------------------------------------------------------------------------------
THE SENTINEL FUNDS
Supplement dated September 29, 2000 to Prospectus dated March 30, 2000
Financial Highlights
--------------------
The financial highlights for the Class A shares of the Balanced Fund were
inadvertently omitted from the Financial Highlights section of the Prospectus,
on pages 48-49. This information is set forth below.
<TABLE>
<CAPTION>
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Net gains or
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Losses on
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Fiscal Net asset Net Securities Dividends
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
year value, investment (both Realized Total From (from net Distributions
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
(period beginning income and Investment investment (from capital Total
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Fund ended) of period (loss) Unrealized) Operations income) gains) Distributions
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balanced 11/30/95 14.08 0.58 2.78 3.36 0.59 0.01 0.60
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
A 11/30/96 16.84 0.54 2.13 2.67 0.54 0.42 0.96
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/97 18.55 0.56 2.18 2.74 0.55 0.45 1.00
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/98 20.29 0.54 1.76 2.30 0.55 1.16 1.71
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/99 20.88 0.55 (0.03) 0.52 0.54 1.48 2.02
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Ratio of Ratio of
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Expenses to Ratio Net Investment
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
Fiscal Net asset Net assets Ratio of Average net of Net Income to Avg.
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
year value, Total at end of Expenses to Assets before Income to net assets before Portfolio
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
(period end of return* period average net Expense Avg. net voluntary expense -turnover
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
ended) period (%) (000 omitted) assets (%) Reduction**(%) assets (%) reimbursements Rate (%)
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/95 16.84 24.4 $ 267,103 1.27 1.29 3.77 -.- 110
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/96 18.55 16.6 297,288 1.20 1.22 3.13 -.- 83
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/97 20.29 15.4 314,948 1.16 1.17 2.93 -.- 63
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/98 20.88 12.2 330,067 1.12 1.13 2.69 -.- 81
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
11/30/99 19.38 2.6 297,027 1.10 1.12 2.73 - - 110
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------ -------------
----------- ----------- ------------ ------------- ---------------- ---------------- ------------ ------------------
</TABLE>
* Total return is calculated assuming an initial investment made at
the net asset value at the beginning of the period, reinvestment of all
distributions at the net asset value during the period, and a redemption on
the last day of the period. Initial sales charge is not reflected in the
calculation of total return.
** Expense reductions are comprised of the voluntary expense
reimbursements and include the earnings credits that are received from the
custodian and dividend paying agent on cash balances.
Current Portfolio Managers
--------------------------
David Alger is now the portfolio manager of the Flex Cap Opportunity Fund.
David Hyun is no longer with Alger. David Brownlee is now the portfolio
manager of the Bond Fund. With respect to the Balanced Fund, Van Harissis is
leader of the equity team, and Mr. Brownlee is leader of the bond team. Mr.
Buck is no longer directly active in the day to day operations of the Balanced
Fund. Also, the sole portfolio manager of the Money Market Fund is now Darlene
Coppola. Ms. Coppola, Money Market Trader of Sentinel Advisors, has been
employed by Sentinel Advisors or its affiliates since 1974.
Net Asset Value Purchasers
--------------------------
The list of persons eligible to purchase Class A shares of the Funds at net
asset value, on page 34 of the Prospectus, has been expanded to include all
employees of securities dealers that have entered into a sales agreement with
Sentinel Financial, rather than only registered representatives of such
dealers.
Excessive Trading Policy
------------------------
The Funds have adopted a policy designed to prevent excessive trading, or
market timing, activity by shareholders from having an adverse impact on the
investment strategies and results of the Funds. Under this policy, the Funds
may reject or restrict any exchange request, if an investor has a history of
excessive trading, or if an investor's trading, in the judgment of the Funds,
has been or may be disruptive to a Fund. For additional information on this
policy, see the Funds' Statement of Additional Information.
Government Securities Fund Promotion
------------------------------------
For the period from October 1, 2000 to March 31, 2001, the Government
Securities Fund will be offering a special promotion, under which selling
dealers will receive dealer reallowances that are 0.50% higher than those
normally paid. The sales charges paid by shareholders will not increase. The
table below shows the sales charges and dealer reallowances that will apply to
purchases of the Government Securities Fund during this promotion.
Sales charge as
a percentage of:
----------------------------------------
offering net amount Dealer
Sale Size price invested Reallowance
---- ---- ----- -------- -----------
$0 to $99,999 4.00% 4.17% 4.50%
$100,000 to $249,999 3.50% 3.63% 3.75%
$250,000 to $499,999 2.50% 2.56% 2.75%
$500,000 to $999,999 2.00% 2.04% 2.25%
$1,000,000 or more -0- -0- -0-
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
March 30, 2000, as amended on September 29, 2000
THE SENTINEL FUNDS
National Life Drive
Montpelier, Vermont 05604
(800) 282-FUND (3863)
Sentinel Common Stock Fund (the "Common Stock Fund")
Sentinel Balanced Fund (the "Balanced Fund")
Sentinel Mid Cap Growth Fund (the "Mid Cap Growth Fund")
Sentinel Small Company Fund (the "Small Company Fund")
Sentinel Growth Index Fund (the "Growth Index Fund")
Sentinel Flex Cap Opportunity Fund (the "Flex Cap Opportunity Fund")
Sentinel World Fund (the "World Fund")
Sentinel High Yield Bond Fund (the "High Yield Fund")
Sentinel Bond Fund (the "Bond Fund")
Sentinel Government Securities Fund (the "Government Securities Fund")
Sentinel Short Maturity Government Fund (the "Short Maturity Government Fund")
Sentinel U.S. Treasury Money Market Fund (the "Money Market Fund")
Sentinel Tax-Free Income Fund (the "Tax-Free Income Fund")
Sentinel New York Tax-Free Income Fund (the "New York Fund")
Sentinel Pennsylvania Tax-Free Trust (the "Pennsylvania Fund")
Each of SENTINEL GROUP FUNDS, INC. (the "Company") and the Pennsylvania Fund
is a managed, open-end investment company, which continuously offers its
shares to investors. The Company consists of fourteen separate and distinct
funds, twelve of which are diversified (the Growth Index and New York Funds
being non-diversified), and the Pennsylvania Fund is a separate,
non-diversified fund. The fourteen funds of the Company and the Pennsylvania
Fund are referred to hereinafter collectively as the "Funds", and individually
as a "Fund". The Funds are described in a Prospectus of the Funds dated March
30,2000 (the "Prospectus"). Each of the Funds has different investment
objectives and risk characteristics.
Sentinel Advisors Company (the "Advisor") acts as the investment advisor to
the Funds. Shares of the Funds are distributed by Sentinel Financial Services
Company ("SFSC"). Both the Advisor and SFSC are partnerships whose partners
are affiliates of National Life Insurance Company ("National Life"), Provident
Life Insurance Company ("Provident") and The Penn Mutual Life Insurance
Company ("Penn Mutual").
This Statement of Additional Information is not a Prospectus and should be
read in conjunction with the Prospectus. The Prospectus, which has been filed
with the Securities and Exchange Commission (the "SEC"), can be obtained upon
request and without charge by writing to the Funds at the above address, or by
calling 1-800-282-FUND(3863). The Financial Statements of the Funds that are
included in the Annual Report of the Funds dated November 30, 1999 have been
incorporated by reference into this Statement of Additional Information. This
Annual Report can be obtained in the same way as the Prospectus of the Funds.
This Statement of Additional Information has been incorporated by reference
into the Prospectus.
<PAGE>
TABLE OF CONTENTS
Page
----
The Funds................................................................2
Investment Objectives and Policies.......................................3
Investment Restrictions..................................................15
Management of the Funds..................................................17
Principal Shareholders...................................................21
The Investment Advisor...................................................22
Principal Underwriter....................................................25
The Distribution Plans...................................................26
The Fund Services Agreements.............................................28
Portfolio Transactions and Brokerage Commissions.........................29
Portfolio Turnover.......................................................31
Capitalization...........................................................32
How To Purchase Shares and Reduce Sales Charges..........................32
Issuance of Shares at Net Asset Value....................................33
Determination of Net Asset Value.........................................33
Computation of Maximum Offering and Redemption Prices....................35
Taxes....................................................................36
Shareholder Services.....................................................41
Total Return, Yield and Tax-Equivalent Yield Information.................42
General Information......................................................46
Financial Statements.....................................................46
Appendix A - Description of Bond Ratings.................................47
Appendix B - Economic and Other Conditions in New York...................51
Appendix C - Economic and Financial Conditions in Pennsylvania...........70
<PAGE>
THE FUNDS
Originally incorporated in the State of Delaware on December 5, 1933 as
Group Securities, Inc., the Company became a Maryland corporation on February
28, 1973. On November 30, 1973, the Company's name was changed to USLIFE
Funds, Inc. On September 30, 1976, the Company's name was changed to Sentinel
Group Funds, Inc.
On March 31, 1978, Sentinel Bond Fund, Inc. (formerly Sentinel Income
Fund, Inc.) and Sentinel Mid Cap Growth Fund, Inc., both managed, open-end,
diversified investment companies incorporated in Maryland on October 24, 1968,
were merged into the Company as separate classes of stock. On March 27, 1986,
the Board of Directors created, as a new class of stock of the Company, the
Government Securities Fund. The Board of Directors created the Tax-Free Income
Fund as a new class of the Company's stock on June 14, 1990.
The Pennsylvania Fund is a trust formed under the laws of Pennsylvania in
1986. The Fund became a member of the Sentinel Family of Funds on March 1,
1993. On that date the Advisor and SFSC became the investment advisor and
distributor, respectively, to the Fund. Immediately prior to March 1, 1993,
the investment advisor to the Fund was ProvidentMutual Management Co., Inc.
("PMMC"), and its distributor was ProvidentMutual Financial Services, Inc.,
both of which are affiliates of Provident.
On March 1, 1993, the Company completed the acquisition of substantially
all of the assets of eight ProvidentMutual Funds, and Sentinel Cash Management
Fund, Inc., ("SCMF") in exchange solely for common stock of the corresponding
Funds of the Company that acquired such assets. In order to facilitate the
acquisitions, on August 13, 1992 the Board of Directors authorized the
creation of three new classes of stock of the Company, namely, the Small
Company, World and Money Market Funds. From March 1, 1993 to March 29, 1994,
the Small Company Fund's name was Sentinel Aggressive Growth Fund, and from
March 29, 1994 to March 31, 1997, the Small Company Fund's name was Sentinel
Emerging Growth Fund. Also on March 1, 1993, the Investment Advisory Agreement
between the Company and Sentinel Advisors, Inc., ("Sentinel Advisors"), an
indirect wholly-owned subsidiary of National Life, and the Distribution
Agreement between the Company and Equity Services, Inc. ("ESI"), also an
indirect wholly-owned subsidiary of National Life, terminated, and were
replaced by the arrangements described in the Prospectus under "Management of
the Funds" and "Purchase Options".
On March 27, 1995, the Company completed the acquisition of substantially
all of the assets of seven funds of The Independence Capital Group of Funds,
Inc., in exchange solely for common stock of the corresponding Funds of the
Company that acquired such assets. In order to facilitate the acquisitions, on
December 15, 1994, the Board of Directors authorized the creation of two new
classes of stock of the Company, namely, the New York and Short Maturity
Government Funds. From March 27, 1995 to February 3, 1997, the Short Maturity
Government Fund's name was Sentinel Short-Intermediate Government Fund.
On March 14, 1997, the Board of Directors of the Company authorized the
creation of the High Yield Fund as a new series of the Company. On June 10,
1999, the Board of Directors of the Company authorized the creation of the
Growth Index Fund as a new series of the Company. On December 9, 1999, the
Board of Directors of the Company authorized the creation of the Flex Cap
Opportunity Fund as a new series of the Company.
INVESTMENT OBJECTIVES AND POLICIES
The investment objectives and certain fundamental policies of each of the
Funds are set forth in the Prospectus.
General Considerations and Risks
--------------------------------
Each Fund is an open-end, management investment company. All Funds are
diversified investment companies except the Growth Index, New York and
Pennsylvania Funds, which are non-diversified investment companies.
Each Fund's fundamental policies and investment objectives as they affect
each such Fund cannot be changed without the approval of the lesser of (i) 67
percent or more of the voting securities of each such Fund present at a
meeting if the holders of more than 50 percent of the outstanding voting
securities of each such Fund are present or represented by proxy, or (ii) more
than 50 percent of the outstanding voting securities of each such Fund. With
respect to the submission of a change in fundamental policy or investment
objective of each such Fund, such matter shall be deemed to have been
effectively acted upon with respect to any such Fund if a majority of the
outstanding voting securities of such Fund vote for the approval of such
matters, notwithstanding (1) that such matter has not been approved by a
majority of the outstanding voting securities of any other Fund affected by
such matter and (2) that such matter has not been approved by a majority of
the outstanding voting securities of the Company. Fundamental policies adopted
with respect to each Fund, except the Pennsylvania Fund and the New York Fund,
provide that no Fund shall concentrate its investments in a particular
industry or, except for the Flex Cap Opportunity Fund, group of industries,
nor will it purchase a security if, as a result of such purchase, more than
25% of its assets will be invested in a particular industry.
Repurchase Agreements. Each of the Funds to a limited extent may enter
into repurchase agreements with selected banks and broker-dealers under which
the Fund purchases securities issued or guaranteed by the U.S. Government or
its agencies or instrumentalities ("U.S. Government Securities") and agrees to
resell the securities at an agreed upon time and at an agreed upon price. The
difference between the amount a Fund pays for securities and the amount it
receives upon resale is interest income to a Fund. Failure of the seller to
repurchase the securities as agreed may result in a loss to a Fund if the
market value of the securities has fallen to less than the repurchase price.
In the event of such a default, a Fund may also experience certain costs and
be delayed or prevented from recovering or liquidating the collateral
securities, which could result in further loss to a Fund. The Funds (except
for the Flex Cap Opportunity Fund, whose investments in repurchase agreements
are discussed separately below) will use repurchase agreements as a means of
making short-term investments of seven days or less and in aggregate amounts
of not more than 25% of the net assets of the Fund. All repurchase agreements
used by the Funds, except for the Flex Cap Opportunity Fund, will provide that
the value of the collateral underlying the repurchase agreement always will be
at least equal to 102% of the repurchase price. The Advisor will monitor on a
continuing basis the creditworthiness of all parties with which it might enter
into repurchase agreements and will enter into repurchase agreements only if
it determines that the credit risk of such a transaction is minimal.
Illiquid and Restricted Securities. As stated in the Prospectus, the High
Yield Fund may invest in Rule 144A Securities and corporate loans; however,
the High Yield Fund's investment in illiquid securities is limited to 15% of
its net assets. The Bond Fund may not invest in illiquid securities, but may
invest Rule 144A Securities to the extent deemed to be liquid under the
policies and procedures discussed below. The Flex Cap Opportunity Fund may
also invest up to 15% of its net assets in illiquid securities, which include
restricted securities, securities for which there is readily available market,
and repurchase agreements with maturities of greater than 7 days. In
promulgating Rule 144A under the Securities Act of 1933 (the "Securities
Act"), the Securities and Exchange Commission ("SEC") stated that although the
ultimate responsibility for liquidity determinations rests with a fund's board
of directors, the board may delegate the day-to-day function of determining
liquidity to the investment advisor or subadvisor provided the board retains
sufficient oversight. The Board of Directors of the Company will consider the
adoption of policies and procedures for the Bond Fund, the High Yield Fund and
the Flex Cap Opportunity Fund for the purpose of determining whether Rule 144A
Securities and, in the case of the High Yield Fund only, corporate loans, in
which such Fund proposes to invest are liquid or illiquid and will consider
guidelines under these policies and procedures pursuant to which the Advisor
or applicable subadvisor will make these determinations on an ongoing basis.
In making these determinations, consideration will be given to, among other
things, the frequency of trades and quotes for the investment, the number of
dealers willing to sell the investment and the number of potential purchasers,
dealer undertakings to make a market in the investment, the nature of the
investment, the time needed to dispose of the investment, the method of
soliciting offers, and the mechanics of transfer. The Board of Directors will
review periodically purchases and sales of Rule 144A Securities by the Bond
Fund, the High Yield Fund and the Flex Cap Opportunity Fund, and corporate
loans by the High Yield Fund.
