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

…..

SPONSOR Carraro

DATE TYPED 01/31/05 HB

SHORT TITLE Standards for Investment of State Funds

SB 60

ANALYST Geisler

REVENUE

Estimated Revenue

Subsequent

Years Impact

Recurring

or Non-Rec

Fund

Affected

FY05

FY06

$42,000 Significant. See Narrative Recurring Pension and Trust

Funds

(Parenthesis ( ) Indicate Revenue Decreases)

Relates to: HB 55, HB 389, SB 392

SOURCES OF INFORMATION

LFC Files

State Investment Council (SIC)

Educational Retirement Board (ERB)

Public Employees Retirement Association (PERA)

SUMMARY

Synopsis of Bill

Senate Bill 60 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 Em-

ployees Retirement Association (PERA), Educational Retirement Board (ERB), and the State

Investment Council (SIC). 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 fiduci-

aries or trustees to take into account 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” dictates.

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

Senate Bill 60 -- Page 2

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.

•

Senate Bill 60 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.

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

Senate Bill 60 -- Page 3

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)

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

House Bill 389 and Senate Bill 392 are Legislative Finance Committee endorsed legislation that

will eliminate the state investing agencies (SIC, PERA an ERB) current legal lists of permissible

investments and replace them with the higher standard of the UPIA. SIC, PERA and ERB sup-

port this legislation.

HB 55, sponsored on behalf of the Legislative Education Study Committee, eliminates the cur-

rent legal lists of permissible investments for ERB and replaces it with the higher standard of the

UPIA

OTHER SUBSTANTIVE ISSUES

Additional background provided by PERA:

Senate Bill 60 -- Page 4

Brief History of the ‘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%

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%.

Senate Bill 60 -- Page 5

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.

TECHNICAL ISSUES

See Amendments for PERA suggested technical adjustments to SB 60.

ALTERNATIVES

PERA notes that the investing agencies (PERA, ERB and SIC) have jointly made technical

changes to Legislative Finance Committee-sponsored legislation drafted to replace each invest-

ing agency’s current “legal list” of permissible investments with higher standard of investing un-

der the UPIA. PERA believes the LFC-sponsored legislation will have all the technical drafting

changes recommended by the investing agencies and recommends the alternative language of

that bill be used.

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.

AMENDMENTS

PERA suggests the following technical changes to SB 60:

1.

For clarification, specific reference should be made in the bill to the Uniform Prudent Inves-

tor Act, Chapter 45, Article 7, NMSA 1978.

2.

On page 10, line 18, after the deleted language [classes of securities and investments:], add

the following language: “The retirement board shall invest and reinvest the funds in accor-

dance with the Uniform Prudent Investor Act, Chapter 45, Article 7, NMSA, 1978, as

amended.”

3.

On page 16, delete the language from lines 14 through page 17 line 5.

4.

On page 17, line 6, delete the following caption letter: [E.]. Add in its place the letter “C.”

5.

On page 17, line 12, delete the following caption letter: [F.]. Add in its place the letter “D.”

6.

On page 17, line 21, after the word “services,” add the following language, “and related in-

vestment management services”

7.

On page 17, line 22, add a coma after the word “powers.” Strike through the words “or of”

before the word, an investment counseling

Senate Bill 60 -- Page 6

8.

On page 17, line 23 add the following language after the word “firm” and before the word

“and,” “or brokers for the purchase and sale of securities, commission recapture and transi-

tioning services”

9.

On page 18, line 3, delete the following caption letter: [G.]. Add in its place the letter “E.”

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)

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

staff.

GG/lg