Presentation of Paul A. Dillon Vice President and Director Economic Research Division Mid America Appraisal & Research Corp. Before the Midwestern Conference Business Development Task Force Council of State Governments

ST. LOUIS, MISSOURI DECEMBER 8, 1982

“Capital formation” will continue to be a buzzword for policymakers in the 1980s. Without channeling a greater proportion of our national income into productive investment, it is argued, we cannot lick the stagflation that has plagued the economy in recent years. To achieve this goal, Americans must save more and spend less on both private and public expenditures that do not contribute to capital formation.

But capital formation involves a good deal more than whether we have a five percent or six percent personal savings rate. Most importantly, it involves how savings in our economy is invested. Just as the liberal economists of the 1960s and 1970s were often myopic in their excessive focus on aggregate demand, so today’s “supply siders “ neglect a critical aspect of the economy in their preoccupation with the level of savings to the exclusion of its allocation. The overall performance of the economy, and the distribution of economic activity among different population groups, regions, and sectors, depends on how well our capital markets function. Will capital be allocated for investment in raw land, commodities, and the rearrangement of corporate ownership, or in innovative technology, basic capital equipment, and unmet housing needs?

One cannot talk about capital allocation in the United States without placing pension funds at the center of discussion. The facts are impressive. With $650 billion in assets nationwide, public and private pension funds provided more than one quarter of all the new capital available for investment in 1980.

Pension funds are one of the fastest growing single sources of investment capital in the United States today. Between 1955 and 1980, total pension assets in the United States increased over sixteen times, from $40.4 billion to $653.4 billion. During this same period, state and local government pension funds grew at an even faster rate, increasing from $10.8 billion to $202.7 billion.

This rapid and sustained expansion of pension fund assets has given pension funds a growing influence in the economy of the United States. In 1954, pension fund assets comprised only 7.4 percent of the total U.S. capital investments. By 1979, this percentage had grown to 16.6 percent. A recent study by the Council of State Planning Agencies estimated that if the rate of increase continues, by the end of the 1980s, pension funds will account for greater than one half of all capital raised in the United States. Total assets are expected to reach $11 trillion by 1995.

The significance of pension fund capital goes well beyond its relative size. Pension funds are also important because of their financial characteristics, especially the very long-term nature of their financial liabilities. Banks and savings and loans, for example, have liabilities that mature in a day, a week, a month, a year or, at most, a few years. Pension funds by contrast have benefit liabilities that, on average, will not mature for decades. This makes them a unique source of long-term capital for business and housing ventures.

The economic, social, and political implications of pension fund investments became a growing concern in the late 1970s. A few commentators had noted the future prominence of this enormous capital pool as early as the 1950s, but it took two more decades and the doubling of pension funds five times in the postwar era before their investment practices became the subject of popular debate.

During the development and passage of the Employee Retirement Income Security Act of 1974, new attention was drawn to the investment practices of private pension funds. During this process, there were sporadic discussions of the economic and social impact of investments, although the issues dealt with in the final bill were narrower than this debate.

Over the next four years, however, two books appeared that further popularized the issue: Peter Drucker’s The Unseen Revolution and Jeremy Rifkin and Randy Barber’sThe North Will Rise Again. Drucker argued that the enormous share of corporate stock held in pension funds effectively meant that the economy was now characterized by social ownership, although he concluded that this development had as yet produced few effects. Rifkin and Barber catalyzed the movement of labor unions and public fund sponsors toward a more active control over how these funds are invested, arguing the beneficial ownership of pension assets by workers was not synonymous with real control, and that pension fund investments were often being made against the broader economic and social interests of pension fund members. They pointed out that the funds of northern and union workers were commonly used to finance nonunion enterprises in the south and overseas, for example.

While these books put pension funds on the political agenda, they also reflected certain other developments. The economy as a whole was stagnating and beset with persistent inflation. Whole industries and regions were becoming less competitive. A growing number of people -politicians, policy makers, and the public at large came to believe that these economic problems were finally resistant to the fiscal and monetary policies promoted only a decade before. Second, the vulnerability of labor unions, produced by their declining share of the work force and the increasing resistance of many employers to worker organizations, made new sources of political and economic clout vital for the labor movement. Third, many states and localities were approaching fiscal crisis, and had less money available for such traditional and costly development tools as tax abatements. New, more efficient ways of promoting economic and housing development were sorely needed. Finally, confidence in the management of pension funds was eroding, largely in response to the relatively poor pension fund median annual returns of the 1970s, which were well below both the CPI and the Treasury bill rate.

Together these forces have given rise to the trend called ” social investing”, or the effort to accomplish through pension investments various economic or social objectives, including a higher rate of economic growth, job creation on a national or regional basis, more affordable housing, a cleaner environment, etc.