To the extent that liquid Rule 144A Securities or corporate loans or
other securities in which the Funds invest become illiquid, due to the lack of
sufficient qualified institutional buyers or market or other conditions, the
Advisor (or the subadvisor), under the supervision of the Board of Directors,
will consider appropriate measures to enable the Fund to maintain sufficient
liquidity for operating purposes and to meet redemption requests. If
institutional trading in restricted securities were to decline to limited
levels, the liquidity of these Funds could be adversely affected.
If an investment becomes illiquid, the affected Fund's Advisor or
subadvisor will determine the best course of action to permit the Fund to
realize maximum value, which could include, among other possibilities,
continuing to hold or seeking a private sale.
Considerations and Risks Applicable to the Fixed-Income Funds
-------------------------------------------------------------
Each of the Bond Fund and the fixed income portion of the Balanced Fund
may invest up to 20% of its total assets, and each of the New York Fund and
the Tax-Free Income Fund may invest up to 5% of its total assets, in debt
securities which are rated below "investment grade", i.e., lower than "Baa" by
Moody's Investors Service, Inc. ("Moody's") or lower than "BBB" by Standard &
Poor's Ratings Services ("Standard & Poor's") or which, in the Advisor's
judgment, possess similar credit characteristics. See Appendix A -
"Description of Bond Ratings" for additional information regarding ratings of
debt securities. The Advisor considers the ratings assigned by Standard &
Poor's or Moody's as one of several factors in its independent credit analysis
of issuers. Such securities are considered by Standard & Poor's and Moody's to
have varying degrees of speculative characteristics. Consequently, although
securities rated below investment grade can be expected to provide higher
yields, such securities may be subject to greater market price fluctuations
and risk of loss of principal than lower yielding, higher rated debt
securities. Investments in such securities will be made only when in the
judgment of the Advisor, such securities provide attractive total return
potential relative to the risk of such securities, as compared to higher
quality debt securities. The Funds do not intend to purchase debt securities
that are in default or which the Advisor believes will be in default. The
risks of below-investment grade securities are described further in the
Prospectus under "Details About the Funds' Investment Objectives, Principal
Investment Strategies and Related Risks - General Information Relevant to the
Investment Practices of the Funds, and Associated Risks - Information Relevant
to the Fixed Income Funds - Risks of Lower Quality Bonds" on pages 25-28.
When Issued Purchases. The High Yield, Bond, New York, Pennsylvania,
Tax-Free Income, Government Securities and Short Maturity Government Funds and
the bond portion of the Balanced Fund may purchase bonds on a when issued or
delayed-delivery basis. Delivery of and payment for these bonds could take
place a month or more after the date of the transaction. During this time, the
value of the purchase commitment will fluctuate with the market for these
bonds. However, when a Fund makes a commitment to purchase the bonds, the
payment and interest terms of these issues are fixed. A Fund will make these
commitments only with the intention of acquiring the bonds, but may sell those
bonds before settlement date if Sentinel Advisors or Evergreen Investment
Management Company ("Evergreen"), the subadvisor to the High Yield Fund,
believes that would benefit shareholders. When a Fund purchases bonds on a
when issued or delayed-delivery basis, it will provide its custodian with
enough cash or short-term investments to pay the purchase price of these bonds
upon delivery. This policy ensures that when issued or delayed-delivery
purchases will not be used as a form of borrowing to make investments.
Considerations and Risks Applicable to the Tax-Exempt Funds
-----------------------------------------------------------
As described in the Prospectus, the Tax-Free Income Fund, the
Pennsylvania Fund and the New York Fund (together, the "Tax-Exempt Funds") may
purchase and sell exchange-traded financial futures contracts ("financial
futures contracts") to hedge their portfolios of municipal bonds against
declines in the value of such securities and to hedge against increases in the
cost of securities they intend to purchase. This is not a principal investment
strategy of the Funds. To hedge their portfolios, the Tax-Exempt Funds may
take an investment position in a financial futures contract which will move in
the opposite direction from the portfolio position being hedged. While the use
of hedging strategies is intended to moderate fluctuations in market value of
portfolio holdings and thereby reduce the volatility of the net asset value of
Fund shares, the Tax-Exempt Funds anticipate that their net asset values will
fluctuate. Set forth below is information concerning financial futures
transactions.
Description of Financial Futures Contracts. A financial futures contract
is an agreement between two parties to buy and sell a security, or in the case
of an index-based financial futures contract, to make and accept a cash
settlement for a set price on a future date. A majority of transactions in
financial futures contracts, however, do not result in the actual delivery of
the underlying instrument or cash settlement, but are settled through
liquidation, i.e., by entering into an offsetting transaction. Financial
futures contracts have been designed by boards of trade which have been
designated "contracts markets" by the Commodity Futures Trading Commission
(the "CFTC").
The purchase or sale of a financial futures contract differs from the
purchase or sale of a security in that no price or premium is paid or
received. Instead, an amount of cash or securities acceptable to the broker
and the relevant contract market, which varies but is generally about 5% of
the contract amount, must be deposited with the broker. This amount is known
as "initial margin" and represents a "good faith" deposit assuring the
performance of both the purchaser and seller under the financial futures
contract. Subsequent payments to and from the broker, called "variation
margin", are required to be made on a daily basis as the price for the futures
contract fluctuates and makes the long and short positions in the futures
contract more or less valuable, a process known as "mark to the market". At
any time prior to the settlement date of the futures contract, the position
may be closed out by taking an opposite position which will operate to
terminate the position in the futures contract. A final determination of
variation margin is then made, additional cash is required to be paid to or
released by the broker and the position generates a loss or a gain. In
addition, a nominal commission is paid on each completed sale transaction.
The Tax-Exempt Funds may deal in financial futures contracts based on a
long-term municipal bond index developed by the Chicago Board of Trade (the
"CBT") and The Bond Buyer (the "Municipal Bond Index"). The Municipal Bond
Index is comprised of 40 tax-exempt municipal revenue bonds and general
obligations bonds. Each bond included in the Municipal Bond Index must be
rated "A" or higher by Moody's or Standard & Poor's and must have a remaining
maturity of 19 years or more. Twice a month new issues satisfying the
eligibility requirements are added to, and an equal number of old issues are
deleted from, the Municipal Bond Index. The value of the Municipal Bond Index
is computed daily according to a formula based on the price of each bond in
the Municipal Bond Index, as evaluated by six dealer-to-dealer brokers.
The Municipal Bond Index financial futures contract is traded only on the
CBT. Like other contract markets, the CBT assures performance under financial
futures contracts through a clearing corporation, a non-profit organization
managed by the exchange membership which is also responsible for handling
daily accounting of deposits or withdrawals of margin.
The Tax-Exempt Funds may purchase and sell financial futures contracts on
U.S. Government Securities as a hedge against adverse changes in interest
rates as described below. With respect to U.S. Government Securities,
currently there are financial futures contracts based on long-term U.S.
Treasury bonds, U.S. Treasury notes, Government National Mortgage Association
("GNMA") Certificates and three-month U.S. Treasury bills. The Tax-Exempt
Funds may purchase and write call and put options on financial futures
contracts on U.S. Government Securities in connection with their hedging
strategies.
The Tax-Exempt Funds also may engage in other financial futures contracts
transactions, such as financial futures contracts on other municipal bond
indices which may become available, if the Advisor should determine that there
is normally a sufficient correlation between the prices of such financial
futures contracts and the municipal bonds in which the Tax-Exempt Funds invest
to make such hedging appropriate.
Futures Strategies. A Tax-Exempt Fund may sell a financial futures
contract (i.e., assume a short position) in anticipation of a decline in the
value of their investments in municipal bonds resulting from an increase in
interest rates or otherwise. The risk of decline could be reduced without
employing futures as a hedge by selling such municipal bonds and either
reinvesting the proceeds in securities with shorter maturities or by holding
assets in cash. This strategy, however, entails increased transaction costs in
the form of dealer spreads and typically would reduce the average yield of the
Funds' portfolio securities as a result of the shortening of maturities. The
sale of financial futures contracts provides an alternative means of hedging
against declines in the value of their investments in municipal bonds. As such
values decline, the value of the Funds' positions in the financial futures
contracts will tend to increase, thus offsetting all or a portion of the
depreciation in the market value of the Funds' municipal bond investments
which are being hedged. While the Tax-Exempt Funds will incur commission
expenses in selling and closing out financial futures contract positions,
commissions on financial futures contract transactions are lower than
transaction costs incurred in the purchase and sale of municipal bonds. In
addition, the ability to trade in the standardized contracts available in the
futures markets may offer a more effective defensive position than a program
to reduce the average maturity of the portfolio securities, due to the unique
and varied credit and technical characteristics of the municipal debt
instruments available to the Funds. Employing futures as a hedge also may
permit the Tax-Exempt Funds to assume a defensive posture without reducing the
yield on their investments beyond any amounts required to engage in futures
trading.
When the Tax-Exempt Funds intend to purchase municipal bonds, they may
purchase financial futures contracts as a hedge against any increase in the
cost of such municipal bonds, resulting from a decrease in interest rates or
otherwise, that may occur before such purchases can be effected. Subject to
the degree of correlation between the municipal bonds and the financial
futures contracts, subsequent increases in the cost of municipal bonds should
be reflected in the value of the futures held by the Tax-Exempt Funds. As such
purchases are made, an equivalent amount of financial futures contracts will
be closed out. Due to changing market conditions and interest rate forecasts,
however, a financial futures contract position may be terminated without a
corresponding purchase of portfolio securities.
Call Options on Financial Futures Contracts. The Tax-Exempt Funds also
may purchase and sell exchange-traded call and put options on financial
futures contracts on U.S. Government Securities. The purchase of a call option
on a financial futures contract is analogous to the purchase of a call option
on an individual security. Depending on the pricing of the option compared to
either the financial futures contract on which it is based, or the price of
the underlying debt securities, it may or may not be less risky than ownership
of the financial futures contract or the underlying debt securities. Like the
purchase of a financial futures contract, a Tax-Exempt Fund will purchase a
call option on a financial futures contract to hedge against a margin advance
when it is not fully invested.
The writing of a call option on a financial futures contract constitutes
a partial hedge against declining prices of the securities which are
deliverable upon exercise of the financial futures contract. If the futures
price at expiration is below the exercise price, the Tax-Exempt Fund will
retain the full amount of the option premium which provides a partial hedge
against any decline that may have occurred in the Fund's portfolio holdings.
Put Options on Financial Futures Contracts. The purchase of a put option
on a financial futures contract is analogous to the purchase of a protective
put option on a portfolio security. The Tax-Exempt Funds may purchase put
options on financial futures contracts to hedge the Funds' portfolios against
the risk of rising interest rates.
The writing of a put option on a financial futures contract constitutes a
partial hedge against increasing prices of the securities which are
deliverable upon exercise of the futures contract. If the futures price at
expiration is higher than the exercise price, the Tax-Exempt Funds will retain
the full amount of the option premium which provides a partial hedge against
any increase in the price of municipal bonds which the Funds intend to
purchase.
The writer of an option on a financial futures contract is required to
deposit initial and variation margin pursuant to requirements similar to those
applicable to financial futures contracts. Premiums received from the writing
of an option will be included in initial margin. The writing of an option on a
financial futures contract involves risks similar to those relating to
financial futures contracts.
Restrictions on Use of Futures Transactions. Regulations of the CFTC
applicable to the Tax-Exempt Funds provide that the Tax-Exempt Funds may
purchase and sell financial futures contracts and options thereon either (a)
for bona fide hedging purposes or (b) for non-hedging purposes, provided that
the aggregate initial margins and premiums required to establish positions in
such contracts and options do not exceed 5% of the liquidation value of a
Tax-Exempt Fund's portfolio assets after taking into account any unrealized
profits and losses on such contracts or options. (However, as stated above,
the Tax-Exempt Funds intend to engage in futures and options transactions for
hedging purposes only.) Margin deposits may consist of cash or securities
acceptable to the broker and the relevant contract market.
When the Tax-Exempt Funds purchase a financial futures contract or a call
option with respect thereto or write a put option on a financial futures
contract, an amount of cash, cash equivalents or short-term, high-grade,
fixed-income securities will be deposited in a segregated account with the
Funds' custodian so that the amount so segregated, plus the amount of initial
and variation margin held in the account of their broker, equals the market
value of the financial futures contract, thereby ensuring that the use of such
futures is unleveraged.
Risk Factors in Futures and Options Transactions. Investment in financial
futures contracts involves the risk of imperfect correlation between movements
in the price of the financial futures contract and the price of the security
being hedged. The hedge will not be fully effective when there is imperfect
correlation between the movements in the prices of two financial instruments.
For example, if the price of the financial futures contract moves more than
the price of the hedged security, the Tax-Exempt Funds will experience either
a loss or gain on the financial futures contract which is not completely
offset by movements in the price of the hedged securities. To compensate for
imperfect correlations, the Tax-Exempt Funds may purchase or sell financial
futures contracts in a greater dollar amount than the hedged securities if the
volatility of the price of the hedged securities is historically greater than
that of the financial futures contracts. Conversely, the Tax-Exempt Funds may
purchase or sell fewer financial futures contracts if the volatility of the
price of the hedged securities is historically less than that of the financial
futures contracts.
The particular municipal bonds comprising the index underlying the
Municipal Bond Index financial futures contract may vary from the bonds held
by the Tax-Exempt Funds. As a result, each Fund's ability to hedge effectively
all or a portion of the value of its municipal bonds through the use of such
financial futures contracts will depend in part on the degree to which price
movements in the index underlying the financial futures contract correlate
with the price movements of the municipal bonds held by that Fund. The
correlation may be affected by disparities in the average maturity, ratings,
geographic mix or structure of such Fund's investments as compared to those
comprising the Municipal Bond Index, and general economic or political
factors. In addition, the correlation between movements in the value of the
Municipal Bond Index may be subject to change over time as additions to and
deletions from the Municipal Bond Index alter its structure. The correlation
between financial futures contracts on U.S. Government Securities and the
municipal bonds held by the Tax-Exempt Funds may be adversely affected by
similar factors and the risk of imperfect correlation between movements in the
prices of such financial futures contracts and the prices of the municipal
bonds held by the Tax-Exempt Funds may be greater.
The Tax-Exempt Funds expect to liquidate a majority of the financial
futures contracts they enter into through offsetting transactions on the
applicable contract market. There can be no assurance, however, that a liquid
secondary market will exist for any particular financial futures contract at
any specific time. Thus, it may not be possible to close out a financial
futures contract position. In the event of adverse price movements, the
Tax-Exempt Funds would continue to be required to make daily cash payments of
variation margin. In such situations, if a Fund has insufficient cash, it may
be required to sell portfolio securities to meet daily variation margin
requirements at a time when it may be disadvantageous to do so. The inability
to close out financial futures contract positions also could have an adverse
impact on a Fund's ability to hedge effectively its investments in municipal
bonds. The Tax-Exempt Funds will enter into a financial futures contract
position only if, in the judgment of the Advisor, there appears to be an
actively traded secondary market for such financial futures contracts.
The liquidity of a secondary market in a financial futures contract may
be adversely affected by "daily price fluctuation limits" established by
commodity exchanges which limit the amount of fluctuation in a futures
contract price during a single trading day. Once the daily limit has been
reached in the contract, no trades may be entered into at a price beyond the
limit, thus preventing the liquidation of open financial futures contract
positions. Prices have in the past reached or exceeded the daily limit on a
number of consecutive trading days.
The successful use of transactions in futures and related options also
depends on the ability of the Advisor to forecast correctly the direction and
extent of interest rate movements within a given time frame. To the extent
interest rates remain stable during the period in which a financial futures
contract or option is held by the Tax-Exempt Funds or such rates move in a
direction opposite to that anticipated, a Fund may realize a loss on the
hedging transaction which is not fully or partially offset by an increase in
the value of portfolio securities. As a result, a Fund's total return for such
period may be less than if it had not engaged in the hedging transaction.
