By Winfield P. Nelson
Most agree that the human suffering in Sudan is appalling, but it is difficult to believe that the pension fund sanctions of Illinois will persuade warring factions to behave in a more civilized fashion. Although highly principled in its intent, Illinois Public Act 94-0079 will likely have a greater economic and social impact on the people of Illinois. Further, I have sufficient reason to believe that the act (1) is unconstitutional under federal law; (2) will cause fiduciaries to violate the prudent-expert standard imposed upon them by state and federal law; and (3) gives rise to an unjust double standard.
If trustees and professional fiduciaries comply with the law, what protections will they have against a future legal action based on the merits of my allegations? My fear is that there will be none, other than insurance and personal savings. The Illinois Legislature is unquestionably using its economic clout via public funds to affect U.S. foreign policy and commerce, a practice that is unconstitutional under federal law. The Legislature's action is causing state plan fiduciaries to violate the prudent-expert standard imposed upon them by state and federal law.
Given the state and federal conflicts, as well as the general uncertainty for fiduciaries, it seems there is little choice but to organize a public and private sector challenge to this principled yet poorly crafted piece of legislation.
My firm serves as a fee-only SEC registered investment adviser to a number of smaller Illinois public pension plans. There are roughly 600 of these smaller plans. Total assets are approaching $8 billion. Plans that want to invest in equities and have less than $5 million in assets are required by state statute to use mutual funds and/or annuity separate accounts. Plans with more than $5 million may own individual equities but, as a practical matter, most use mutual funds or registered annuities for a variety of reasons that include expertise, diversification, cost, convenience and flexibility. As for fixed income, a number of plans make use of insurance company general account products.
Illinois' Sudan divestiture law requires investment advisers and providers of investment products to certify that future investments will be Sudan-free according to the state's defined implementation schedule. Naturally, a firm such as ours cannot extend any guarantees — all we can do is respond when we learn of fund and annuity holdings. Likewise, fund and annuity providers cannot be expected to abridge policies or stated objectives just to satisfy Illinois' or some other state's statute. What if the other divest-Sudan states (Louisiana, Oregon and New Jersey) change the scope of their legislation? What if each state legislated its own notion of foreign policy as it relates to the capital markets and commerce?
This legislation poses problems for my Illinois clients as fiduciaries. For example, if underwriters of general and separate account annuity products held by these plans refuse to sign a Sudan-free certification, the contract(s) will be deemed a prohibited investment and plan trustees will be required to divest.
Given the contractual terms of most insurance products, will the underwriter or the plan endure the sizable expense associated with the liquidation of a prohibited investment? If the underwriter refuses and forces the plan to incur the expense, that could be construed by some interested parties as a breach of the trustees' fiduciary duty. In such instance, each plan's legal counsel would then be required to make every effort to protect trustees and plan participants through expensive mediation or litigation with the underwriters.
How big of a problem is this in Illinois? According to the Illinois Department of Insurance's 2002 data, the latest available, the smaller plans' total annuity assets are approaching $1 billion. How much could it cost to unwind all of these contracts? A reasonable estimate is $20 million-plus in separate account termination charges and perhaps a like amount in market-value adjustments for general account holdings, for a total financial impact in excess of $40 million.
Similarly, for large state plans involved with private-equity and other illiquid investments, I have seen written estimates stating that the direct and indirect costs of terminating their contracts will likely be another $150 to $200 million. Given the enormity of Illinois' unfunded pension liability, fiduciaries and taxpayers should not be burdened with financially unsound investment policies.
As for mutual fund shares, all non-Sudan-free funds (perhaps due to just one holding) will be prohibited investments and trustees will have to divest, which is a shame. My core domestic equity composite, using active funds, is 500 basis points ahead of the S&P 500 for the last three years, annualized. We will attempt to manage around this new law but it will be very tough, particularly in the large- and midcap sector. Prohibited lists produced by research firms include Coca-Cola Co., Goodyear Tire and Rubber Co., Eastman Kodak Co., Marathon Oil Corp., PepsiCo Inc., Procter & Gamble Co., Schlumberger Ltd. and Xerox Corp. The international asset class, with more than 120 names on the prohibited list, is virtually hands-off for downstate plans when globalization is the dominant investment theme.
To those who say don't worry, some fund company will respond with eligible product, I say you're right, but that will not do my Illinois clients any good for at least five years, and perhaps never. Why? In Illinois, an individual mutual fund must have a five-year track record and at least $250 million in assets to be considered an eligible investment. Sudan-free collective trust index funds, which are not subject to the five-year and $250 million constraints, aren't a solution. The value-added returns to Illinois public funds that have defrayed funding costs over the past three years would not have been possible if I excluded the superior security selection skills of my active managers. If I am forced to liquidate and accept less return with the same amount or more risk, does not that put me and my clients at risk as fiduciaries?
While the state of Illinois is demanding that we incur additional expense and put ourselves as well as our clients at risk of breaching the law, the state, its agencies, authorities, campuses, departments, divisions, health-care facilities and those of its municipal governments are fostering and sustaining an unjust double standard by investing precious time, money, resources and lots of public goodwill in the procurement and consumption of goods and services from the very companies that are prohibited investments.
According to Gov. Rod Blagojevich's proclamation, the law sends a clear message to the Sudanese government: the people of Illinois will not condone human rights abuses and genocide. OK, then, what about the retail tax revenue these prohibited concerns generate, money the state has not given up? Has a single Lincoln penny from any tax dollar been earmarked by the state for relief efforts in Sudan? How many Sudanese lives will be further imperiled by this legislation? Questions worth asking, don't you think? I suspect the answers will lend further support to the notion that this law sanctions an unjust double standard.
As fiduciaries, we must always use the care, skill, prudence, and diligence that any informed person would use under the circumstances then prevailing. And, we must be faithful to the law. Yet, in that regard, the general impression of the Illinois law is that it (1) puts public pension plan fiduciaries squarely at odds with state and federal law about foreign policy and commerce; and (2) creates conflicting loyalties, in that the state's seemingly illegal mandate now takes precedent over loyalties to the financial well-being of public pension plans. With that said, it is only proper to acknowledge my deepest sympathies for the people of Illinois and Sudan — for it is they who will suffer most from the unintended consequences of this public act. Ironic, isn't it?
Winfield P. Nelson is executive vice president of Sovereign Advisers, Charlotte, N.C.
