H.F. 2458 (Smith); S.F. 1806 (Kubly) amends the investment authority provision for larger pension funds other than the State Board of Investment (the expanded list is found in Minnesota Statutes, Section 356A.06, Subdivision 7) to permit investing in annuities.

H.F. 2458 (Smith); S.F. 1806 (Kubly) was introduced due to a problem in the investment portfolio of a local volunteer fire plan, the Bellingham Firefighters Relief Association. The association bought an indexed annuity in 1998 and continues to hold that annuity, and possibly others. The Office of the State Auditor (OSA) recently informed the Bellingham Firefighters Relief Association that annuities are not an authorized investment for the relief association because annuities are not included under the investment authorization provision, Section 356A.06, Subdivision 7. The OSA has authority to notify the Commissioner of Revenue that all aid to the relief association should be withheld until the association is in compliance with all laws governing its operation. Therefore, the Bellingham Relief Association may be required to remove the annuities from the portfolio if there is no change in the law.

The change in law is being requested by the Treasurer of the Bellingham Firefighters Relief Association. That individual is an insurance agent. Insurance companies sell annuities. The treasurer indicates that he used another agent when purchasing these annuities for the relief association in an effort to avoid a conflict of interest.

If a volunteer fire relief association provides lump sum pensions, it is permitted under law (Section 424A.02, Subdivision 8a) to purchase an annuity on behalf of a retiring member equal to the service pension that is provided. This allows the retiree to avoid an immediate tax liability and to tailor a payout option over time, if desired. However, relief associations are not permitted to purchase an annuity as part of their special fund portfolio. The special fund is the pension fund that is used to accumulate and invest the association’s pension assets.

Chapter 356A, Public Pension Fiduciary Responsibility, covers general fiduciary and investment issues applicable to all Minnesota public pension plans. The following is a brief statement of relevant key provisions in Chapter 356A:

1. Fiduciary Status and Activities. All members of the plan’s governing board, the executive director (if applicable), and members of investment advisory councils or committees are fiduciaries. Fiduciary activities include the investment of assets, proper computation of benefits, the determination of benefit eligibility, proper determination of funding requirements, expenditure of plan assets, and maintenance of membership and financial records. (Section 356A.02.)

2. Fiduciary Duty. Fiduciaries have a fiduciary duty to plan beneficiaries (active, retired, and deferred members), to the state that established the plan, and to taxpayers who finance the plan through local taxes and state aids financed by state taxes. All fiduciary duties must be conducted faithfully and without prejudice. Fiduciary activities are for the purpose of paying appropriate plan benefits, incurring and paying reasonable plan expenses, and managing the plan’s affairs consistent with law and the plan document. (Section 356A.04, Subdivision 1, and Section 356A.05.)

3. Prudent Person Standard. In addition to other applicable laws governing investment activity and general plan administration, these fiduciary activities must be conducted consistent with the prudent person standard, which requires the fiduciary to act in good faith and to use the judgment and care that persons of prudence, discretion, and intelligence would exercise in the management of their own affairs, not for speculation, considering the probable safety of the capital as well as the probable investment return. (Section 356A.04, Subdivision 2.)

4. Diversification Requirement. The portfolio must be effectively diversified to minimize the risk of substantial investment losses. (Section 356A.06, Subdivision 2.)

5. Title to Assets. Only the plan treasurer or the depository agent for the plan may hold plan assets. Legal title must be vested in the plan, the government entity that sponsors the plan, the nominee of the plan or the depository agent. (Section 356A.06, Subdivision 1.)

6. Absence of Personal Profit. No fiduciary may profit, directly or indirectly, from the investment or management of plan assets. (Section 356A.06, Subdivision 3.)

7. Economic Interest Statements. The executive director of the fund and each governing board member must complete an annual economic interest statement, intended to reveal any real or potential conflicts of interest, and copies are to be sent to the Ethical Practices Board. (Section 356A.06, Subdivision 4.)

8. Minimum Liquidity Requirements. A plan must keep sufficient short-term cash investments to cover benefit payments as they occur. (Section 356A.06, Subdivision 8.)

9. Collateralization Requirement. The governing board must designate a bank, credit union, or insured thrift organization as a depository for plan assets not held by the custodian. Assets deposited in the designated bank, credit union, or insured thrift may not exceed the amount of insurance, unless the excess is covered by appropriate collateral. (Section 356A.06, Subdivision 8a.)

10. Prohibited Transactions. Certain transactions are specifically prohibited. These include sales, exchanges, or leasing of real estate between the plan and a fiduciary, lending plan money to a fiduciary, and any transfer of assets or provision of services to a fiduciary beyond that necessary to perform the fiduciary duties. A fiduciary may not receive anything of more than nominal value from a third party in consideration for a pension plan disbursement. (Section 356A.06, Subdivision 9.)