Because of low initial margin deposits made on the opening of a financial
futures contract position, futures transactions involve substantial leverage.
As a result, relatively small movements in the price of the financial futures
contracts can result in substantial unrealized gains or losses. Because the
Tax-Exempt Funds will engage in the purchase and sale of financial futures
contracts solely for hedging purposes, however, any losses incurred in
connection therewith should, if the hedging strategy is successful, be offset
in whole or in part by increases in the value of securities held by the Funds
or decreases in the price of securities that the Funds intend to acquire.
The amount of risk the Tax-Exempt Funds assume when they purchase an
option on a financial futures contract is the premium paid for the option plus
related transaction costs. In addition to the correlation risks discussed
above, the purchase of an option on a financial futures contract also entails
the risk that changes in the value of the underlying financial futures
contract will not be fully reflected in the value of the option purchased.
Municipal Bond Index financial futures contracts only recently have been
approved for trading and therefore have little trading history. It is possible
that trading in such financial futures contracts will be less liquid than
trading in other futures contracts. The trading of financial futures contracts
also is subject to certain market risks, such as inadequate trading activity,
which could at times make it difficult or impossible to liquidate existing
positions.
Tax-Exempt Obligations. The Tax-Exempt Funds may invest in municipal
obligations that constitute "private activity bonds" under the Internal
Revenue Code of 1986, as amended (the "Code") which may subject certain
investors to a federal alternative minimum tax ("AMT"). The provisions of the
Code relating to private activity bonds generally apply to bonds issued after
August 15, 1986, with certain transitional rule exemptions. Private activity
bonds are eligible for purchase by the Tax-Exempt Funds provided that the
interest paid thereon qualifies as exempt from federal income taxes (and in
the case of the New York and Pennsylvania Funds, New York State and City, and
Pennsylvania, personal income taxes, respectively). It is the position of the
SEC and the Funds that municipal obligations that generate income subject to
the AMT should not be counted as tax-exempt for the purpose of determining
whether 80% of a Fund's net assets are invested in tax-exempt obligations.
Tax-exempt obligations held by the Tax-Exempt Funds generally will
consist of investment grade municipal obligations with maturities of longer
than one year. Long-term obligations normally are subject to greater market
fluctuations as a result of changes in interest rates and market conditions
than are short-term obligations. The two principal classifications of
municipal obligations which may be held by the Tax-Exempt Funds are "general
obligation" bonds and "revenue" bonds. General obligation bonds are secured by
the issuer's pledge of its full faith, credit and taxing power in support of
the payment of principal and interest. Revenue bonds are payable only from the
revenues derived from a particular facility or class of facilities or, in some
cases, from the proceeds of a special excise tax or other specific revenue
source such as the user of the facility being financed. Tax-exempt private
activity bonds (including industrial development bonds) are in most cases
revenue bonds and are not payable from the unrestricted revenues of the
issuer. Consequently, the credit quality of private activity bonds usually is
related directly to the credit standing of the corporate user of the facility
involved. In addition, the Tax-Exempt Funds may invest in short-term municipal
obligations (commonly referred to as municipal notes). Municipal notes often
are used to provide for short-term capital needs and generally have maturities
of one year or less. Municipal notes include variable and floating rate demand
obligations, tax anticipation notes, revenue anticipation notes, construction
loan notes and bond anticipation notes.
The Pennsylvania Fund will attempt to invest 100% of its assets in
Pennsylvania obligations, and the New York Fund will attempt to invest 100% of
its assets in New York obligations. As a matter of fundamental policy, the
Pennsylvania and New York Funds, under normal market conditions, will invest
at least 80% of their net assets in tax-exempt Pennsylvania obligations or New
York obligations, respectively, in each case which are rated within the top
four rating categories by a nationally recognized statistical rating
organization or, if not rated, which, in the opinion of the Advisor, possess
equivalent investment characteristics. The fourth grade is considered
medium-grade and has speculative characteristics. The Pennsylvania Fund may
invest up to 25% of its assets in securities rated at this fourth grade, and
the New York Fund may invest without limitation in securities rated at this
fourth grade. These bond ratings are described in Appendix A.
During temporary defensive periods when, in the Advisor's opinion,
suitable Pennsylvania or New York obligations are unavailable, or the Advisor
anticipates an increase in interest rates, the Pennsylvania and New York Funds
may invest not more than 20% of their assets in obligations, the interest on
which is exempt only from federal income taxes (such as obligations issued by
states other than Pennsylvania or New York, respectively) or is exempt only
from Pennsylvania or New York personal income taxes, respectively (such as
obligations issued or guaranteed by the U.S. Government or its agencies or
instrumentalities). Moreover, under such conditions, all three Tax-Exempt
Funds may make temporary investments in high-quality obligations, the interest
on which is not exempt from either federal or any state personal income taxes.
Such investments will consist of debt securities (including commercial paper)
of issuers having, at the time of purchase, a quality rating within the two
highest categories of either Standard & Poor's or Moody's, certificates of
deposit, banker's acceptances, or repurchase agreements.
Variable or Floating Rate Notes. The Tax-Exempt Funds may invest in
variable or floating rate demand obligations, which are securities that
provide for adjustment in their interest rates at intervals ranging from daily
to up to one year based upon prevailing market rates for similar investments
and an adjustment formula that is intended to maintain the market value of the
security at par. These obligations normally have a stated maturity in excess
of one year but permit the holder to demand repayment of principal plus
payment of accrued interest at any time upon a specified number of days'
notice. The Tax-Exempt Funds will have the right to receive repayment of
principal and payment of accrued interest within seven days. Some notes may be
rated by credit rating agencies but unrated notes purchased by the Funds, in
the Advisor's opinion, will be of comparable quality at the time of purchase
to instruments that are rated as high quality. Where necessary to ensure that
an unrated note is of high quality, the Funds will require that the issuer's
obligation to pay the principal of the note be backed by an unconditional
domestic or foreign bank letter or line of credit, guarantee or commitment to
lend. In such a case, the quality of the bank will be looked to for purposes
of satisfying the Funds' quality standards. In addition, the Advisor will
consider that foreign banks are not subject to the same regulations as are
domestic banks and may be involved in different business activities and have
different risks. Although there may be no active secondary market for a
particular instrument, the Funds may, upon notice, exercise a note's demand
feature or resell the note at any time to a third party. If a significant
portion of a Fund's assets were invested in notes of a single issuer, however,
the issuer's ability to meet the demand feature could affect that Fund's
liquidity. Included in the variable and floating rate demand instruments that
the Tax-Exempt Funds may purchase are participations in municipal obligations
purchased from and owned by financial institutions, primarily banks, the
interest on which, in the opinion of counsel to the issuer, is exempt from
federal income taxes and in the case of the New York and Pennsylvania Funds,
New York State and City, and Pennsylvania, personal income taxes,
respectively. In determining average weighted portfolio maturity, an
instrument will be deemed to have a maturity equal to the longer of the period
remaining to the next interest rate adjustment or the demand notice period.
Municipal Bond Insurance. Certain of the municipal obligations held in
the portfolios of the Tax-Exempt Funds may be insured. Different types of such
insurance include a "New Issue Insurance Policy", a "Mutual Fund Insurance
Policy" or a "Secondary Market Insurance Policy".
A New Issue Insurance Policy is obtained by the issuer of the securities,
and all premiums for such a policy are paid in advance by the issuer. Such
policies are generally used by an issuer to increase the credit rating of a
lower-rated security, and therefore may increase both the purchase price and
the subsequent resale value of a security for a Fund's portfolio. They are
non-cancellable and continue in force as long as the securities are
outstanding and the respective insurers remain in business. Premiums for
issuer insurance are paid in advance by the issuer and are reflected in a
somewhat higher purchase price paid by the Tax-Exempt Funds for these
obligations. The creditworthiness of the issuer will be evaluated in order to
determine its ability to meet its obligations to pay interest and repay
principal. The insurance covers the event that the issuer defaults on an
interest payment or principal repayment; if this occurs, the insurer will be
notified and will make payment to the bondholders. There is, however, no
guarantee that the insurer will meet its obligations. These insurance policies
do not protect bondholders from adverse changes in interest rates.
A Mutual Fund Insurance Policy is used to guarantee specific bonds only
while owned by a mutual fund. If a Fund were to purchase such a policy,
payment of the annual premiums would reduce such Fund's current yield. The
Tax-Exempt Funds have no plans to purchase a Mutual Fund Insurance Policy at
this time.
A Secondary Market Insurance Policy is purchased by an investor
subsequent to a security's issuance and generally insures a particular
security for the remainder of its term. The Tax-Exempt Funds may purchase
securities which already have been insured under a Secondary Market Insurance
Policy by a prior investor, or such Funds may purchase such a policy from a
vendor providing such a service.
Other Matters Specific to the New York Fund. The New York Fund is a
non-diversified series of the Company under the Investment Company Act of
1940, as amended (the "1940 Act"). Therefore, the New York Fund could invest
all of its assets in securities of a single issuer. However, as the Fund
intends to comply with Subchapter M of the Code, at least 50% of its total
assets must be comprised of individual issues, each of which represents no
more than 5% of such Fund's total assets and not more than 10% of the issuer's
outstanding voting securities. Those issues which represent more than 5% of
the New York Fund's total assets must be limited in the aggregate to 50% of
such Fund's total assets, provided, however, that no more than 25% of the
Fund's total assets may be invested in any one issuer. For these purposes, a
security is considered to be issued by the governmental entity (or entities)
whose assets or revenues back the security, or with respect to a private
activity bond that is backed only by the assets and revenues of a
non-governmental user, a security is considered to be issued by such
non-governmental user. In accordance with SEC regulations, the guarantor of a
guaranteed security may be considered to be an issuer in connection with such
guarantee. Since investment return on a non-diversified portfolio typically is
dependent upon the performance of a smaller number of securities relative to
the number held in a diversified portfolio, the New York Fund is more
susceptible to economic, political and regulatory developments and the change
in value of any one security will affect the overall value of a
non-diversified portfolio and thereby subject its net asset value per share to
greater fluctuations.
Because the New York Fund invests at least 80% of its assets in New York
obligations, its net asset value is particularly sensitive to changes in the
economic conditions and governmental policies of the State of New York. See
Appendix B - "Economic Conditions in New York" for additional information
regarding these factors.
Other Matters Specific to the Pennsylvania Fund. The Pennsylvania Fund is
registered as a non-diversified, open-end investment company under the 1940
Act. Therefore, the Pennsylvania Fund could invest all of its assets in
securities of a single issuer. However, as the Pennsylvania Fund also intends
to comply with Subchapter M of the Code, it must observe the same
diversification restrictions set forth in the preceding section for the New
York Fund. Since investment return on a non-diversified portfolio typically is
dependent upon the performance of a smaller number of securities relative to
the number held in a diversified portfolio, the Pennsylvania Fund is also more
susceptible to economic, political and regulatory developments, and the change
in value of any one security will affect the overall value of a
non-diversified portfolio and thereby subject the Pennsylvania Fund's net
asset value per share to greater fluctuations.
Because the Pennsylvania Fund invests at least 80% of its assets in
Pennsylvania obligations, its net asset value is particularly sensitive to
changes in the economic conditions and governmental policies of the
Commonwealth of Pennsylvania. See Appendix C - "Economic Conditions in
Pennsylvania" for additional information regarding these factors.
The Pennsylvania Fund's portfolio turnover rate generally will not exceed
100%. A portfolio turnover rate of 100% or higher will result in higher
transaction costs, which must be borne directly by the Pennsylvania Fund and
ultimately by its shareholders. High portfolio turnover may result in the
realization of substantial net capital gains, and possibly interest income,
representing accrued market discount. To the extent net short-term capital
gains are realized, any distributions resulting from such gains are considered
ordinary income for federal income tax purposes.
In addition, the Pennsylvania Fund does not intend to (i) invest in
securities secured by real estate or interests therein or issued by companies
or investment trusts which invest in real estate or interests therein, or (ii)
invest in securities issued by companies which, together with any predecessor,
have been in continuous operation for fewer than three years. The Pennsylvania
Fund would seek to notify shareholders before changing any of these policies.
Considerations Applicable to the Flex Cap Opportunity Fund
----------------------------------------------------------
Cash Position. In order to afford the Flex Cap Opportunity Fund the
flexibility to take advantage of new opportunities for investments in
accordance with its investment objective or to meet redemptions, it may, under
normal circumstances, hold up to 15% of its total assets in money market
instruments including, but not limited to, certificates of deposit, time
deposits and bankers' acceptances issued by domestic bank and thrift
institutions, U.S. Government securities, commercial paper and repurchase
agreements. When the analysis of economic and technical market factors by the
subadvisor, Fred Alger Management, Inc. ("Alger") suggests that common stock
prices will decline sufficiently that a temporary defensive position is deemed
advisable, the Fund may invest in high-grade senior securities or U.S.
Government securities or retain cash or cash equivalents, all without
limitation.
Small Capitalization Investments. Certain companies in which the Flex Cap
Opportunity Fund will invest may still be in the developmental stage, may be
older companies that appear to be entering a new stage of growth progress
owing to factors such as management changes or development of new technology,
products or markets or may be companies providing products or services with a
high unit volume growth rate. Investing in smaller, newer issuers generally
involves greater risk than investing in larger, more established issuers. Such
companies may have limited product lines, markets or financial resources and
may lack management depth. Their securities may have limited marketability,
and may be subject to more abrupt or erratic market movements than securities
of larger, more established companies or the market averages in general.
Repurchase Agreements. Like the other Funds, the Flex Cap Opportunity
Fund may invest in repurchase agreements. Repurchase agreements the Fund will
enter into will usually be for periods of one week or less, and the value of
the underlying securities, including accrued interest, will be at least equal
at all times to the total amount of the repurchase obligation, including
interest. The Fund bears the same risk of loss in the event that the other
party to a repurchase agreement declares bankruptcy or defaults on its
obligations that is discussed on page 3 of this Statement of Additional
Information. Alger reviews the creditworthiness of the banks and dealers with
which the Fund enters into repurchase agreements to evaluate these risks and
monitors on an ongoing basis the value of the securities subject to repurchase
agreements to ensure that the value is maintained at the required level.
Warrants and Rights. The Flex Cap Opportunity Fund may invest in
securities convertible into or exchangeable for equity securities including
warrants and rights. A warrant is a type of security that entitles the holder
to buy a proportionate amount of common stock at a specified price, usually
higher than the market price at the time of issuance, for a period of years or
to perpetuity. In contrast, rights, which also represent the right to buy
common shares, normally have a subscription price lower than the current
market value of the common stock and a life of two to four weeks. Warrants are
freely transferable and are traded on the major securities exchanges.
Portfolio Depositary Receipts. To the extent otherwise consistent with
its investment policies and applicable law, the Flex Cap Opportunity Fund may
invest up to 5% of its total assets in Portfolio Depositary Receipts, which
are exchange-traded shares issued by investment companies, typically unit
investment trusts, holding portfolios of common stocks designed to replicate
and, therefore, track the performance of various broad securities indexes or
sectors of such indexes. For example, the Fund may invest in Standard & Poor's
Depositary Receipts(R) (SPDRs), issued by a unit investment trust whose
portfolio tracks the S&P 500 Composite Stock Price Index, or Standard & Poor's
MidCap 400 Depositary Receipts(R) (MidCap SPDRs), similarly linked to the S&P
MidCap 400 Index.
Foreign Securities. The Flex Cap Opportunity Fund may invest up to 20% of
the value of its total assets in foreign securities (not including American
Depositary Receipts ("ADRs"), American Depositary Shares ("ADSs") or U.S.
dollar denominated securities of foreign issuers). Foreign securities
investments may be affected by changes in currency, rates or exchange control
regulations, changes in governmental administration or economic or monetary
policy (in the United States and abroad) or changed circumstances in dealings
between nations. Dividends paid by foreign issuers may be subject to
withholding and other foreign taxes that may decrease the net return on these
investments as compared to dividends paid to the Fund by domestic
corporations. There may be less publicly available information about foreign
issuers than about domestic issuers, and foreign issuers are not subject to
uniform accounting, auditing and financial reporting standards and
requirements comparable to those of domestic issuers. Securities of some
foreign issuers are less liquid and more volatile than securities of
comparable domestic issuers and foreign brokerage commissions are generally
higher than commissions in the United States. Foreign securities markets may
also be less liquid, more volatile and subject to less government supervision
than those in the United States. Investments in foreign countries could be
affected by other factors not present in the United States, including
expropriation, confiscatory taxation and potential difficulties in enforcing
contractual obligations. Securities purchased on foreign exchanges may be held
in custody by a foreign bank or a foreign branch of a domestic bank.