Several public and private pension funds have begun implementing variants of this new approach to investing with some of their funds, and a much larger number of funds and groups are involved in an active debate on the merits of the approach. The central issues in this debate are largely identical to the questions any pension fund will encounter in deciding whether to engage in some form of constructive investing: what should be the goal of constructive investing? How will it affect the retirement income objective? Is it legal and desirable? How can it be implemented?

The general debate is, de facto, slowly creeping to resolution in favor of those advocating different forms of constructive investing. Each passing week brings new stories in the financial press reporting that in Kansas, the public pension system produced a return of 10.7 percent last year by investing part of its $950 million in assets in small Kansas based companies. In Ohio, the State Teachers Retirement System has invested in higher risk venture companies. Meanwhile, New York City is considering a plan to create a local development corporation that would use municipal pension fund money to channel low interest loans to small businesses and growing companies. A study shows the loans could retain or create 4,000 jobs while helping 490 companies in the city to expand.

Much of the reluctance to invest pension fund assets in development investments has stemmed from a belief that prudent financial standards would necessarily be lowered. Advocates of development investing have frequently contributed to this perception by failing to understand the implications of their proposals for financial performance. Other advocates have ended up at the other extreme, proposing investments that, while financially sound. (and this is very important) are so unimaginative that they merely displace existing investors. There are inherent dangers in these opposite tendencies, with only one approach deemed fully compatible with the dual objectives of safeguarding retirement income and enhancing development. The key to success is concentrating on sectors and enterprises that have been under financed due to gaps and inefficiencies in our financial system.

Whether development investing can supplement or must inevitably interfere with the primary objective of pension funds has been the central point of contention between opponents and advocates. Opponents have argued that development investing will impair portfolio performance, violate the law, and be impossible to implement. Development investing based on the “ capital gap filling “ model, however, offers the chance to be successfully merged with investing designed to provide the best retirement benefits at least cost.

Effective, yet financially sound development investing first requires identifying situations where the unavailability of capital on competitive terms is impeding development that would otherwise take place. It then requires using the correct investment vehicles to direct funds to these unmet capital needs. This sounds simple, yet in reality, it is rather difficult to achieve and, and there is ample evidence to indicate that, by and large, state and local governments have not, as yet, found appropriate vehicles to further the development-investing concept, while preserving traditional risk/reward investment criteria.

Among the types of investment vehicles used for accomplishing alternative purposes, residential mortgages and corporate debt seem to offer the greatest opportunity for state and local pension systems to make investments thought to have an impact on economic activity and fill local “capital gap” needs. Notwithstanding their economic impact, however, a recent study of state and municipal pension fund investments performed by the Municipal Finance Officers Association (MFOA), found that the first and foremost motivation for these investments was their ability to earn a good rate of return at acceptable levels of risk. In other words, the added benefit of boosting the local economy or housing market was considered secondary to the objective of meeting traditional investment standards.

To develop examples of public pension experience with alternative investments, ten state and local jurisdictions were selected for in depth case studies by the Municipal Finance Officers Association. The detailed investigations reaffirmed the more general survey findings. Systems making alternative investments concentrated their prime efforts on finding securities that could meet traditional financial criteria, but which might also have local development enhancing attributes. Such investments fell into four broad categories: targeted government guaranteed market securities; private placements in debt of equities; local or in state mortgages purchased directly from private mortgage bankers or savings and loan associations; and direct real estate investments.

The rules for channeling pension funds into alternative investments were similar in content regardless of whether they were matters of law or system policy. Such guidelines typically acknowledged that pension systems were important sources of capital in attaining economic objectives, but explicitly denied that there should be any reduction in the quality of investment or rates of return. Also, there were no cases where “ basket clauses” had been adopted to give fund managers the capacity of making investments without regard to traditional investment standards.

The MFOA and the National Conference of State Legislatures in a survey of states regarding steps taken to promote alternative investments undertook another analysis of alternative investing. Ten of the twenty-three states responding indicated there had been legislative interest in the possibilities of pension funds making investment decisions on bases other than only risk and return considerations. Very little has been done, however, aside from adopting statements that in state investments are favored, if risk and return characteristics are otherwise identical to those available on other investments.

Still, the number of bills proposed in states within the past six or seven years suggests that interest is strong in liberalizing the rules or revising old statutes to permit more alternative investments to fulfill economic development and “capital gap” requirements. But, even the most recent proposals do little more than extol the virtues of investing in locally based firms and targeting mortgage investment. Where alternative investments are formally encouraged, the legislation is permissive rather than mandatory.

The research by the MFOA concluded that funds pursuing alternative investment practices are probably having little economic impact on the targeted uses or areas. The guaranteed federal securities relied upon extensively for making alternative investments in these pension fund portfolios are traded in the national capital markets and are homogeneous in credit quality. Therefore, these pension investments are most likely merely displacing those that would be made by other investors. To the extent that pension money is fully substituted for money that would be provided by other investors, there is no net increase in the capital flowing into the area. So, while creation of special institutions like the Government National Mortgage Association have helped hold down the cost of mortgage financing, there is little reason to believe that investment actions of individual pension funds which employ such nationally traded securities have had much economic impact on housing in a selected geographic area. Many of the same arguments apply to pension fund investments in the guaranteed portion of loans to small businesses offered through the Small Business Administration. As with the mortgage backed securities, these investment instruments are traded in national markets, so the displacement effects discussed are likely to occur.