11. Disclosure of Investment Authority; Receipt of Statement. The administrators of the public pension plan must annually provide to each investment broker, manager, and advisor used by the plan, a written statement of investment restrictions in law or in the investment policy statement applicable to the plan. The broker, manager, or advisor must provide written acknowledgment of receipt of that statement, and must agree to handle the fund’s affairs consistent with the applicable legal restrictions and board policy. (Section 356A.06, Subdivision 8b.)

    This last requirement was added to law in an effort to ensure that Minnesota pension plan assets are invested in assets that are permitted under law. Plan administrators must identify those investment authority laws and note the types of investments permitted under those laws and those that are not. The board may add additional restrictions as a matter of board policy. The board must then communicate those restrictions to all individuals and firms involved in the investing of plan assets.

In addition to all the requirements of Chapter 356A, pension plans have specific investment authority provisions covering the range of investments permitted in the portfolios. The primary investment authority provision for larger Minnesota pubic pension plans is Section 356A.06, Subdivision 7 (expanded list, permissible securities). Many volunteer fire plans are also subject to this provision. This is the primary investment authority provision for any volunteer fire relief association with assets in excess of $1 million, or which uses the services of a registered investment advisor to invest at least 60 percent of its assets, or which uses SBI to invest at least 60 percent of its assets, or which uses an investment advisor and SBI in combination to invest at least 75 percent of its assets. The following describes the securities and other investment forms permitted under Section 356A.06, Subdivision 7:

1. Types of Permissible Investments. Permissible investments may be owned directly or through commingled trusts and are of the following types:

   1. Government debt obligations, including debt obligations of the United States Government and its agencies, government sponsored organizations of which the United States is a member, state and local governments, and Canada and its provinces. All obligations must be backed by the full faith and credit of the issuing organization or be rated as an investment-grade security by a nationally recognized rating agency, and principal and interest must be payable in United States dollars. (An investment grade debt security is one rated in the top four quality categories.).

   2. Investment-grade corporate debt of companies organized under the laws of the United States and Canada, including bond notes, debentures, providing the securities are investment grade and are payable in United States dollars.

   3. Miscellaneous debt and cash equivalent securities, including bankers acceptances, certificates of deposit, commercial paper, mortgage participation securities and asset backed securities, guaranteed investment contracts, providing that securities of a cash equivalent nature are fully backed by insurance, and securities of a longer term debt nature are investment grade. SBI may also purchase Minnesota Housing Finance agency mortgage pools providing none of the mortgages are in default.

   4. Stock or convertible securities of any United States or Canadian company, or of any company listed on domestic stock exchanges. SBI may not own more than five percent of the outstanding shares of any given company.

   5. International securities. While this is not further defined or specified in law, presumably this refers to foreign stocks and bonds.

   6. Puts, calls, futures. A covered pension fund may use puts, calls, and future contracts purchased and sold through regulated markets. Puts and calls are options giving the right to sell (put) or buy (call) a fixed amount of a security at a specified price. Puts can be used if one believes the market price of the security will go down by the contract settlement date; calls could be used if one believes the price may rise. A futures contract is an agreement to exchange securities or currencies at an agreed upon rate.

   7. Various miscellaneous investments, including venture capital investments, regional funds, mutual funds, limited partnerships, real estate investment trusts, and resource investments. For any of these investments, there must be at least four other owners in addition to the covered pension fund, and that pension fund may not own more than 20 percent of the investment, and may not be a general partner or engage in any activity that creates general liability.

2. Asset Mix Restrictions. In addition to specifying legal investments, the section also puts some minimal limits on the proportion of equity investments that a covered pension fund must hold. The total of all forms of equity investments [the domestic stock in (4) above, international securities in (5), and miscellaneous equity investments in (7)] can not exceed 85 percent of the total portfolio’s value. Furthermore, the miscellaneous equity investments in (7) above, considered separately, may not exceed 35 percent of the portfolio’s value.

Investment authority provisions have existed for Minnesota pension plans for many decades. The primary investment authority provision for the State Board of Investment (SBI) is Section 11.24. That section also provided the investment authority for many other Minnesota pension plans by cross-reference to that provision. In the mid-1990s, Section 356A.06, Subdivision 7, was created from these non-SBI plans. That provision was patterned after the SBI provision and remains virtually identical in content.