The Flex Cap Opportunity Fund may purchase ADRs, ADSs or U.S.
dollar-denominated securities of foreign issuers which are not subject to the
20% foreign securities limitation. ADRs and ADSs are traded in U.S. securities
markets and represent the securities of foreign issuers. While ADRs and ADSs
may not necessarily be denominated in the same currency as the foreign
securities they represent, many of the risks associated with foreign
securities may also apply to ADRs and ADSs.
Borrowing. The Flex Cap Opportunity Fund may borrow money from banks and
use it to purchase additional securities. This borrowing is known as
leveraging. Leveraging increases both investment opportunity and investment
risk. If the investment gains on securities purchased with borrowed money
exceed the cost of borrowing, including interest paid on the borrowing, the
net asset value of the Flex Cap Opportunity Fund's shares will rise faster
than would otherwise be the case. On the other hand, if the investment gains
fail to cover the cost (including interest) of borrowings, or if there are
losses, the net asset value of the Flex Cap Opportunity Fund's shares will
decrease faster than would otherwise be the case. The Flex Cap Opportunity
Fund may also borrow from banks for temporary or emergency purposes. The Fund
is required to maintain continuous asset coverage (that is, total assets
including borrowings, less liabilities exclusive of borrowings) of 300% of the
amount borrowed. If such asset coverage should decline below 300% as a result
of market fluctuations or other reasons, the Flex Cap Opportunity Fund may be
required to sell some of its portfolio holdings within three business days to
reduce the debt and restore the 300% asset coverage, even though it may be
disadvantageous from an investment standpoint to sell securities at that time.
Considerations and Risks Applicable to the World Fund
-----------------------------------------------------
Foreign Currency Transactions. The value of the assets of the World Fund
as measured in U.S. dollars may be affected favorably or unfavorably by
changes in foreign currency exchange rates and exchange control regulations,
and the Fund may incur costs in connection with conversions between various
currencies.
The Fund will conduct its foreign currency exchange transactions either
on a spot (i.e., cash) basis at the spot rate prevailing in the foreign
currency exchange market or through the use of forward contracts to purchase
or sell foreign currencies. A forward foreign currency exchange contract
involves an obligation by the Fund to purchase or sell a specific amount of
currency at a future date, which may be any fixed number of days from the date
of the contract agreed upon by the parties, at a price set at the time of the
contract. These contracts are transferable in the interbank market conducted
directly between currency traders (usually large commercial banks) and their
customers. A forward contract generally has no deposit requirements, and no
commissions are charged at any stage for trades. Neither type of foreign
currency transaction will eliminate fluctuations in the prices of the Fund's
portfolio securities or prevent loss if the prices of such securities should
decline.
The World Fund may enter into forward foreign currency exchange contracts
only under two circumstances. First, when the Fund enters into a contract for
the purchase or sale of a security denominated in a foreign currency, it may
desire to "lock in" the U.S. dollar price of the security. The Fund will then
enter into a forward contract for the purchase or sale, for a fixed amount of
dollars, of the amount of foreign currency involved in the underlying
securities transactions; in this manner the Fund will be better able to
protect itself against a possible loss resulting from an adverse change in the
relationship between the U.S. dollar and the subject foreign currency during
the period between the date the securities are purchased or sold and the date
on which payment is made or received.
Second, when the Advisor or INVESCO Global Asset Management (N.A.), Inc.,
the World Fund's subadvisor ("INVESCO") believes that the currency of a
particular foreign country may suffer a substantial decline against the U.S.
dollar, the Fund may enter into a forward contract to sell, for a fixed amount
of dollars, the amount of foreign currency approximating the value of some or
all of the Fund's securities denominated in such foreign currency. The precise
matching of the forward contract amounts and the value of the securities
involved generally will not be possible since the future value of those
securities may change between the date the forward contract is entered into
and the date it matures. The projection of short-term currency market movement
is extremely difficult, and the successful execution of a short-term hedging
strategy is highly uncertain. The Advisor does not intend to enter into such
forward contracts under this second circumstance on a regular or continuous
basis. The Fund will not enter into such forward contracts or maintain a net
exposure to such contracts when the consummation of the contracts would
obligate the Fund to deliver an amount of foreign currency in excess of the
value of the Fund's securities or other assets denominated in that currency.
The Advisor believes that it is important to have the flexibility to enter
into such forward contracts when it determines that to do so is in the best
interest of the Fund. The Fund's custodian bank segregates cash or equity or
debt securities in an amount not less than the value of the Fund's total
assets committed to forward foreign currency exchange contracts entered into
under the second circumstance. If the value of the securities segregated
declines, additional cash or securities are added so that the segregated
amount is not less than the amount of the Fund's commitments with respect to
such contracts. Under normal circumstances, the Fund expects that any
appreciation (depreciation) on such forward exchange contracts will be offset
approximately by the (depreciation) appreciation in translation of the
underlying foreign investment arising from fluctuations in foreign currency
exchange rates.
The Fund will experience the unrealized appreciation or depreciation from
the fluctuation in a foreign currency forward contract as an increase or
decrease in the Fund's net assets on a daily basis, thereby providing an
appropriate measure of the Fund's financial position and changes in financial
position.
Foreign Securities for Funds other than the World Fund
------------------------------------------------------
Before foreign securities are purchased for Funds other than the World
Fund, the differences between them and U.S. securities are considered. This
includes possible differences in taxation, regulation, trading volume and
currency controls, the possibility of expropriation and lack of uniform
accounting and reporting standards. While there may be investment
opportunities in foreign securities, there also may be investment risks not
usually associated with U.S. securities.
INVESTMENT RESTRICTIONS
The Company. Certain By-Laws of the Company, which may be changed only by
a shareholder vote, prohibit the purchase by any Fund other than the Flex Cap
Opportunity Fund of the securities of any company not in operation
continuously for at least three years (including any predecessor company) and,
except for U.S. Government Securities and obligations of the government of
Canada, forbid the purchase of the securities of any one issuer, if the market
value of such securities exceeds 5% of the total market value of all of the
Company's securities and cash.
The Company's Board of Directors has also adopted a policy under which
each of the Common Stock Fund, Balanced Fund, Mid Cap Growth Fund and Bond
Fund cannot purchase securities of any one issuer if the market value of such
securities exceeds 5% of the total market value of each such Fund's securities
and cash.
It is also a fundamental policy of the Company and the Pennsylvania Fund
that they may not borrow money, except as otherwise described above for the
Flex Cap Opportunity Fund and except, for all Funds, from banks in an amount
up to 5% of a Fund's total assets for temporary or emergency purposes or to
meet redemption requests which might otherwise require the untimely
disposition of securities, and it may not purchase securities on margin. Also,
the Company may not lend its cash or securities, may not deal in real estate,
may not act as underwriter of securities issued by others, and may not
purchase from or sell to any officer, director or employee of the Company, the
Advisor, a subadvisor or underwriter, or any of their officers or directors,
any securities other than shares of the Company's capital stock. None of its
Funds may deal in options, commodities or commodities contracts, except as
otherwise described in the Prospectus for the Growth Index Fund, and except
further to the extent the Tax-Exempt Funds or the High Yield Fund may enter
into futures transactions and related options for hedging purposes as
described above. None of the Funds may invest in oil, gas or other mineral
exploration or development programs or leases. None of the Funds, except for
the Flex Cap Opportunity Fund, are able to invest more than 5% of its net
assets in warrants valued at the lower of cost or market, or more than 2% of
its net assets in warrants which are not listed on either the New York Stock
Exchange or the American Stock Exchange.
The Company's By-Laws also prohibit the purchase or retention of the
securities of any one issuer if officers and directors of the Company, its
Advisor or underwriter owning individually more than .5% of the securities of
such issuer together own more than 5% of the securities of such issuer.
The Company may not purchase more than 10% of the voting securities of
any issuer. The Company may not invest in companies for purposes of exercising
control or management and, except to the extent described above for the Flex
Cap Opportunity Fund, the High Yield Bond Fund and the Bond Fund, may not
invest in any securities of any issuer which the Company is restricted from
selling to the public without registration under the Securities Act. It also
may not purchase for any Fund securities of any issuer beyond a market value
of 5% of such Fund's net assets, except for the Growth Index Fund and the Flex
Cap Opportunity Fund, and may not invest in securities which are not readily
marketable, except to the extent described above for the High Yield Bond Fund
and the Flex Cap Opportunity Fund. The Company may not make short sales of
securities, except to the extent described above for the Flex Cap Opportunity
Fund.
Although not a fundamental policy, so long as the Common Stock Fund is
used as the underlying investment vehicle for a National Life separate
account, it is the view of management that its investment policies will be
affected by insurance laws of certain states, principally New York, which,
among other things, may limit most of the Common Stock Fund's investment in
common stocks to the common stocks of listed companies meeting certain
earnings tests. These essentially are qualitative limitations imposed upon the
investments of life insurance companies in order to reduce the risk of loss.
Restrictions and policies established by resolution of the directors may
be changed by the Board, with any material changes to be reported to
shareholders. The securities of foreign companies or governments may be
selected as being suitable for one or more of the Funds.
The Pennsylvania Fund. The following investment limitations are
applicable to the Pennsylvania Fund, and may not be changed without a vote of
the Pennsylvania Fund's shareholders.
The Pennsylvania Fund may not:
1. Purchase or sell real estate, except that the Fund may invest in
municipal obligations which are secured by real estate or interests therein.
2. Make loans, except that the Fund may purchase or hold debt instruments
and enter into repurchase agreements pursuant to its investment objective and
policies.
3. Underwrite the securities of other issuers, except to the extent that
the acquisition or disposition of municipal obligations or other securities
directly from the issuer thereof in accordance with the Fund's investment
objective and policies might be deemed to be an underwriting.
4. Purchase securities of companies for the purpose of exercising
control.
5. Acquire any other investment company or investment company security,
except in connection with a merger, consolidation, reorganization or
acquisition of assets.
6. Purchase securities on margin, make short sales of securities or
maintain a short position, provided that the Fund may enter into futures
contracts.
7. Issue senior securities except insofar as borrowing in accordance with
the Fund's investment objective and policies might be considered to result in
the issuance of a senior security; provided that the Fund may enter into
futures contracts.
8. Invest in or sell interests in oil, gas or other mineral exploration
development programs.
9. Invest in private activity bonds where the payment of principal and
interest are the responsibility of a company (including its predecessors) with
less than three years of continuous operations.
The above investment limitations are considered at the time that
portfolio securities are purchased.
If a percentage restriction is satisfied at the time of investment, a
later increase or decrease in such percentage resulting from a change in asset
value will not constitute a violation of the restriction.
In order to permit the sale of Pennsylvania Fund shares in certain
states, the Pennsylvania Fund may make commitments more restrictive than the
investment policies and limitations described above. Should the Pennsylvania
Fund determine that any such commitment is no longer in the best interests of
the Fund, it will revoke the commitment by terminating sales of its shares in
the state involved.
MANAGEMENT OF THE FUNDS
Management is made up of (i) the Company's Board of Directors and the
Pennsylvania Fund's Board of Trustees, which consist of the same twelve
individuals and which are responsible for the Funds' operations; (ii) the
officers of the Company and the Pennsylvania Funds, who are responsible to the
Boards; and (iii) the Advisor which, under agreements with the Company and the
Pennsylvania Fund, supervises and assists in the management of the Funds and
the purchase and sale of securities. In addition, the Advisor has retained the
services of INVESCO with respect to the World Fund, Evergreen with respect to
the High Yield Fund, and Alger with respect to the Flex Cap Opportunity Fund.
See the "The Investment Advisor", below. Set forth below is information
regarding the directors/trustees and officers of the Company and the
Pennsylvania Fund, their ages and their principal occupations during the past
five years. In the case of those persons who also hold positions with
affiliated persons of the Funds, such positions are also indicated.
PATRICK E. WELCH * - CHAIRMAN AND DIRECTOR/TRUSTEE
National Life Drive
Montpelier, VT 05604
Age 53
National Life - Chairman and Chief Executive Officer, 1997 to present; GNA
Corporation (Insurance) - Chairman of the Board, Chief Executive Officer and
President of GNA Corporation - 1992 to 1996; LSW National Holdings, Inc. -
Chairman and Director; National Financial Services, Inc. - President and
Director; Administrative Services - Director - 1997 to present, National Life
Investment Management Company, Inc., - Director - 1997 to present; Equity
Services, Inc. - Director - 1997 to present; Sentinel Administrative Service
Corporation - Director - 1997 to present; and National Retirement Plan
Advisors, Inc.- Director - 1997 to present.
JOSEPH M. ROB* - PRESIDENT AND DIRECTOR/TRUSTEE
National Life Drive
Montpelier, Vermont 05604
Age 57
Sentinel Management Company - Chief Executive Officer, 1993 to present;
Sentinel Financial Services Company - Chief Executive Officer, 1993 to
present; Sentinel Administrative Services Company - Chief Executive Officer,
1993 to present; ESI - Chairman, Chief Executive Officer, and Director, 1985
to present, President, 1997 to present; American Guaranty & Trust Company -
Director, 1993 to present; LSW National Holdings, Inc. - Director, 1996 to
present; Life Insurance Company of the Southwest - Director, 1996 to present.
RICHARD J. BORDA - DIRECTOR/TRUSTEE
P. O. Box 6091
Carmel, California 93923
Age 68
National Life - Former Vice Chairman of the Board, 1985 to 1990, Director,
1975 to 1991; The Monterey Institute for International Studies - Vice
Chairman, Director and Trustee, 1991 to present; Air Force Aid Society -
President, 1980 to 1995.
DR. KALMAN J. COHEN - DIRECTOR/TRUSTEE
2312 Honeysuckle Court
Chapel Hill, North Carolina 27514-1711
Age 69
Distinguished Bank Research Professor Emeritus, The Fuqua School of Business,
Duke University, 1993 to present; USLIFE Income Fund, Inc. - Director, 1973 to
present; Sentinel Cash Management Fund, Inc. - Director, 1981 to 1993.
JOHN D. FEERICK - DIRECTOR/TRUSTEE
140 West 62nd Street
New York, New York 10023
Age 63
Fordham University School of Law - Dean, 1982 to present; American Home
Products Corporation - Director, 1987 to present.
RICHARD I. JOHANNESEN, JR. - DIRECTOR/TRUSTEE
87 Whitney Lane
Stowe, Vermont 05672
Age 65
Retired; Former Vice President and Manager - Bond Market Research Department,
Salomon Brothers Inc.
ROBERT B. MATHIAS - DIRECTOR/TRUSTEE
7469 East Pine Avenue
Fresno, California 93727
Age 69
Sports Consultant; formerly Executive Director- National Fitness Foundation;
former U.S. Congressman.
KENISTON P. MERRILL* - DIRECTOR/TRUSTEE
Brainstorm Farm, P. O. Box 404
Randolph, Vermont 05060
Age 63
Chairman of the Board of the Company, 1990 to 1997; Chairman of the Board of
the Pennsylvania Fund, 1990 to 1997; Sentinel Advisors Company - Chairman and
Chief Executive Officer, 1993 to 1997; National Life - Executive Vice
President and Chief Investment Officer, 1994 to 1995; National Life Investment
Management Company, Inc. - Chairman and Chief Executive Officer, 1990 to 1995;
American Guaranty & Trust Company - Director, 1993 to 1997.
DEBORAH G. MILLER - DIRECTOR/TRUSTEE
1117 Hamilton Avenue
Palo Alto, CA 94301
Age 50
Digital Equipment Corporation - Vice President-Americas Systems Business Unit,
1995 to present; Miller Van Buren, Inc. - Chief Executive Officer, 1994 to
1995.
