The UPIA sets a higher standard of care for a fiduciary or trustee, above and beyond the current

standard and guiding principles in law. The UPIA requires fiduciaries or trustees to take into ac-

count the condition of the entire trust and other modern economic factors in making investment

decisions instead of just considering individual assets as the old standard and “legal lists” dic-

tates.

Under the UPIA, trustees shall invest and manage the trust assets as a prudent investor would, by

considering the purposes, terms, distribution requirements and other circumstances of the trust.

To satisfy this higher standard, trustees shall exercise reasonable care, skill, and caution. As a

result of the standard of care, trustees’ investment and management decisions respecting individ-

ual assets must be evaluated in the context of the trust as a whole and part of an overall invest-

ment strategy with specific risk and reward objectives identified by the trust.

Significant Issues

•

The UPIA holds trustees to a higher standard by requiring investment decisions to be

made prudently and be supported by expertise with the sole interest of the beneficiaries in

mind.

•

The higher standard of prudence applies to the entire trust not just assets in isolation (as

the current guiding principles dictate).

•

The UPIA requires that trustees set investment strategy based on the risk and reward ob-

jectives suitable for the trust and its beneficiaries.

•

House Bill 389 eliminates legal lists and allows trustees to invest in any asset that con-

forms to the prudence standard and achieves the risk/reward objectives of the trust. New

asset types may include real estate, private equity, and hedge funds.

•

Given changing and dynamic investment markets, UPIA allows trustees to invest in any

asset that meets the higher standard of prudence. This provides the trust greater flexibility

and options to improve the performance of the fund while holding or decreasing risk.

House Bill 389/aHAFC -- Page 3

•

Concerns about implementation of UPIA for the investing agencies include the financial

expertise of board members and the applicability of UPIA to State Investment Council

differential (or “below market”) investments in New Mexico private equity funds and

businesses.

PERFORMANCE IMPLICATIONS

State investment agencies believe that their investment performance will improve by having in-

vestments governed by the UPIA instead of legal lists.

FISCAL IMPLICATIONS

According to the state investment agencies, moving from the current “legal list” to the UPIA can

have a significant positive impact on the future investment performance of the agencies, in par-

ticular given the modest return predicted in investment markets during the next five years. For

example, PERA’s investment consultant projects stocks to only average 6% to 10% growth an-

nually and annual fixed income return to be in the 4% to 6% range. Alternative investment types

are expected to offer higher returns (real estate 7.6%, private equity 12%, and hedge funds

6.5%). Adding additional asset classes to a portfolio also diversifies it, which helps minimize

investment losses during negative market periods. (See additional discussion under substantive

issues)

•

PERA’s projection for investment return with their current portfolio of mostly stock and

bonds for the next five years is 7.35% annually, which is .65% (or 65 basis points) less than

their actuarial target of 8% return. Under the UPIA, if approximately 16% of PERA assets

are allocated to new assets classes such as real estate, hedge funds, and private equity, PERA

projects expected investment return of 8%, an increase in 55 basis points.

•

ERB’s projected investment return for the same 5 year period is approximately 7.65 % with a

similar mix of assets, which is .35% (or 35 basis points) less than their actuarial targeted re-

turn of 8%. By adding new asset classes ERB projects a minimum gain of .26 basis points,

which brings them closer to their targeted return.

•

SIC projected annual investment return of 8.51% over the next five years barely meets the

8.5% target return necessary to meet their constitutionally mandated payout obligations. By

adding new asset classes, SIC projects a minimum increased return of 8.85%--a increase of

34 basis points.

The table below shows the four year estimate of added investment returns in dollars by moving

to the UPIA and adding new asset classes.

ERB

PERA

SIC

Total

FY 06

8,000

$

10,000

$

24,000

$

42,000

$

FY 07

30,000

$

71,200

$

76,176

$

177,376

$

FY 08

55,000

$

142,000

$

137,249

$

334,249

$

FY 09

83,000

$

223,000

$

208,373

$

514,373

$

Total

176,000

$

446,200

$

445,798

$

1,067,998

$

Projected Increase in Investment Return for First 4 Years of UPIA

Implementation (000's)

House Bill 389/aHAFC -- Page 4

Because new asset classes could not be fully implemented for FY06, the positive fiscal impact is

approximately $42 million in FY06. However, when the changes can be fully implemented the

positive fiscal impact will be larger; $177.3 million for FY07, $334.2 million for FY08, and

$514.3 million for FY09. To put these projected increases in returns in perspective, it is impor-

tant to note that ERB, PERA, and SIC have combined assets of approximately $27.3 billion as of

June 30, 2004.

ADMINISTRATIVE IMPLICATIONS

If this bill were to become law, ERB, PERA, and SIC would not be able to invest in any new op-

tions until such time as alternative investments were approved as eligible investments by its

board.

CONFLICT, DUPLICATION, COMPANIONSHIP, RELATIONSHIP

Duplicates Senate Bill 392. SB 60 also will eliminate the state investing agencies (SIC, PERA,

ERB) current legal lists of permissible investments and replace them with the higher standard of

the UPIA. The major difference between HB 389 and SB 60 are that SB 392 reflects the latest

edits coordinated with PERA, SIC, and ERB and adds a requirement for the investing agencies to

report performance quarterly to the Legislative Finance Committee and the Department of Fi-

nance and Administration, as well as report annually on any changes in written investment poli-

cies.

