Implement an Option Overwriting Strategy - Susan Combs - Texas

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					Implement an Option Overwriting Strategy The Permanent School Fund should implement an option overwriting strategy. Background Any discussion of Permanent School Fund (PSF) investment strategies is, of necessity, technical and complex. But all Texans can agree that safe, smart ways to increase funds for public education should be explored. The PSF was created as a perpetual endowment in support of free public schools in Texas. Early constitutional provisions set aside both land and money to fund the PSF, with the original assets intended to stay as untouched principal, and the income generated from these assets to go to the Available School Fund (ASF) to support the state's public schools. An 1854 law dedicated $2 million to the PSF from the settlement of a boundary dispute with the U.S. government. The current state constitution, adopted in 1876, dedicated additional lands and their proceeds to the PSF. In all, more than 46.5 million acres have been granted to the PSF, including mineral interests from 7.1 million acres.1 Today, the PSF's principal growth comes from two sources: mineral royalties and other income from dedicated land managed by the General Land Office (GLO), and capital gains from the growth in the value of stocks and bond investments. Income from the PSF is allocated to the ASF for distribution to school districts. This income consists primarily of interest on bond investments, dividends from stock investments and land lease income. Investment opportunities have expanded since the original PSF was created, as has the wealth available for investment. Much of the original land has been sold and the proceeds invested in stocks and bonds, along with mineral lease royalties. Indeed, virtually all the wealth in the PSF has now been converted into securities. During the 72nd Legislature, second called session, in July 1991, the State Board of Education (SBOE) and the Comptroller's office agreed to increase the income paid to the ASF by $50 million over normal income during the 1992-93 biennium. To do this, the PSF investment portfolio was changed so that sales of stocks and subsequent purchases of bonds would generate the additional money during the biennium. Bond interest income during the biennium exceeded the dividend income that would have been received if the stocks had been held.

Legislation in 1993 requested that SBOE "provide to the Comptroller of Public Accounts a memorandum of commitment indicating that changes in the PSF investment strategy will result in an additional $50 million over the Comptroller's official estimate of PSF...earnings as reported in the Biennial Revenue Estimate for 1994-95...." In response, SBOE passed a motion at its September 9, 1994, meeting authorizing the adoption of "General Accepted Accounting Principles in place of the Statutory Accounting System for the treatment of premium and discount, as it relates to fixed income securities, and authorize the Commissioner of Education to develop and prepare at the next session of the Legislature the appropriate revision to Chapter 15 of the Texas Education Code to reflect the above changes, and any other changes in the Administrative Code or the Investment Operating Manual as needed for consistency with this amendment." This change should result in a one-time income boost of about $40 million for the ASF. In the summer of 1994, TEA staff members received a proposed asset allocation plan from William M. Mercer Asset Planning, Inc., recommending that the PSF invest more in stocks and less in bonds. This move would increase the long-term growth of the fund's principal, although it might significantly decrease the amount of current income provided to the ASF in the years ahead. Income likely would remain below what it would be if the bonds are held until fiscal 2009. Total losses from the Mercer strategy, under the best available assumptions, are projected at about $1.5 billion through 2009, after which income should grow beyond what the old asset mix would have allowed. Option Overwriting To increase income paid to the ASF, the PSF could undertake an "option overwriting" program on its equity portfolio. The investment advisory committee, created by SBOE to advise the board on PSF administration, suggested the option overwriting strategy in July 1993, while looking for ways to increase income produced by the PSF. Although the suggestion was not adopted, members of the investment advisory committee described it as easy to operate and the largest income producer of seven investment methods then under consideration. Option overwriting is a conservative strategy that smooths income flow and removes some of stock ownership's inherent risk. To operate option overwriting, the PSF would select certain stocks in its portfolio on which to write covered call options_essentially, agreements to sell the shares to a brokerage firm at an agreed-upon later date_with prudent limits on how many and which shares could be offered. In devising these options, a process called "exposing a share," PSF staff would set a "strike price"_an amount for which each share would be sold. If the market price rises above

the strike price at the end of a six-month period, PSF then would sell the stock for the strike price. (No sale would occur if the stock fails to reach the strike price at the end of the option's expiration date.) PSF would receive a dollar amount called a "call premium" on the day the option was written, and that call premium would be paid to the ASF the day it was received. The call premium is retained whether or not the stock is actually sold. TEA staff members have conducted a dry-run pilot program using real stocks from their portfolio and actual quotes from Merrill Lynch, although they did not actually write options, and no money changed hands. From September 21 to October 21, 1993, they referred to real stock prices from the New York Stock Exchange. The results, projected to a full year, indicated that the strategy would have earned $33.3 million for the ASF on just over 1.9 million shares of stock sold by the PSF for the strike price. The 1.9 million shares that would have been sold represent only 2 percent of PSF's total stock portfolio. The Texas Constitution states: [N]otwithstanding any other provisions of this constitution, in managing the assets of the permanent school fund, the SBOE may acquire, exchange, sell, supervise, manage, or retain through procedures and subject to restrictions it establishes and in amounts it considers appropriate, any kind of investment_that persons of ordinary prudence, discretion, and intelligence, exercising the judgment and care under the circumstances then prevailing, acquire or retain for their own account in the management of their affairs, not in regard to speculation but in regard to the permanent disposition of their fund, considering the probable income as well as the probable safety of their capital.2 This provision is commonly referred to as the "prudent person rule." Under its guidance, the PSF instituted a securities lending program in February 1993 to enhance income. It is a small program, but it is producing some $4 million each year in incremental income for the ASF. Option overwriting could be added under the same prudent person rule. Many institutions currently employ option overwriting, including the Harvard University Endowment Fund, the Houston Police Officers Pension System, the San Diego (California) County Employees Retirement System, Pennsylvania's Public School Employees Retirement System, the City of Baltimore's Employees Retirement Fund, and the Firefighters Pension and Retirement Fund of Oklahoma. Recommendation

The Texas Education Agency (TEA) should institute an option overwriting program by entering into a memorandum of understanding with the Comptroller of Public Accounts indicating the basic mechanism and timing of the program. Revenue generated as a result of this program would be appropriated to school districts contingent upon a determination by the Comptroller that the TEA had complied with the provisions of the memorandum. Implications During the first year, an additional $17.5 million would be generated as the program is phased in. Beginning in fiscal 1997, an additional $32.5 million would be made available annually to the Available School Fund (ASF). This would be done while exposing no more than 20 percent of the equity portfolio. Analysis conducted during the pilot project indicated that less than 2 percent of the equity portfolio would actually be called away. Fiscal Impact The option overwriting program would generate an additional $50 million in revenue for ASF spending during the 1996-97 biennium. ASF revenue is distributed to local school districts and is an offset to General Revenue. Fiscal Year 1996 1997 1998 1999 2000 Gain/(Loss) to Available School Fund $17,500,000 32,500,000 33,000,000 33,500,000 34,000,000 Change in FTEs 0 0 0 0 0

1 Texas Education Agency, Committee on the Permanent School Fund, Ensuring The Future of Texas: The Permanent School Fund, Austin, Texas, April 1992. 2 Vernon's Ann. Tex. Const. Art. 7, 5(d).

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