JOHN RAISIAN, Ph.D. - DIRECTOR/TRUSTEE
Hoover Institution, Stanford University
Serra and Galvey Streets
Stanford, California 94305-6010
Age 50
Director and Senior Fellow - Hoover Institution (academic institution), 1991
to present; Director, Stanford Faculty Club, 1994 to present; Member of the
Editorial Board, Journal of Labor Research, 1983 to present; Member, American
Economic Association, World Affairs Council, Council of Foreign Relations,
National Association of Scholars.
SUSAN M. STERNE - DIRECTOR/TRUSTEE
5 Glen Court
Greenwich, Connecticut 06830-4505
Age 54
Economic Analysis Associates, Inc. - President and Chief Economist, 1979 to
present.
ANGELA E. VALLOT - DIRECTOR/TRUSTEE
Director of Stakeholder Relations
Texaco, Inc.
200 Westchester Avenue
White Plains, New York 10650
Age 43
Texaco, Inc. (major oil company) - Director of Stakeholder Relations, 1997 to
present; Arent Fox Kintner Plotkin & Kahn (law firm) - Lawyer, 1990 to 1997;
Trustee, District of Columbia Retirement Board; Member of the Steering
Committee of the NAACP Legal Defense Fund.
JOHN M. GRAB, JR., C.P.A.* - VICE PRESIDENT
National Life Drive
Montpelier, Vermont 05604
Age 53
Sentinel Management Company - Senior Vice President, 1993 to present; Sentinel
Administrative Service Company - Senior Vice President, 1993 to present; ESI -
Senior Vice President and Chief Financial Officer, 1988 to present; American
Institute of Certified Public Accountants; The Vermont Society of Certified
Public Accountants.
THOMAS P. MALONE* - VICE PRESIDENT & TREASURER
National Life Drive
Montpelier, Vermont 05604
Age 44
Sentinel Administrative Service Company - Vice President, 1997 to present;
Assistant Vice President, 1990 to 1997; Sentinel Group Funds, Inc. - Vice
President & Treasurer, 1997 to present; Assistant Vice President, 1990 to 1997
D. RUSSELL MORGAN* - SECRETARY
National Life Drive
Montpelier, Vermont 05604
Age 44
National Life - Senior Counsel, 2000 to present; Counsel, 1994 to 2000;; ESI -
Counsel, 1986 to present; Sentinel Advisors Company - Sentinel Financial
Services Company - Sentinel Administrative Service Company - Counsel, 1993 to
present; LSW National Holdings, Inc. - Secretary, 1996 to present.
*"Interested Persons" (as defined in the 1940 Act).
The officers and directors/trustees of the Funds who are employees of
National Life, Provident, Penn Mutual, or their respective subsidiaries do not
receive any compensation from the Funds. The Company pays to each director who
is not an affiliate of the Advisor an annual fee of $16,000 plus $1,500 for
each meeting of the Board of Directors attended by the director, and the
Pennsylvania Fund pays to each such trustee an annual fee of $2,500 plus $200
for each meeting of the Board of Trustees attended by such trustee. The
Company and the Pennsylvania Fund also reimburse directors/trustees for travel
and other out-of-pocket expenses incurred by them in connection with attending
such meetings. The aggregate remuneration paid by the Funds during the fiscal
year ended November 30, 1999 to the officers and directors/trustees of the
Funds as a group was $313,278.
The following table sets forth for the fiscal year ended November 30,
1999 compensation paid by the Company and by the Pennsylvania Fund to the
directors/trustees who are not affiliated with the Advisor:
<TABLE>
<CAPTION>
Pension or Total
Aggregate Retirement Compensation
Compensation Benefits from Fund
Name of Aggregate From Accrued as and Sentinel
Director/ Compensation Pennsylvania Part of Fund Pennsylvania
Trustee from Company Tax-Free Trust Expense Tax-Free Trust
------- ------------ -------------- ------- --------------
<S> <C> <C> <C> <C>
Richard J. Borda $23,500 $3,500 None $27,000
Kalman J. Cohen $23,500 $3,500 None $27,000
Richard D. Farman $ 5,500 $ 825 None $ 6,325
John D. Feerick $23,500 $3,500 None $27,000
Richard I. Johannesen $23,500 $3,500 None $27,000
Robert B. Mathias $23,500 $3,500 None $27,000
Deborah G. Miller $23,500 $3,500 None $27,000
John Raisian $23,500 $3,500 None $27,000
Susan M. Sterne $23,500 $3,500 None $27,000
Angela E. Vallot $23,500 $3,500 None $27,000
</TABLE>
Code of Ethics
--------------
The Boards of the Funds have adopted a Code of Ethics pursuant to Rule
17j-1 under the 1940 Act, and the Advisor has adopted a similar Code of Ethics
(together, the "Codes of Ethics"). The Codes of Ethics significantly restrict
the personal investing activities of all employees of the Advisor.
The Codes of Ethics require that all employees preclear any personal
securities transaction (with limited exceptions, such as mutual funds and
government securities). The preclearance requirement and associated procedures
are designed to identify any substantive prohibition or limitation applicable
to the proposed transaction. The substantive restrictions include a ban on
acquiring any securities in an initial public offering, and a prohibition on
profiting from short-term trading in securities (with certain exceptions). In
addition, no employee may purchase or sell any security which at the time is
being purchased or sold by any mutual fund advised by the Advisor.
Furthermore, the Codes of Ethics provide for seven day trading "blackout
periods" which prohibit trading by employees of the Advisor in proximity to
periods of trading by mutual funds managed by the Advisor in the same (or
equivalent) security unless certain conditions are present.
PRINCIPAL SHAREHOLDERS
As of February 29, 2000, the Company's and the Pennsylvania Fund's
directors/trustees and officers as a group owned less than 1% of the
outstanding shares of each Fund. In addition, as of such date, National Life
and its affiliates, each of whose address is National Life Drive, Montpelier,
Vermont 05604, except for American Guaranty & Trust Company, whose address is
220 Continental Drive, Newark, Delaware 19713 owned of record and beneficially
58,168,774.544 shares amounting to 21.3% of the outstanding shares of the
Company (13% of the voting power) which included 3,057,959.833 shares of the
Common Stock Fund amounting to 7.7% of such Fund, 2,054,507.504 shares of the
Balanced Fund amounting to 11.6% of such Fund, 2,074,317.286 shares of the Mid
Cap Growth Fund amounting to 18.9% of such Fund, 2,058,873.528 shares of the
Small Company Fund amounting to 8.5% of such Fund, 1,851,719.630 shares of the
World Fund amounting to 25.7% of such Fund, 2,781,981.106 shares of the High
Yield Fund amounting to 28.8% of such Fund, 4,118,496.682 shares of the Bond
Fund amounting to 24.8% of such Fund, 715,797.596 shares of the Government
Securities Fund amounting to 11.1% of such Fund, 224,345.892 shares of Short
Maturity Fund amounting to 3.4% of such Fund, 36,915,551.510 shares of the
Money Market Fund amounting to 30.9% of such Fund, 423,226.422 shares of the
Tax-Free Income Fund amounting to 6.7% of such Fund, and 68,320.253 shares of
the New York Fund amounting to 4.7% of such Fund. National Life and its
affiliates also owned 52,526.201 shares of the Pennsylvania Fund amounting to
2.2% of the outstanding shares on such date.
As of February 29, 2000, none of the approximately 116,599 shareholders
owns as much as 5% of the voting stock of any Fund except National Life and
its affiliates, and except for the following shareholders of the New York
Fund: Mr. Louis P. Dicerbo, 261 Madison Avenue, New York, New York 10016-2303
- 157,838.527 shares amounting to 10.8% of the class; Donaldson, Lufkin &
Jenrette Securities Corporation Inc., P. O. Box 2052, Jersey City, New Jersey
07303-2052, 122,448.980 shares amounting to 8.4% of the class; Mr. John Kenny
Carlin and Mary Anne Carlin, 6110 South County Line Road, Burr Ridge, Illinois
60521-5220 - 178,524.924 shares amounting to 12.2% of the class; and Ms.
Arlene Federico, 39 Fruitledge Road, Brookville, New York 11545-3315 -
74,008.919 shares amounting to 5.1% of the class.
In the case of the High Yield Fund, the World Fund and the Money Market
Fund, the ownership by National Life and its affiliates may be deemed to be a
controlling interest in the Fund. As a result, on matters in which these Funds
vote separately as a class, it may be difficult for the other shareholders to
adopt resolutions opposed by National Life, or to defeat proposed resolutions
supported by National Life. National Life is organized under the laws of the
State of Vermont.
THE INVESTMENT ADVISOR
The Advisor provides general supervision of the Funds' investments as
well as certain administrative and related services. The Advisor is a Vermont
general partnership, the general partners of which are affiliates of National
Life, Provident, and Penn Mutual. National Life's affiliate is the majority
partner of the Advisor. Patrick E. Welch, the Chairman and Chief Executive
Officer of the Funds, is also Chairman and Chief Executive Officer of National
Life. As such, he may be deemed to control the Advisor. Joseph M. Rob, the
President of the Funds, is also Chief Executive Officer of SFSC, the Funds'
distributor, Sentinel Administrative Service Company, the Funds' transfer
agent and fund accounting service provider, and Sentinel Management Company,
an umbrella partnership which coordinates the activities of the other
partnerships. SFSC, Sentinel Administrative Service Company and Sentinel
Management Company are all also Vermont general partnerships of which the
general partners are affiliates of National Life, Provident and Penn Mutual,
with National Life being the majority partner in each case. Mr. Rob is also
Chairman & Chief Executive Officer of Equity Services, Inc., a broker-dealer
which is wholly owned by National Life. John M. Grab, Jr., Thomas P. Malone,
and D. Russell Morgan, the Vice President, Vice President and Treasurer, and
Secretary of the Funds, respectively, also hold the positions with the
affiliates of the Advisor shown on pages 18-20.
As compensation in full for services rendered under its advisory
agreement applicable to all Funds other than the High Yield Fund, the Growth
Index Fund and the Flex Cap Opportunity Fund, the Company will pay to the
Advisor a monthly fee determined as follows: (1) With respect to the Small
Company, Mid Cap Growth, World and Balanced Funds: 0.70% per annum on the
first $200 million of aggregate average daily net assets of such funds in the
aggregate; 0.65% per annum on the next $100 million of such assets; 0.60% per
annum on the next $100 million of such assets; and 0.55% per annum on such
assets in excess of $400 million. (2) With respect to the Common Stock Fund:
0.55% per annum on the aggregate average daily net assets of the Fund. (3)
With respect to the Bond, New York, Tax-Free Income, Government Securities and
Short Maturity Government Funds: 0.55% per annum on the first $200 million of
aggregate average daily net assets of such funds in the aggregate; 0.50% per
annum on the next $200 million of such assets; and 0.45% per annum on such
assets in excess of $400 million. (4) With respect to the Money Market Fund:
0.40% per annum on the first $300 million of aggregate average daily net
assets; and 0.35% per annum on such assets in excess of $300 million. Under a
separate advisory agreement with the High Yield Fund, the Advisor receives
from the High Yield Fund a fee based on the average daily value of the net
assets of the High Yield Fund in accordance with the following schedule: 0.75%
per annum on the first $100 million of average daily net assets of the High
Yield Fund; 0.70% per annum on the next $100 million of such assets; 0.65% per
annum on the next $100 million of such assets; and 0.60% per annum on such
assets in excess of $300 million. Under a separate advisory agreement with the
Growth Index Fund, the Advisor receives from the Growth Index Fund a fee based
on the average daily value of the net assets of the Growth Index Fund equal to
0.30% per annum on such average daily net assets. Under a separate advisory
agreement with the Flex Cap Opportunity Fund, the Advisor receives from the
Flex Cap Opportunity Fund a fee based on the average daily value of the net
assets of the Flex Cap Opportunity Fund equal to 0.90% per annum on such
average daily net assets. Before waivers of advisory fees, for the fiscal year
ended November 30, 1999, such fees aggregated $17,372,950, for the fiscal year
ended November 30, 1998, such fees aggregated $16,207,972, and for the fiscal
year ended November 30, 1997, such fees aggregated $13,907,812. Of the above
advisory fees, $775,429 were waived in the fiscal year ended November 30,
1999.
As compensation in full for services rendered under its advisory
agreement, the Pennsylvania Fund pays to the Advisor a monthly fee of 0.55%
per annum on the first $50 million of aggregate average daily net assets of
the Fund; 0.50% per annum on the next $50 million of such assets; and 0.45%
per annum on such assets in excess of $100 million. For the fiscal years ended
November 30, 1999, November 30, 1998 and November 30, 1997, the Pennsylvania
Fund paid advisory fees of $180,302, $190,754 and $188,819, respectively. Of
these advisory fees, $ 180,302 were waived in the fiscal year ended November
30, 1999.
Under the Company's advisory agreement applicable to all Funds other than
the High Yield Fund, the Growth Index Fund and the Flex Cap Opportunity Fund,
fees are allocated to the various Funds of the Company which share common fee
schedules in proportion to such Funds' net assets.
Effective March 31, 2000, the Advisor has voluntarily agreed for a period
at least until November 30, 2000, to waive the following Funds' advisory fees
or other expenses necessary to limit these Funds' overall expense ratios to
the amounts shown below:
Bond Fund Class A shares.....................................0.75%
Government Securities Fund Class A shares....................0.84%
Short Maturity Government Fund Class A shares................0.75%
Tax-Free Income Fund Class A shares..........................0.77%
Pennsylvania Fund Class A shares.............................0.76%
New York Fund Class A shares.................................0.00%
Growth Index Class A shares..................................0.65%
In the case of the Bond Fund, the waiver of advisory fees also benefits the
Class B shares of the Bond Fund, which will experience the same reduced
effective advisory fee rate as the Class A shares of the Bond Fund. The
Advisor currently intends to reset the above expense caps annually to amounts
approximately equal to 90% of the average expense ratios of the Class A shares
of such Funds' peer groups (except that in the case of the Short Maturity
Government Fund, the expense cap is expected to be increased by approximately
0.15% to take that Fund's higher Rule 12b-1 fee into account). However, these
arrangements may be changed or terminated at any time after November 30, 2000.
Effective September 10, 1999, the Advisor has voluntarily agreed for a
period at least until November 30, 2000, to waive advisory fees or other
expenses necessary to cap the expense ratio of the Growth Index Fund at 0.65%.
In addition to the above waiver program, the Advisor has a policy of
waiving advisory fees to the extent, if any, necessary to maintain the
aggregate expense ratios of the Class A shares of all of the Funds, except for
the World Fund, to 1.30%. In the event that a waiver were required under this
policy, the waiver would apply to the same extent across all classes of shares
of these Funds, and the aggregate expense ratios of the Class B and Class C
shares of these Funds, and the Class D shares of the Balanced Fund, would be
reduced proportionately. Although the Advisor has no present intention to do
so, this arrangement may be terminated at any time. The aggregate expense
ratio of the Class A shares of the Funds was less than 1.30% during fiscal
1999, and no reimbursement was required under this policy.
The Company's advisory agreement applicable to all Funds other than the
High Yield Fund, the Growth Index Fund and the Flex Cap Opportunity Fund which
was approved by the Company's shareholders on November 30, 1992, the advisory
agreement applicable to the High Yield Fund, which was approved by the
Company's Board of Directors on March 14, 1997 and the High Yield Fund's
shareholders on June 20, 1997, the advisory agreement applicable to the Growth
Index Fund, which was approved by the Company's Board of Directors on June 10,
1999 and the Growth Index Fund's shareholders on September 13, 1999, and the
advisory agreement applicable to the Flex Cap Opportunity Fund, which was
approved by the Company's Board of Directors on December 9, 1999 and the Flex
Cap Opportunity Fund's shareholders on February 25, 2000, must each be
approved annually by vote of the Board of Directors of the Company or by the
vote of a majority of the outstanding voting securities of the applicable
Fund, but in either event it must also be approved by a vote of a majority of
the directors who are not parties to the contract, or "interested persons", as
defined in the 1940 Act, of any such party cast in person at a meeting called
for the purpose of voting on such approval. With respect to the submission of
the Company's advisory agreement applicable to all Funds other than the High
Yield Fund, Growth Index Fund and Flex Cap Opportunity Fund, for approval by
the shareholders, such matters shall be deemed to be acted upon effectively
with respect to any class of the Company if a majority of the outstanding
voting securities of such class vote for approval of such matter,
notwithstanding (A) that such matter has not been approved by a majority of
the outstanding voting securities of any other class affected by such matter,
and (B) that such matter has not been approved by a vote of a majority of the
outstanding voting securities of the Company.