Another bill, HB 55, sponsored on behalf of the Legislative Education Study Committee, elimi-

nates the current legal lists of permissible investments for ERB and replaces it with the higher

standard of the UPIA

OTHER SUBSTANTIVE ISSUES

Board Expertise in the Investment Area

One area of concern is that the removal of the legal list in favor of UPIA assumes that the in-

vestment agency “trustees”, as defined in the UPIA, possess sufficient expertise in modern port-

folio management theory and practice and are therefore in a position to strategically and vigi-

lantly oversee the portfolio under the prudent investment standards. For example, the Educa-

tional Retirement Board is composed of seven members, consisting of the following: the superin-

tendent of public instruction; the state treasurer; one member to be elected for a term of four

years by the New Mexico association of educational retirees; one member to be elected for a

term of four years by the members of the New Mexico education association; one member to be

elected for a term of four years by the New Mexico members of the American association of

university professors; and two members to be appointed by the governor for terms of four years

each. Although all of these are distinguished policy makers and citizens, only a few of these po-

sitions are filled by members with financial or investment experience.

SIC Targeted Economic Investments and UPIA

The AG notes that the bill expressly states that “market rate investments” are subject to the Uni-

form Prudent Investor Act. It does not expressly state this for “differential rate investments.”

(Differential rate investments are allowed to balance non-rate of return factors in different pro-

House Bill 389/aHAFC -- Page 5

portions than market rate investments.) However, the Attorney General’s office has previously

opined that the Uniform Prudent Investor Act governs both types of investments.

Differential rate investments are SIC investments of Severance Tax Permanent Fund monies in

New Mexico private equity funds and businesses for the purpose of stimulating the New Mexico

economy (return considerations are secondary). Since maximizing return is not the primary ob-

jective, this may appear to conflict with the standards of the UPIA. Clarifying language in statue

may be required to facilitate continuation of investment in New Mexico private equity funds and

businesses under UPIA.

Brief History of the Uniform Prudent Investor Act

Before the Uniform Prudent Investor Act, the previous investment standard was the ‘Prudent

Man Rule’. However, in 1974, the Employee Retirement Security Act (ERISA), adopted by

Congress, recognized the shortcomings of the ‘Prudent Man Rule’ by setting a standard of pru-

dence more in step with economic realities and modern portfolio management. After adjustments

to ERISA’s standard, the National Conference of Commissioners on State Laws formally ap-

proved a model Uniform Prudent Investor Act in 1994, which is in use in almost 40 states and

the District of Columbia today.

Advantage of UPIA over Legal Lists of Investments

The current “legal list” is a confusing and cumbersome list of what assets may be invested in by

the investing agencies. Some persons may be interpret the legal list to include certain invest-

ments, yet others may not have the same interpretation. The UPIA removes the confusion result-

ing from different interpretations and legal opinions and places this responsibility, within the

standard of the UPIA, with the trustees. Elimination of the legal list also reduces the multi-year

lag time between getting legislative approval for a new asset class, getting board approval, and

procuring new investment managers.

Projected Investment Return and Risk for Asset Classes

PERA provided the following information from their investment consultants, Callan Associates.

Callan 5-Year Annualized Capital Market Projections

Asset Class

Expected Return Risk

Equities

Broad Domestic Equity

9.00%

16.90%

Large Cap

8.80%

16.20%

Small/Mid Cap

10.10%

23.50%

International Equity

9.30%

20.30%

Emerging Markets

9.80%

33.00%

Fixed Income

Domestic Bonds

4.75%

4.50%

Non-US Bonds

4.65%

9.60%

High Yield

6.75%

12.10%

Alternatives

Real Estate

7.60%

16.50%

Private Equity

12.00%

34.00%

Hedge Funds

6.50%

10.50%

House Bill 389/aHAFC -- Page 6

It should be noted that while the alternative investment classes such as real estate, private equity,

and hedge funds offer higher return they also have higher risk (“standard deviation”). An assets

standard deviation is a measure of the volatility of its likely investment return. For example, as

noted above PERA’s projects 7.35% annual return over the next five years with their current mix

of assets (approximately 60% stocks and 40% bonds). The standard deviation associated with

that portfolio is 10.65%. If PERA diversified their portfolio by adding 16% alternative asset

classes (reducing bonds by that amount) projected return would increase from 7.35% to 8% but

the risk of volatility in return would increase from 10.65% percent to 12.3%.

It would appear that adding new investment classes would therefore be riskier, but the investing

agencies disagree—in their view the increase in added investment return from asset diversifica-

tion (both in good years and down markets) outweighs the added increase in risk from a more

diversified portfolio.

WHAT WILL BE THE CONSEQUENCES OF NOT ENACTING THIS BILL.

The investing agencies will continue to invest under the rules of the current statutory provisions

and their respective board’s investment guidelines. The investing agencies believe failure to pass

legislation of this type will hamper future investment performance.

POSSIBLE QUESTIONS

1)

How has the investment performance of PERA, ERB, or SIC been harmed by the legal list.

2)

If the legislature provides additional investment flexibility to the investing agencies by im-

plementing the Uniform Prudent Investor Act, what other statutes or rules will protect the

fund by regulating the conduct of the investing agencies boards and staff.

3)

What are some of the risks associated with new assets classes such as real estate, private eq-

uity, and hedge funds.

4)

Would it be appropriate for there to be limits in statute on the amount of the fund which can

be invested in alternative/more volatile asset classes.

5)

Elaborate on how the UPIA provides for a higher standard of care by the board trustees and

staff.

GGG/yr:sb