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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 3/02/05
HB
SHORT TITLE Permanent Fund Investment Criteria
SB 392/aSFC
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, SB 60
Duplicates: HB 389
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.
pg_0002
Senate Bill 392/aSFC -- Page 2
Synopsis of SFC Amendment
The Senate Finance Committee amendment to House Bill 389 clarifies that the Uniform Prudent
Investor Act and generally accepted accounting standards apply to the State Investment Coun-
cil’s differential rate investments. (Differential rate investments are those targeted to NM
economic development, such as the film program and regional private equity.)
Synopsis of Original Bill
Senate Bill 392 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). Senate
Bill 392 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.
Senate Bill 392 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.
pg_0003
Senate Bill 392/aSFC -- 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)
pg_0004
Senate Bill 392/aSFC -- 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 House Bill 389. 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 SB 392 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-
portions than market rate investments.) However, the Attorney General’s office has previously
pg_0005
Senate Bill 392/aSFC -- Page 5
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%
pg_0006
Senate Bill 392/aSFC -- 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.
GG/yr:sb