The Pennsylvania Fund's advisory agreement, which was approved by the
shareholders of the Fund on February 19, 1993, must be approved annually by
vote of the Board of Trustees or by the vote of a majority of the outstanding
voting securities of the Pennsylvania Fund, but in either event it must also
be approved by a vote of a majority of the trustees who are not parties to the
contract, or "interested persons", as defined in the 1940 Act, of any such
party cast in person at a meeting called for the purpose of voting on such
approval.
Each advisory agreement will terminate automatically in the event of its
assignment and is terminable at any time without penalty by the Board, or,
with respect to a particular Fund, by a majority of the Fund's outstanding
voting securities on not more than 60 days' written notice to the Advisor and
by the Advisor on 60 days' written notice to the Fund.
As described in the Prospectus, with respect to the World Fund only, the
Advisor has entered into a sub-advisory agreement with INVESCO dated July 1,
1999. In accordance with this sub-advisory agreement, INVESCO provides the
World Fund with a continuous investment program consistent with its stated
investment objectives and policies. The Advisor pays to INVESCO a fee equal to
the greater of (i) 0.375% per annum of the World Fund's aggregate average
daily net assets up to $500 million, and 0.30% per annum of such net assets in
excess of $500 million, or (ii) $20,000 per year. Such fee is paid monthly in
arrears. The sub-advisory agreement must be approved annually in one of the
same ways as for the Company's advisory agreement as described above. The
sub-advisory agreement also may be terminated by either INVESCO or by action
of the Board of Directors of the Company or the shareholders of the World Fund
on 60 days' written notice, without penalty, and terminates automatically in
the event of its assignment. For the period April 1, 1996 to June 30, 1999,
INVESCO provided the same services under identical sub-advisory agreements and
prior to that, Cashman Farrell & Associates was the subadvisor under a similar
sub-advisory agreement.
Also as described in the Prospectus, the Advisor has entered into a
sub-advisory agreement with Evergreen with respect to the High Yield Fund.
Pursuant to this agreement, Evergreen provides the Advisor with a continuous
investment program consistent with the High Yield Fund's stated investment
objectives and policies. Under this agreement, the Advisor pays a fee to
Evergreen equal to one half of the fee paid by the High Yield Fund to the
Advisor, provided that the fee paid by the Advisor to Evergreen will always be
at least 0.35% per annum of the average daily net assets of the High Yield
Fund. This agreement became effective June 20, 1997. This sub-advisory
agreement also may be terminated by either of the Advisor or Evergreen or by
action of the Board of Directors of the Company or the shareholders of the
High Yield Fund on 60 days' written notice, without penalty, and terminates
automatically in the event of its assignment.
Also, as described in the Prospectus, the Advisor has entered into a
sub-advisory agreement with Alger with respect to the Flex Cap Opportunity
Fund. Pursuant to this agreement, Alger provides the Advisor with a continuous
investment program consistent with the Flex Cap Opportunity Fund's stated
investment objective and policies. Under this agreement, the Advisor pays a
fee to Alger equal to 0.50% per annum of the average daily net assets of the
Flex Cap Opportunity Fund. This agreement became effective February 29, 2000.
This sub-advisory agreement also may be terminated by either of the Advisor or
Alger or by action of the Board of Directors of the Company or the
shareholders of the Flex Cap Opportunity Fund on 60 days' written notice,
without penalty, and terminates automatically in the event of its assignment.
The fees paid to INVESCO and Evergreen by the Advisor for the fiscal year
ended November 30, 1999 were $465,054 and $346,694, respectively. The fees
paid to INVESCO and Evergreen by the Advisor for the fiscal year ended
November 30, 1998 were $430,058 and $253,092, respectively; and the fees paid
to INVESCO and Evergreen by the Advisor for the fiscal year ended November 30,
1997 were $329,200 and $52,589, respectively.
PRINCIPAL UNDERWRITER
SFSC acts as the principal underwriter of shares of the Funds. Its
principal business address is National Life Drive, Montpelier, Vermont 05604.
The Funds receive the net asset value, as determined for the purpose of
establishing the offering price, of each share sold. SFSC has advised the
Funds that it allows dealer concessions as shown in the Prospectus, except
that items of a promotional nature amounting in value to not more than $100
may be given from time to time as a sales incentive to registered
representatives. SFSC has advised the Funds that the total amount of
underwriting commissions paid to it in the fiscal years ended November 30,
1999, 1998 and 1997 were $3,382,541, $4,834,945 and $4,790,051, respectively.
Of this amount, SFSC retained, in the fiscal years ended November 30, 1999,
1998 and 1997, $157,275, $153,177 and $148,883.
During the fiscal year ended November 30, 1999, SFSC also received
$785,304 in contingent deferred sales loads. It did not receive any brokerage
commissions or other compensation from the Funds. The distribution contracts
of the Company and the Pennsylvania Fund provide that SFSC use its best
efforts to continuously offer the Funds' shares. These contracts may be
terminated by either party thereto on 60 days' written notice, without
penalty, and they terminate automatically in the event of their assignment.
The distribution contracts must be approved annually in one of the same ways
as described above for the advisory agreements.
THE DISTRIBUTION PLANS
The Company and the Pennsylvania Fund have adopted several plans pursuant
to Rule 12b-1 under the 1940 Act. One such plan applies to the Class A shares
of the Company's Funds (other than the Money Market Fund). In addition, the
Short Maturity Government Fund has a separate Supplemental Distribution Plan
applicable only to it. The Pennsylvania Fund has a Distribution Plan
applicable only to it. The Class B shares of the Small Company, World, Common
Stock, Balanced, and Bond Funds have adopted a Class B Distribution Plan,
effective April 1, 1996. The Plans were extended to include the High Yield
Fund's Class A and Class B shares on March 14, 1997, and the Class B
Distribution Plan was extended to include the Class B shares of the Mid Cap
Growth Fund effective January 12, 1998. The Plans were extended to include the
Class A shares and Class B shares of the Growth Index Fund on June 10, 1999.
Effective May 4, 1998, the Class C shares of the Common Stock, Balanced, World
and High Yield Funds have adopted a Class C Distribution. The Class D shares
of the Balanced Fund adopted a Class D Distribution Plan on August 21, 1998
Plan (all of these plans are collectively hereinafter referred to as the
"Plans"). The Plans were further extended to include the Class A, Class B and
Class C shares of the Flex Cap Opportunity Fund on December 9, 1999. In all
cases, the Plans reimburse SFSC for expenses actually incurred.
The Class A, Class B and Class C shares of each Fund (except for the
Money Market Fund) paid fees for the various activities shown below under the
Plans in the amounts set forth below for the fiscal year ended November 30,
1999.
<TABLE>
<CAPTION>
RECOVERY OF SALARY RENT
SERVICE FEES PREPAID SALES AND & OTHER
FUND PAID TO DEALERS COMMISSION BENEFITS MISC. EXP.
<S> <C> <C> <C> <C>
Common $2,572,400 $1,059,634 $1,398,354 272,248
Balanced 631,092 388,919 298,428 57,867
Mid Cap Growth 196,125 60,856 98,496 19,828
Small Company 202,588 87,064 94,707 18,403
World 93,750 151,269 98,103 19,459
High Yield 58,200 316,445 58,147 11,362
Bond 101,511 135,418 82,651 16,098
Government 60,032 - 56,106 10,832
Short Maturity 63,117 - 56,727 11,066
Tax Free 166,316 - 69,484 13,521
NY Tax Free 27,413 - 12,541 2,484
PA Tax Free 17,625 - 25,877 5,000
Growth Index - 4,518 1,562 605
TOTAL $4,190,169 $2,204,123 $2,351,183 $ 458,773
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
FUND PROSPECTUS TOTAL
PRINTING & TRAVEL & 12B-1
SALES ENTERTAINMENT ACCRUAL
PROMOTION
<S> <C> <C> <C>
Common $ 752,231 $ 236,461 $ 9,952
Balanced 166,176 50,442 6,347,823
Mid Cap Growth 61,711 16,692 1,528,854
Small Company 65,369 15,990 438,285
World 59,286 16,616 452,477
High Yield 31,911 9,831 536,938
Bond 45,904 13,975 494,567
Government 31,729 9,484 363,256
Short Maturity 30,391 9,597 142,162
Tax Free 36,725 11,760 253,042
NY Tax Free 6,263 2,122 177,146
PA Tax Free 13,991 4,369 32,161
Growth Index 1,226 284 65,572
TOTAL $1,302,913 $ 397,623 $10,842,235
</TABLE>
Under the Plan applicable to the Class B shares of the Funds, it is
expected that the amounts payable to SFSC will be equal to 1.00% of the net
assets of the Class B shares of the relevant Funds (except that this amount
will be less for the High Yield Fun Class B shares for so long as National
Life maintains a significant investment in High Yield Fund Class B shares).
SFSC will use such payments to recoup the cost of commissions paid to brokers
at the time of sale of the Class B shares, service fees to brokers with
respect to the Class B shares, and the same types of other marketing expenses
for which SFSC receives reimbursement under the Plans applicable to the Class
A shares.
Under the Plan applicable to the Class C shares of the Funds, it is
expected that the amounts payable to SFSC will be equal to 1.00% of the net
assets of the Class C shares of the relevant Funds. SFSC will use such
payments to recoup the cost of commissions paid to brokers at the time of sale
of the Class C shares, and pay continuing commissions and service fees to
brokers with respect to the Class C shares.
Under the Plan applicable to the Class D shares of the Balanced Fund, it
is expected that the amounts payable to SFSC will be equal to 0.75% of the net
assets of the Class D shares of the Balanced Fund. SFSC will use such payments
to recoup the cost of commissions paid to brokers at the time of sale of the
Class D shares.
The Boards of the Funds believe that a consistent cash flow resulting
from the sale of new shares is necessary and appropriate to meet redemptions
and for the Funds to take advantage of buying opportunities without having to
make unwarranted liquidations of portfolio securities. Since SFSC receives no
other compensation from the Funds, the Boards believe it would benefit the
Funds to have monies available for the direct distribution activities of SFSC
in promoting the sale of shares of the Funds.
The Plans have been approved by the Company's Board of Directors and the
Pennsylvania Fund's Board of Trustees, including all of the directors/trustees
who are not interested persons as defined in the 1940 Act. The Plans must be
renewed annually by the Boards, including a majority of the directors/trustees
who are not interested persons and who have no direct or indirect financial
interest in the operation of the Plans. It is also required that the selection
and nomination of such directors/trustees be done by the disinterested
directors/trustees. The Plans and any distribution agreement may be terminated
at any time, without penalty, by such directors/trustees on 60 days' written
notice. SFSC or any dealer may also terminate their respective distribution
agreement at any time upon written notice.
The Plans and any distribution agreement may not be amended to increase
materially the amount spent for distribution expenses or in any other material
way without approval by a majority of the Funds' outstanding shares, and all
such material amendments to any Plan or any distribution agreement also shall
be approved by a vote of a majority of the disinterested directors/trustees,
cast in person at a meeting called for the purpose of voting on any such
amendment.
SFSC is required to report in writing to the Board of Directors of the
Company and the Board of Trustees of the Pennsylvania Fund at least quarterly
on the amounts and purpose of any payments made under the Plans and any
distribution agreement, as well as to furnish the Boards with such other
information as reasonably may be requested in order to enable the Boards to
make informed determinations of whether the Plans should be continued.
THE FUND SERVICES AGREEMENTS
Sentinel Administrative Service Company ("Sentinel Service"), in
accordance with its Fund Services Agreements with the Funds, provides the
Funds with certain fund accounting, financial administration, transfer agency
and shareholder relations services. Sentinel Service performs the transfer
agency responsibilities utilizing, through State Street Bank & Trust - Kansas
City ("State Street"), the computer system of DST Systems, Inc. ("DST") on a
remote basis.
For these services, the Fund Services Agreements currently provide for
the Funds to pay to Sentinel Service fixed fees totalling $896,625 per year
for fund accounting and financial administration services. The Agreements also
provide for an annual fee for transfer agency and shareholder relations
services to the Company and the Pennsylvania Fund of $2,563,000 and $37,000,
respectively, plus amounts equal to annual rates of $15 per shareholder
account in excess of 106,500 and 1,500, respectively, in each case as of the
last day of the month preceding the installment due date. Each Fund also is
responsible for the charges for remote access to the computer system of DST.
Generally, this is a fixed annual charge per shareholder account, plus certain
out-of-pocket expenses, minus certain credits. The fixed fees are subject to
increase under inflation clauses for fiscal years beginning December 1, 1994,
and thereafter, to the extent approved by the Board of Directors or Board of
Trustees. Fees are payable monthly in arrears.
Total fees payable to Sentinel Service under the Fund Services Agreements
for the years ended November 30, 1999, 1998 and 1997 were $3,660,697,
$3,596,581 and $3,526,500, respectively.
Sentinel Service is a Vermont general partnership of which affiliates of
National Life, Provident and Penn Mutual are the general partners.
The Company's Fund Services Agreement was approved by the Company's
shareholders on November 30, 1992, and the Pennsylvania Fund's Fund Services
Agreement was approved by that Fund's shareholders on February 19, 1993. The
agreements were approved by the Company's Board of Directors and the
Pennsylvania Fund's Board of Trustees on August 13, 1992 and August 14, 1992,
respectively. Each agreement must be approved annually by vote of the Board or
by the vote of a majority of the outstanding voting securities of each Fund,
but in either event it must also be approved by a vote of a majority of the
directors/trustees who are not parties to the contract, or interested persons,
as defined in the 1940 Act, of any such party, cast in person at a meeting
called for the purpose of voting on such approval. The Fund Services
Agreements will terminate automatically in the event of their assignment and
are terminable at any time without penalty by the applicable Board or, as to a
particular Fund, by a majority of the applicable Fund's outstanding voting
securities on not more than 60 days' written notice to Sentinel Service and by
Sentinel Service on 60 days' notice to the Fund.
PORTFOLIO TRANSACTIONS
AND BROKERAGE COMMISSIONS
The Funds' policy, other than for the Flex Cap Opportunity Fund, in the
case of listed securities is to place its orders with firms that are members
of a stock exchange on which such securities are listed or traded and in the
case of securities traded in the over-the-counter market to deal directly with
dealers who are primary market makers in such securities, without the use of a
broker unless the Funds can obtain better price or execution through the use
of a broker. Purchases are made for investment and not for trading purposes,
except for the fixed income Funds where trading may be an important factor.
Subject to the direction and control of the Boards and in accordance with its
advisory agreements, the Advisor supervises the investments of the Funds and,
as an essential feature thereof, places orders for the purchase and sale of
portfolio securities and supervises their execution, including negotiating the
amount of the commission rate paid, in each case at prices it believes to be
the best then available, taking into consideration such factors as price,
commission, size of order, difficulty of execution and skill required of the
executing broker-dealer as well as the extent to which a broker capable of
satisfactory execution may provide research information and statistical and
other services to the Advisor. Sales of shares of the Funds may also be
considered as a factor in the selection of broker-dealers to execute portfolio
transactions for the Funds, subject to the conditions that commissions paid to
such broker-dealers be no higher than would otherwise be paid, and that the
prices be, in the judgment of the Advisor, the best then available.