Of the alternative investment mediums identified, the private placements in mortgages acquired from local lending institutions probably offer the greatest opportunities for affecting state and local economies, and filling necessary capital gaps. These investments can be imperfect in their impact, however, since economic benefits can leak to other areas. For example, loans made to in state firms may be used to expand facilities outside the targeted area.

If, as previously noted, public pension funds are to be used for providing needed capital to projects that have selective economic development impacts, investment forms must be found that meet the traditional risk and return criteria and are effective in targeting previously unmet capital flows to selected areas and selected area businesses. It is doubtful that, as a practical or ethical matter, pension funds can or will subsidize such activities through concessions of lower returns or higher risk. Thus, it is important to emphasize that the potential for directing more capital to support local or in state economic goals mandates the creation of new investments or institutions (or modifying existing ones) which are capable of shielding the funds from loss of return, excessive risk and possible conflicts of interests.

Representative innovative investments or organizational investment vehicles which might meet these criteria and provide unmet capital needs, include:

1. Pools of development oriented investments, such as working with banks, insurance companies or mutual funds in developing a pool of equity issues of in state growth oriented, high technology or energy development firms.

2. Pools of privately insured mortgage pass through certificates to expand the home building industry.

3. Venture capital limited partnerships.

4. Small business investment companies.

It was to this end that Governor James R. Thompson created the Illinois Study Commission on Public Pension Investment Policies in March 1981. The purpose of this Commission was to: (1) review the investment policies and practices of the five major Illinois public employee pension funds, which have assets of $4.5 billion, (2) determine how these funds could be used for economic development, consistent with the need to protect the future of beneficiaries, and (3) recommend any prudent statutory or administrative changes, which would improve the investment policies and help promote the investment of the funds to serve state goals of economic growth and job creation.

In order to ensure a comprehensive and open review of the issues, the Governor appointed twenty-eight members to the Commission, representing pension and investment experts, labor, public employee unions, retired people, business, community organizations, the public and the legislature. Following public hearings in Chicago, Springfield and Marion, Illinois, the Commission’s final report was published in March 1982. The recommendations of the Commission were enacted into legislation and signed into law by the Governor on August 25, 1982.

The major findings and conclusions of the Commission’s report were as follows:

The first and foremost purpose of the Illinois pension funds, as trusts, is to provide for the payment of pension benefits. In order to protect the assets of the funds, the fiduciaries must balance the risk and return of investments and diversify the funds’ portfolios. The fiduciaries should only accept a lower rate of return for a lower level of risk, and not for any other purpose.

The state pension funds have averaged market rates of return of approximately 5% over the past five years, while pension funds throughout the U.S. have averaged 8.6%. This is due in large part to the statutory restrictions on investment authority, with which the state funds must comply.

Greater flexibility is needed to improve investment performances, which not only can strengthen the financial integrity of the funds in a cost effective manner, but also can have a positive economic impact on the state.

State economic and community development goals are a legitimate factor for fiduciaries to consider when analyzing investments to the extent that prudent policies are maintained. Suitable investments can be found to serve the dual goal of protecting beneficiaries’ interests and stimulating economic development. In making conventional and economic development investments, the fiduciaries should consider investments that they have determined to be equally prudent and that will stimulate job creation or capital formation.

In order to provide the state pension funds with the necessary legal authority to prudently safeguard the interest of beneficiaries, to improve the opportunities for maximizing financial performance, and to serve the economic development needs of Illinois, the Commission further recommended that the investment of the funds be subject to the prudent person rule, and that the previously utilized statutory list of specific investor restrictions be eliminated. This now permits the fiduciaries to utilize a broader range of investments and investment strategies.

With this broader authority, the trustees should consider investments that can be prudent and help meet the state’s development needs. Some of these investment vehicles have been identified previously in this presentation.

An article in the April 24, 1978 issue of Pension and Investments magazine reads in part:

“As pension funds become an even more dominant force in the capital markets, their collective investment practices will, for better or worse, determine the future of the United States economy. Up until now, pension funds have operated in a politically neutral netherworld when it comes to the overall impact of their investment practices, but the rumblings of change are beginning to be heard.”

These rumblings of change, at least regarding the impact of public pension funds on state and community economic development goals, continue to be felt across our urban landscapes. It will be interesting to see if these rumblings are merely part of a passing “ thunder “ of interest in innovative alternative uses for pension funds, or portend the arrival of a major storm of activity in utilizing public pension funds to further state and local community development goals.