by Paul A. Dillon
Vice President, Economic Research Division, Mid America Appraisal and Research Corp.1/

THE USE of public pension funds to further state and community economic development goals is currently one of the hottest topics in government circles. Indeed, 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. Even more significant, 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 U.S. increased over 16 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.

A Growing Influence

As a consequence of this rapid and sustained expansion of assets, pension funds are a growing influence in our national economy. In 1954, pension fund assets comprised only 7.4% of the total U.S. capital investments. By 1979, this figure had grown to 16.6%. 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 nation. Total assets are expected to reach $4 trillion by 1995.

Pension funds are also important because of the very long term nature of their financial liabilities. While banks and thrift institutions have liabilities that typically mature in a few days, at most, pension funds have benefit liabilities that, on average, may not mature for decades. As a result of this financial characteristic, pension funds are a unique source of long term capital for business and housing ventures.

States and municipalities are slowly beginning to recognize the importance of this innovative source of development 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 % in 1981 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 that the loans could retain or create 4,000 jobs while helping 400 companies in the city to expand.

A Twofold Problem

The problem with investing pension fund assets in economic development is generally conceded to be twofold:

The belief that prudent financial standards for pension funds must necessarily be lowered to accomplish development investing objectives. Proponents of this belief argue that development investing will impair portfolio performance, violate the law, and be impossible to impossible to implement.

The opposite extreme, which proposes investments that, while financially sound (and this is very important), are so unimaginative that they merely displace existing investors. Examples of these investments might be guaranteed federal securities, such as GNMA mortgaged backed securities and the guaranteed portion of loans to small businesses offered by the Small Business Administration, which are traded on the national capital markets and are homogeneous in credit quality.

Investments by public pension funds in these types of instruments are most likely merely displacing those that would be made by other investors, resulting in no net increase in capital flowing into a particular geographical area.

Solution to Problems

There is a solution to both problems. If public pension funds are to be used for providing needed capital to projects that have selective state or municipal economic development impacts, investment forms must be found that both 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) that are capable of shielding the funds from loss of return, excessive risk and possible conflicts of interest.

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

1. Pools of development oriented investments. Working with banks, insurance companies or mutual funds, a pool of equity issues of in state growth oriented, high technology or energy development firms can be developed.

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.

Commission Appointed

It was to this end that Governor James R. Thompson created the Illinois Study Commission on Public Pension Investment Policies in March 1981. 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. Therefore, the fiduciaries should only accept investments with a lower rate of return for a lower level of risk, and not for any other purpose.

Greater flexibility is needed to improve the investment performances of the state pension funds.

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. 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.

The investment of funds should be subject to the prudent person rule and the previously utilized statutory list of specific investor restrictions should be eliminated. This now permits the fiduciaries to utilize a broader range of investments and investment strategies.

With this broader authority, the trustees of Illinois’ pension system are now considering investments that can be prudent and can also help meet the state’s development needs.

1/The author is chairman of the Committee on Alternative Investments, Illinois Study Commission on Public Pension Investment Policies.

Reprinted with permission of State Government News, copyright The Council of State Governments.

Commerce , July, 1983

Used with permission of the Chicagoland Chamber of Commerce