To the extent consistent with applicable provisions of the 1940 Act and
the rules and exemptions adopted by the SEC thereunder, as well as other
regulatory requirements, portfolio transactions for the Flex Cap Opportunity
Fund will be executed through Fred Alger & Company, Incorporated (the "Alger
Broker"), if in the judgment of Alger, the use of the Alger Broker is likely
to result in price and execution at least as favorable as those of other
qualified broker-dealers and if, in particular transactions, the Alger Broker
charges the Flex Cap Opportunity Fund a rate consistent with that charged to
comparable unaffiliated customers in similar transactions. Over-the-counter
purchases and sales are transacted directly with principal market makers
except in those cases in which better prices and executions may be obtained
elsewhere. Principal transactions are not entered into with affiliates of the
Fund except pursuant to exemptive rules or orders adopted by the SEC.
In selecting brokers or dealers to execute portfolio transactions for the
Flex Cap Opportunity Fund, Alger seeks the best overall terms available. In
assessing the best overall terms available for any transaction, Alger will
consider the factors it deems relevant, including the breadth of the market in
the investment, the price of the investment, the financial condition and
execution capability of the broker or dealer and the reasonableness of the
commission, if any, for the specific transaction and on a continuing basis.
In making such purchases and sales, the brokerage commissions are paid by
the Funds. The Funds may also buy or sell securities from, or to, dealers
acting as principals.
Section 28(e) of the 1934 Act, which was enacted by Congress in
connection with the elimination of fixed commission rates on May 1, 1975,
provides that, except as agreements such as investment advisory contracts
otherwise provide, money managers such as the Advisor and the Funds'
subadvisors will not be deemed to have acted unlawfully or to have breached a
fiduciary duty if, subject to certain conditions, a broker-dealer is paid in
return for brokerage and research services an amount of commission for
effecting transactions for accounts, such as the Funds, in excess of the
amount of commission another broker-dealer would charge for effecting the
transaction. In order to cause the Funds to pay such greater commissions, the
Advisor or subadvisor has to determine in good faith that the greater
commission is reasonable in relation to the value of the brokerage and
research services provided by the broker-dealer viewed in terms of either a
particular transaction or the Advisor's or subadvisor's overall
responsibilities to the Funds and to its other clients.
Brokerage and research services, as provided in Section 28(e) of the 1934
Act, include advice as to the value of securities, the advisability of
investing in, purchasing or selling securities, the availability of securities
or purchasers or sellers of securities; furnishing analyses and reports
concerning issuers, industries, securities, economic factors and trends,
portfolio strategy and the performance of accounts and effecting securities
transactions and performing functions incidental thereto (such as clearance,
settlement and custody).
Although research and market and statistical information from brokers and
dealers can be useful to the Funds, to the Advisor, and to the subadvisors, it
is the opinion of the management of the Funds that such information is only
supplementary to the Advisor's and the subadvisors' own research effort since
the information must still be analyzed, weighed and reviewed by the Advisor's
staff or the subadvisors' staffs.
The Advisor obtains several research services specifically in exchange
for commissions paid by the Funds and its other clients. These services
primarily consist of electronic research services from Bloomberg, ILX,
Factset, and First Call. The Funds also obtain Lipper Directors' Analytical
Data from Lipper Analytical Distributors, Inc., in exchange for Fund brokerage
commissions. This service is available only for brokerage commissions.
The research services provided by brokers through which the Funds effect
securities transactions may be used by the Advisor or the subadvisors in
managing its other client accounts, as well as the Funds. However, the Advisor
and the subadvisors use the commissions paid by most of their other client
accounts to obtain research services as well, and this research is also useful
in managing the Funds' accounts, as well those of other clients.
Except for implementing the policies stated above, there is no commitment
to place portfolio transactions with brokers or dealers who provide investment
research. The Advisor has advised the Funds that it is not feasible to assign
any precise value to services provided by such brokers and dealers to it, nor
does the use of such services reduce its expense by any measurable or
significant amount. For the years ended November 30, 1999, 1998 and 1997 the
Funds paid total brokerage commissions of $1,895,116, $1,804,189 and
$1,467,627, respectively. Brokerage commissions paid by each Fund were as
follows:
<PAGE>
Year Ended
Fund 11/30/99 11/30/98 11/30/97
---- -------- -------- --------
Common Stock 1,820,575 $1,152,082 $860,093
Balanced 258,922 194,922 119,380
Mid Cap Growth 254,820 255,666 222,905
Small Company 128,898 201,520 128,474
World 156,812 90,926 136,775
High Yield(1) --- --- ---
Bond --- --- ---
Government Securities --- --- ---
Short Maturity Gov't (2) --- --- ---
Money Market --- --- ---
Tax-Free Income --- --- ---
New York (3) --- --- ---
Pennsylvania --- --- ---
Growth Index (4) --- --- ---
Flex Cap Opportunity(5) --- --- ---
(1) Commenced operations on June 23, 1997
(2) Commenced operations on March 24, 1995.
(3) Commenced operations on March 27, 1995.
(4) Commenced operations on September 10, 1999.
(5) Commenced operations on February 29, 2000.
The Funds paid brokerage commissions of $54,684, $28,702 and $24,384 to
Janney Montgomery Scott Inc. for the fiscal years ended November 30, 1999,
November 30, 1998 and 1997, respectively. Janney Montgomery Scott, Inc. is
wholly owned by Penn Mutual, an affiliate of a general partner of the Advisor.
These commissions were 2.1% of the Funds' aggregate brokerage commissions paid
in the fiscal year ended November 30, 1999. The commission rate applicable to
all such transactions was $.06 per share, the same commission rate paid by the
Funds in all its transactions.
Such commissions were allocated on the basis of research and statistical
or other services provided by the dealer, although selling group dealers may
have participated therein. Of the total commissions paid by the Funds, 100%
was allocated in 1999, 1998 and 1997 to brokers or dealers whose furnishing of
research information was a factor in their selection.
PORTFOLIO TURNOVER
Purchases for the Small Company, Common Stock, Growth Index, World,
Balanced and Pennsylvania Funds are made for long-term investment, and not for
short-term trading profits. However, during rapidly changing conditions, there
necessarily may be more portfolio changes than in a more stable period and
these may result in short-term gains or short-term losses.
The Mid Cap Growth, and Flex Cap Opportunity Funds may have a high level
of portfolio turnover. These Funds may engage in relatively short term trading
in some stocks. This activity may create higher transaction costs due to
commissions and other expenses. In addition, a high level of short term
trading may increase the Mid Cap Growth Fund's and the Flex Cap Opportunity
Fund's realized gains, thereby increasing the amount of taxable distributions
to shareholders at the end of the year.
In pursuit of the investment objectives of the High Yield, Bond,
Government Securities, Short Maturity Government, Tax-Free Income and New York
Funds and the bond portion of the Balanced Fund, it is expected that assets
will be managed actively. In order to maximize income and protect the income
stream or improve the quality of the portfolio, in light of market and
economic conditions as interpreted or anticipated by the Advisor, these Funds'
portfolios will be monitored constantly and will be adjusted when deemed
appropriate in furtherance of the Funds' investment objectives. Portfolio
turnover is the ratio of the lesser of annual purchases or sales of portfolio
securities to average monthly market value, not including short-term
securities.
There were no significant variations in the Funds' portfolio turnover
rates over the two most recently completed fiscal years, or any anticipated
variations in these portfolio turnover rates from those in the fiscal year
ended November 30, 1999, except that portfolio turnover for the Balanced Fund
increased from 81% to 110% due to more active management of the bond portion
of the Fund, and that portfolio turnover increased from 147% to 207% for the
Bond Fund, again due to more active management of the Fund's bond investments.
CAPITALIZATION
Shares of the Company's common stock and shares of beneficial interest in
the Pennsylvania Fund are fully paid and non-assessable. Each such share is
freely assignable to another bona fide investor by way of pledge (as, for
example, for collateral purposes), gift, settlement of an estate and, also, by
an investor who has held such Fund shares for not less than 30 days. Each
share of the Company is entitled to one vote per dollar of net asset value per
share, on matters on which all Funds of the Company vote as a single class.
Each share of the Pennsylvania Fund entitles the holder to one vote for all
purposes.
The proceeds from the sale of shares of each Fund or class of shares of
the Company and all income, earnings and profits therefrom irrevocably
appertain to the Fund or class of shares. Each such Fund or class of shares
records all liabilities (including accrued expenses) in respect of such Fund
or class of shares, as well as a share of such liabilities (including general
liabilities of the Company) in respect to two or more Funds or classes of
shares, in proportion to their average net assets, or in proportion to the
number of their respective shareholders. The Company's Board has adopted an
"Amended Rule 18f-3 Plan" under which the methods of allocating income and
expenses among classes of shares of each Fund which has multiple classes, is
specified, and the Company intends to comply fully with the provisions of Rule
18f-3 under the 1940 Act in allocating income and expenses among the classes
of such Funds. If any reasonable doubt exists as to the Fund or class of
shares to which any asset or liability appertains, the Board may resolve such
doubt by resolution.
In the case of dissolution or liquidation of the Company, the
shareholders of each Fund of the Company are entitled to receive ratably per
share the net assets of such Fund, with any general assets of the Company
distributed ratably per share, regardless of the Fund.
Voting rights are non-cumulative, meaning that the holders of more than
50% of the shares voting for the election of directors/trustees can elect 100%
of the directors/trustees being voted upon if they choose to do so, and, in
such event the holders of the remaining minority of the shares voting for the
election of directors/trustees will not be able to elect any person or persons
to the Board.
HOW TO PURCHASE SHARES
and
REDUCE SALES CHARGES
Shares of the Funds may be purchased at the public offering price from
any authorized investment dealer as described in the Prospectus. The public
offering price of Class A shares, which are offered by every Fund, is the sum
of the current net asset value per share plus a sales charge which ranges from
5.0% to 0% of the purchase price. The public offering price of Class B shares,
which are offered by the Common Stock, Balanced, Mid Cap Growth, Small
Company, World, High Yield and Bond Funds, is equal to the current net asset
value per share. The public offering price of Class C shares, which are
offered by the Common Stock, Balanced, World and High Yield Funds, and the
Class D shares offered by the Balanced Fund, is also equal to the current net
asset value per share. A contingent deferred sales charge ("CDSC") may apply
to redemptions of Class B and Class D shares, redemption of Class C shares in
the first year after purchase, or to redemptions of Class A shares where the
initial sales charge was zero based on a purchase of $1,000,000 or more. See
"Purchase Options" in the Prospectus.
The Group Purchase Program - Clients of a single registered
representative or group of affiliated registered representatives who make
purchases by opening new accounts within a 60-day period and whose funds for
such purchases all originate from a single other source may aggregate such
purchases for purposes of determining the applicable sales charge level or
CDSC schedule for such purchases.
ISSUANCE OF SHARES AT NET ASSET VALUE
Subject to the applicable provisions of the 1940 Act, certain investors
may purchase Class A shares of the Funds at net asset value. Such investors
are listed in the Prospectus. Such investors include officers, directors and
employees of the Funds, the Advisor, and the Advisors' affiliates. See
"Purchase Options - Class A Shares - Reduced Sales Charges" in the Prospectus.
The Funds normally will buy back your shares on demand on any business
day (as defined below). Class A shares generally are repurchased at current
net asset value; a CDSC may be payable on redemptions of Class B, Class C or
Class D shares, or Class A shares of the Money Market Fund received in
exchange for Class C shares of another Fund or Class D shares of the Balanced
Fund, and will be deducted from the redemption proceeds. For further
information, please refer to the Prospectus.
DETERMINATION OF NET ASSET VALUE
The net asset value per share of each Fund or class of shares is computed
by dividing the total value of the assets of that Fund or class of shares,
less its liabilities, by the total number of such Fund's or class of shares'
outstanding shares. Equity securities which are traded on a national
securities exchange are valued at the last reported sale price each business
day at the regular close of trading, currently 4:00 p.m. Eastern time. Equity
securities for which there were no sales during the day are valued at the mean
between the latest available bid and asked prices. Fixed-income securities are
valued daily on the basis of valuations furnished by a pricing service which
determines valuations for normal institutional-sized trading units of debt
securities, without exclusive reliance upon quoted prices. These valuations by
the pricing service are believed to reflect more accurately the fair market
value of such securities than the last reported sale. Net asset value is
calculated once each business day, at 4:00 p.m. Eastern time, and becomes
effective immediately upon its determination. Orders to purchase shares of the
Funds received by dealers prior to 4:00 p.m. Eastern time will be confirmed on
the basis of such closing price, provided they are received by the Distributor
prior to the close of its business day. Orders received by dealers after 4:00
p.m. Eastern time will be confirmed on the same basis as previously stated
with respect to the next business day. "Business day" means a day on which the
New York Stock Exchange is open. The New York Stock Exchange is not open on
New Year's Day, Presidents' Day, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving Day and Christmas Day.
The Money Market Fund values its portfolio securities based on their
amortized cost in accordance with SEC regulations. The amortized cost method
of valuation involves valuing a security at its cost at the time of purchase
and thereafter assuming a constant amortization to maturity of any discount or
premium, regardless of the impact of fluctuating interest rates on the market
value of the instrument. During such periods the yield to investors in the
Money Market Fund may differ somewhat from that obtained in a similar
investment company which uses mark-to-market value for all of its portfolio
securities. For example, if the use of amortized cost resulted in a lower
(higher) aggregate portfolio value on a particular day, a prospective investor
in the Money Market Fund would be able to obtain a somewhat higher (lower)
yield than would result from investment in such a similar company which
utilizes mark-to-market values and existing investors would receive less
(more) investment income. The purpose of this method of calculation is to
attempt to maintain a constant net asset value per share of $1.00.
In accordance with the SEC rule permitting the use of the amortized cost
method of valuation, the Money Market Fund will maintain a dollar-weighted
average portfolio maturity of 90 days or less, and must purchase instruments
having remaining maturities of 397 days (13 months) or less. In addition, the
Directors of the Company have established procedures designed to stabilize, to
the extent reasonably possible, the Money Market Fund's price per share as
computed for the purpose of sales and redemptions at $1.00. The Company's
Directors will review periodically the Money Market Fund's portfolio holdings
to determine whether a deviation exists between the net asset value calculated
using market quotations and that calculated on an amortized cost basis. In the
event the directors determine that a deviation exists which may result in
material dilution or other unfair results to existing shareholders, the Money
Market Fund will take such corrective action as it regards as necessary and
appropriate, including (i) the reduction of the number of outstanding shares
of the Money Market Fund by having each shareholder proportionately contribute
shares to the Money Market Fund's capital, (ii) the sale of portfolio
instruments prior to maturity to realize capital gains or losses or to shorten
average portfolio maturity, (iii) the withholding of dividends or (iv) the
establishment of a net asset value per share by using available market
quotations. If the number of outstanding shares is reduced in order to
maintain a constant net asset value of $1.00 per share, the shareholders will
contribute proportionately to the Money Market Fund's capital the number of
shares which represent the difference between the amortized cost valuation and
the market valuation of the portfolio. Each shareholder will be deemed to have
agreed to such contribution by such shareholder's investment in the Money
Market Fund.
Since the net income of the Money Market Fund is determined and declared
as a dividend immediately prior to each time the asset value of the Money
Market Fund is determined, the net asset value per share of the Money Market
Fund normally remains at $1.00 per share immediately after each such dividend
declaration. Any increase in the value of a shareholder's investment in the
Money Market Fund, representing the reinvestment of dividend income, is
reflected by an increase in the number of shares of the Money Market Fund in
that shareholder's account and any decrease in the value of a shareholder's
investment may be reflected by a reduction in the number of shares in the
account. See "Taxes" below.
<PAGE>
COMPUTATION OF MAXIMUM OFFERING PRICES AT NOVEMBER 30, 1999
Class A Shares:
(Reduced offering prices apply on purchases of $100,000 or more of shares of
the Funds, as described in the Prospectus.)