Despite many decades of public pension plan investing, annuities have to date not been added to the investment authority provisions as permissible investments. The reason is that these investments would be inferior investments within the portfolio of a tax-exempt investor. The public pension plans in our state are tax-exempt investors. They do not pay income tax on the gains generated by the portfolios, whether due to dividends, interest, or recognized or unrecognized capital gains, regardless of the nature or form of the investment.

Annuities may be reasonable investments for certain individual investors. Annuities are investment products sold by the insurance industry which offer a way for individuals to have a tax-deferred investment. But that comes with a downside. Annuities typically have very high charges and fees associated with them. These may include various mortality and expense risk charges of about 1.25 percent per year, in addition to sales charges, surrender charges, and investment management fees. Total costs typically are in excess of two percent per year. Because of the high charges associated with annuities, the Securities and Exchange Commission (SEC) urges any individual considering annuities to first exhaust all other tax-deferred options available to the individual (this statement is found on the bottom of page 1 and the top of page 2 in the attached document from the SEC). Individuals should first consider investing in their employer’s 401(k) plans, deferred compensation plans, and Individual Retirement Accounts (IRAs). That advice is provided because these other tax-deferred investments have lower fees and related charges than annuities. Any cost lowers the net return to the investor and reduces the asset growth. The greater that cost, the lower the net return to the investor.

While annuities may make sense for individuals who have exhausted all other options to invest tax-deferred, annuities do not make sense for a tax-exempt pension fund. They do not need annuity investments to provide tax-exemption. It may never by appropriate for a pension fund to consider an annuity investment even if it were added to law as a permissible investment. It will always be possible to find or construct a similar investment in the same securities with lower cost. Thus, even if added to law as permissible investments, annuities may never by prudent investments for the pension fund portfolio.

H.F. 2458 (Smith); S.F. 1806 (Kubly) amends the investment authority provision for larger pension funds other than the State Board of Investment (the expanded list is found in Minnesota Statutes, Section 356A.06, Subdivision 7) to permit investing in annuities. Pension policy issues raised by the proposed legislation are as follows:

1. Need for Change. The issue is whether there is sufficient justification to revise the investment authority of the Minneapolis Employees Retirement Fund (MERF), the local paid police and fire relief associations, the first class city teacher fund associations, and several hundred local volunteer fire relief associations to permit purchasing annuities as portfolio investments. Annuities do not provide additional diversification since the pension funds can already invest in any of the same underlying securities as those contained in an annuity. From a rate of return standpoint, annuities are inferior to other comparable investments because of the high annuity expenses.

2. Effect of Change. The issue is whether annuities could be considered as prudent investments for a pension fund portfolio, even if added to law as permissible investments. If they are not prudent investments, a fiduciary should not add them to portfolio even if they are made permitted investments under law.

3. Cost to the Volunteer Firefighters and to the State. Investing in annuities is likely to lower returns to the pension fund rather than raising them. This is likely to lead to fewer assets in the portfolio over time than would be the case if more cost-efficient forms of investing were used. This in turn will either harm the volunteer firefighters through lower pensions than could otherwise be provided, or will create requests for increased state aid to offset this effect, or both.

4. Scope/Nature of Problem. The Commission may wish to consider whether H.F. 2458 (Smith); S.F. 1806 (Kubly) properly addresses the problem which caused the legislation to be drafted. The bill, as drafted, may be appropriate if it can be demonstrated that there is a compelling need to add annuities to the investment authority provision. The immediate problem, however, is that the Bellingham Firefighters Relief Association invested in some annuities, contrary to law. In lieu of H.F. 2458 (Smith); S.F. 1806 (Kubly) as drafted, the Commission may wish to consider language which addresses that specific issue. The Commission has a few options. If H.F. 2458 (Smith); S.F. 1806 (Kubly) does not pass in any form, that relief association will have to remove the annuities from the portfolio or face loss of further state aid. If the bill passes as drafted, annuities will be authorized investments as of the effective date, but that does not address the non-compliance of this relief association to date. The Commission may wish to add an effective date provision (currently, there is none), and include some language ratifying past Bellingham Firefighters Relief Association annuity investments. The other alternative would be a delete-all amendment to replace the proposed language with a provision solely for the Bellingham Firefighters Relief Association ratifying the annuity purchases that have occurred.

LCPR04-103 revises an incorrect reference to the State Board of Investment rather than to the covered pension fund, adds an effective date making the legislation effective on the day following final enactment, and ratifies Bellingham Firefighters Relief Association annuity purchases that have occurred.

LCPR04-104, an alternative to LCPR04-103, is a delete-all amendment that replaces the language of H.F. 2458 (Smith); S.F. 1806 (Kubly), as drafted, with language ratifying Bellingham Firefighters Relief Association annuity purchases that have occurred. This will remove the risk that the association will have state aid withheld due to those purchases.