<TABLE>
<CAPTION>
Common Mid Cap Small
Stock Balanced Growth Company World
Fund Fund Fund Fund Fund
<S> <C> <C> <C> <C> <C>
Net assets $1,538,670,516 $297,027,373 $140,632,815 $107,919,194 $107,413,034
Shares outstanding 35,854,259 15,326,401 7,902,012 18,785,106 5,047,081
Net asset value per
share (redemption
price) $42.91 $19.38 $17.80 $5.74 $21.28
Maximum offering
price per share* $45.17 $20.40 $18.74 $6.04 $22.40
==============================================================================================================
==============================================================================================================
Government Short Maturity
Bond Securities Gov't. Money Market
Fund Fund Fund Fund
Net assets $82,106,965 $65,136,283 $67,647,478 $121,884,133
Shares outstanding 13,816,817 6,813,609 7,061,732 121,884,133
Net asset value per
share (redemption
price) $5.94 $9.56 $9.58 $1.00
Maximum offering
price per share* $6.19 $9.96 $9.68 $1.00
==============================================================================================================
==============================================================================================================
Tax-Free
Income New York Pennsylvania High Yield Growth
Fund Fund Fund Bond Fund Index Fund
Net assets $85,974,722 $16,175,014 $30,630,106 $28,252,770 $28,530,231
Shares outstanding 6,822,312 1,444,375 2,521,307 3,074,099 1,339,455
Net asset value per
share (redemption
price) $12.60 $11.20 $12.15 $9.19 $21.30
Maximum offering
price per share* $13.13 $11.67 $12.66 $9.57 $21.85
==============================================================================================================
==============================================================================================================
</TABLE>
The Flex Cap Opportunity Fund did not exist as of November 30, 1999.
For the Common Stock Fund, Balanced Fund, Mid Cap Growth Fund, Small Company
Fund and World Fund, the maximum offering price is 1000/950 times the net
asset value per share. For the High Yield Bond Fund, Bond Fund, Government
Securities Fund, Tax-Free Income Fund, New York Tax-Free Income Fund and
Pennsylvania Tax-Free Trust, the maximum offering price is 1000/960 times the
net asset value per share. For the Short Maturity Government Fund, the maximum
offering price is 1000/990 times the net asset value per share. For the Money
Market Fund, the maximum offering price per share is equal to the net asset
value per share. For the Growth Index Fund, the maximum offering price is
1000/975 times the net asset value per share.
In the case of Class B, Class C shares and Class D shares, the maximum
offering price is equal to the net asset value per share.
TAXES
General
-------
Each Fund intends to continue to qualify (and the Flex Cap Opportunity
Fund intends to elect and to qualify) for the special tax treatment afforded
regulated investment companies ("RICs") under the Code. As long as it so
qualifies, a Fund will not be subject to federal income tax on the part of its
net ordinary income and net realized capital gains which it distributes to
Class A, Class B Class C and Class D shareholders, as applicable. Each Fund
intends to distribute substantially all of such income.
As discussed in the Prospectus, the Company consists of fourteen separate
Funds. Each such Fund is treated as a separate corporation for federal income
tax purposes and is thus considered to be a separate entity in determining its
treatment under the rules for RICs described in the Prospectus. Losses in one
Fund do not offset gains in another Fund, and the requirements (other than
certain organizational requirements) for qualifying for RIC status are
determined at the Fund level rather than at the Company level.
Dividends paid by a Fund from its ordinary income or from an excess of
net short-term capital gains over net long-term capital losses (together
referred to hereafter as "ordinary income dividends") are taxable to
shareholders as ordinary income for federal income tax purposes. However,
"exempt-interest dividends" (as defined in Section 852(b)(5) of the Code) not
subject to federal income tax are expected to be paid by the Tax-Free Income
Fund, "exempt-interest dividends" not subject to either federal income tax or
Pennsylvania personal income tax are expected to be paid by the Pennsylvania
Fund, and "exempt-interest dividends" not subject to either federal income tax
or New York State and City personal income tax are expected to be paid by the
New York Fund, as described in the Prospectus. Distributions made from an
excess of net long-term capital gains over net short-term capital losses
(hereinafter referred to as "capital gain dividends") are taxable to
shareholders as long-term capital gains for federal income tax purposes,
regardless of the length of time the shareholder has owned such Fund's shares.
Certain categories of capital gains are taxable at different rates. Generally
not later than 60 days after the close of its taxable year, each Fund will
provide its shareholders with a written notice designating the amounts of any
exempt-interest dividends and capital gain dividends, (as well as any amount
of capital gain dividends in the different categories of capital gain referred
to above), and the portion of any ordinary income dividends eligible for the
dividends received deduction allowed to corporations under the Code. Any loss
upon the sale or exchange of Fund shares held for six months or less will be
disallowed for federal income tax purposes to the extent of any capital gain
dividends received by the shareholder. Distributions in excess of a Fund's
earnings and profits will first reduce the adjusted tax basis of a holder's
shares and, after such adjusted tax basis is reduced to zero, will constitute
capital gains to such holder for federal income tax purposes (assuming the
shares are held as a capital asset).
With the exception of exempt-interest dividends paid by the Tax-Exempt
Funds, dividends are taxable to shareholders for federal income tax purposes
even though they are reinvested in additional shares of the Funds. Generally,
distributions by the Tax-Exempt Funds, the World Fund, the Bond Fund, the
Government Securities Fund, the High Yield Fund, the Short Maturity Government
Fund and the Money Market Fund will not be eligible for the dividends received
deduction allowed to corporations under the Code. The Funds will allocate any
dividends eligible for dividends received deduction among theClass A, Class B,
Class C and Class D shareholders as applicable according to a method (which
they believe is consistent with SEC Rule 18f-3 which authorizes the issuance
and sale of multiple classes of shares) that is based on the gross income
allocable to Class A, Class B, Class C and Class D shares during the taxable
year, or such other method as the Internal Revenue Service may prescribe. If a
Fund pays a dividend in January which was declared in the previous October,
November or December to shareholders of record on a specified date in one of
such months, then such dividend will be treated for federal income tax
purposes as having been paid by the RIC and received by its shareholders on
December 31st of the year in which the dividend was declared.
If the value of assets held by the Money Market Fund declines, the Board
of Directors may authorize a reduction in the number of outstanding shares in
shareholders' accounts so as to preserve a net asset value of $1.00 per share.
After such a reduction, the basis of eliminated shares will, for federal
income tax purposes, be added to the basis of shareholders' remaining Fund
shares, and any shareholders disposing of shares at that time may recognize a
capital loss. Distributions, including distributions reinvested in additional
shares of the Fund, will nonetheless be fully taxable for federal income tax
purposes, even if the number of shares in shareholders' accounts has been
reduced as described above.
Under certain provisions of the Code, some shareholders may be subject to
a 31% withholding tax on most ordinary income dividends and on capital gain
dividends and redemption payments ("backup withholding"). Generally,
shareholders subject to backup withholding will be those for whom no certified
taxpayer identification number is on file with the Company or the Pennsylvania
Fund, as the case may be, or who, to the Company's or Pennsylvania Fund's
knowledge, have furnished an incorrect number. When establishing an account,
an investor must certify under penalty of perjury that such number is correct
and that such investor is not otherwise subject to backup withholding.
Ordinary income dividends paid to shareholders who are nonresident aliens
or foreign entities will be subject to a 30% United States withholding tax
under existing provisions of the Code applicable to foreign individuals and
entities, unless a reduced rate of withholding or a withholding exemption is
provided under applicable treaty law. Nonresident shareholders are urged to
consult their own tax advisors concerning the applicability of the United
States withholding tax.
Dividends and interest received by the World Fund (and to a lesser
extent, some of the other Funds) may give rise to withholding and other taxes
imposed by foreign countries. Tax conventions between certain countries and
the United States may reduce or eliminate such taxes. Shareholders of the
World Fund may be able to claim United States foreign tax credits with respect
to such taxes, subject to certain conditions and limitations contained in the
Code. A foreign tax credit to be claimed with respect to withholding tax on a
dividend only if the shareholder meets certain holding period requirements. A
Fund also must meet these holding period requirements, and if the Fund fails
to do so, it will not be able to "pass through" to shareholders the ability to
claim a credit or a deduction for the related foreign taxes paid by such Fund.
If a Fund satisfies the holding period requirements and if more than 50% in
value of a Fund's total assets at the close of its taxable year consists of
securities of foreign corporations, such Fund will be eligible to file an
election with the Internal Revenue Service pursuant to which shareholders of
the Fund will be required to include their proportionate shares of such
withholding taxes in their United States income tax returns as gross income,
treat such proportionate shares as taxes paid by them, and deduct such
proportionate shares in computing their taxable incomes or, alternatively, use
them as foreign tax credits against their United States income taxes. No
deductions for foreign taxes, moreover, may be claimed by noncorporate
shareholders who do not itemize deductions. A shareholder that is a
nonresident alien individual or a foreign corporation may be subject to United
States withholding tax on the income resulting from a Fund's election
described in this paragraph but may not be able to claim a credit or deduction
against such United States tax for the foreign taxes treated as having been
paid by such shareholder. Additionally, certain retirement accounts cannot
claim foreign tax credits on investments in foreign securities held in a Fund.
The World Fund, and other Funds to the extent applicable, will report annually
to shareholders the amount per share of such withholding taxes and other
information needed to claim the foreign tax credit. For purposes of passing
through the foreign tax credit, the World Fund will allocate foreign taxes and
foreign source income among the Class A, Class B and Class C shares according
to a method similar to that described above for the allocation of dividends
eligible for the dividends received deduction.
No gain or loss will be recognized for federal income tax purposes by
Class B shareholders on the conversion of their Class B shares into Class A
shares. A shareholder's basis in the Class A shares acquired will be the same
as such shareholder's basis in the Class B shares converted, and the holding
period of the acquired Class A shares will include the holding period for the
converted Class B shares.
If a shareholder exercises an Exchange Privilege as described below
within 90 days of acquiring such shares, then the loss such shareholder can
recognize on the exchange for federal income tax purposes will be reduced (or
the gain increased) to the extent any sales charge paid to the Company (or
Pennsylvania Fund) reduces any sales charge such shareholder would have owed
for the shares of the new Fund in the absence of the Exchange Privilege.
Instead, such sales charge will be treated as an amount paid for the new
shares. Shareholders should consult their tax advisers regarding the state and
local tax consequences of exchanging or converting classes of shares.
A loss realized on a sale or exchange of shares of a Fund will be
disallowed for federal income tax purposes if other Fund shares are acquired
(whether through the automatic reinvestment of dividends or otherwise) within
a 61-day period beginning 30 days before and ending 30 days after the date the
shares are disposed of. In such a case, the basis of the shares acquired will
be adjusted to reflect the disallowed loss.
The Code requires each Fund to pay a non-deductible 4% excise tax to the
extent it does not distribute, during each calendar year, 98% of its ordinary
income, determined on a calendar year basis, and 98% of its capital gains and
foreign currency gains, determined on a November 30th year end, plus certain
undistributed amounts from previous years. The Company and the Pennsylvania
Fund anticipate that the Funds will make sufficient timely distributions to
avoid the imposition of the excise tax. Since the required distributions are
based only on taxable income, the excise tax generally will not apply to the
Tax-Exempt Funds, discussed below.
At November 30, 1999, the Bond, Government Securities, Short Maturity
Government, High Yield, Tax-Free, New York Tax-Free and Pennsylvania Tax-Free
Funds had capital loss carryforwards for federal income tax purposes of
$6,920,574, $7,707,369, $2,856,394, $6,033,602, $668,431, $310,230 and
$96,951, respectively.
Tax-Exempt Funds
----------------
The Tax-Exempt Funds intend to continue to qualify to pay exempt-interest
dividends. The relevant Code provision states that if, at the close of each
quarter of the respective Fund's taxable year, at least 50% of the value of
its total assets consists of obligations exempt from federal income tax
("tax-exempt obligations") under Section 103(a) of the Code (relating
generally to obligations of a state or local governmental unit), such Fund
shall be qualified to pay exempt-interest dividends to its shareholders.
Exempt-interest dividends are dividends or any part thereof paid by a
Tax-Exempt Fund which are attributable to interest on tax-exempt obligations
and designated by the Company or the Pennsylvania Fund, as the case may be, as
exempt-interest dividends in a written notice mailed to shareholders within 60
days after the close of the Fund's taxable year. Exempt-interest dividends may
be treated by shareholders for all purposes as items of interest excludable
from their federal gross income under Code Section 103(a). Exempt-interest
dividends are included, however, in determining the portion, if any, of a
person's social security benefits and railroad retirement benefits subject to
federal income taxes. Interest on indebtedness incurred or continued to
purchase or carry shares of a RIC paying exempt-interest dividends will not be
deductible by the shareholder for federal income tax purposes to the extent
attributable to exempt-interest dividends. Each shareholder is advised to
consult a tax advisor with respect to whether exempt-interest dividends retain
the exclusion under Code Section 103(a) if such shareholder were to be treated
as a "substantial user" or "related person" under Code Section 147(a) with
respect to property financed with the proceeds of an issue of "industrial
development bonds" or "private activity bonds", if any, held by the Tax-Exempt
Funds.
All or a portion of the Tax-Exempt Funds' gain from the sale or
redemption of tax-exempt obligations purchased at a market discount will be
treated as ordinary income for federal income tax purposes rather than capital
gain. This rule may increase the amount of ordinary income dividends received
by shareholders of these Funds.
Any loss upon the sale or exchange of Tax-Exempt Fund shares held for six
months or less will be disallowed for federal income tax purposes to the
extent of any exempt-interest dividends received by the shareholder. In
addition, any such loss that is not disallowed under the rule stated above
will be treated as long-term capital loss to the extent of any capital gain
dividends received by the shareholder.
The Code subjects interest received on certain otherwise tax-exempt
securities to a federal AMT. The AMT applies to interest received on private
activity bonds issued after August 7, 1986. Private activity bonds are bonds
which, although tax-exempt, are used for purposes other than those generally
performed by governmental units and which benefit non-governmental entities
(e.g., bonds used for industrial development or housing purposes). Income
received on such bonds is classified as an item of "tax preference" which
could subject investors in such bonds, including shareholders of the
Tax-Exempt Funds, to an AMT. The Tax-Exempt Funds may purchase such private
activity bonds, and will report to shareholders before February 1 of each year
the portion of such Fund's dividends declared during the preceding calendar
year which constitutes an item of tax preference for AMT purposes. The Code
further provides that corporations are subject to an AMT based, in part, on
certain differences between taxable income as adjusted for other tax
preferences and the corporation's "adjusted current earnings", which more
closely reflect a corporation's economic income. Because an exempt-interest
dividend paid by a Tax-Exempt Fund will be included in adjusted current
earnings, a corporate shareholder may be required to pay the AMT on
exempt-interest dividends paid by such Funds.
The Code provides that every person required to file a tax return must
include on such return the amount of exempt-interest dividends received from
the Tax-Exempt Funds during the taxable year.
Tax Treatment of Options and Futures Transactions
-------------------------------------------------
The Tax-Exempt Funds may purchase or sell financial futures contracts and
call and put options on financial futures contracts. In general, unless an
election is available to a Fund or an exception applies, such options and
futures contracts that are "Section 1256 contracts" will be "marked to market"
for federal income tax purposes at the end of each taxable year, i.e., each
such option or financial futures contract will be treated as having been sold
for its fair market value on the last day of the taxable year, and any gain or
loss attributable to Section 1256 contracts will be 60% long-term and 40%
short-term capital gain or loss. Application of these rules to Section 1256
contracts held by the Tax-Exempt Funds may alter the timing and character of
distributions to shareholders. The mark-to-market rules outlined above,
however, will not apply to certain transactions entered into by the Tax-Exempt
Funds solely to reduce the risk of changes in price or interest rates with
respect to their investments.
Code Section 1092, which applies to certain "straddles", may affect the
taxation of the Tax-Exempt Funds' sales of securities and transactions in
financial futures contracts or options thereon and the World Fund's sales of
securities and transactions in forward foreign exchange contracts, discussed
below. Under Section 1092, the Tax-Exempt Funds may be required to postpone
recognition for tax purposes of losses incurred in certain sales of securities
and closing transactions in financial futures contracts or options thereon.
The World Fund likewise may be required to postpone recognition of losses in
connection with its forward foreign exchange contracts.
Foreign Currency Transactions
-----------------------------
In general, gains from "foreign currencies" and from foreign currency
options, foreign currency futures and forward foreign exchange contracts
relating to investments in stock, securities or foreign currencies will be
qualifying income for purposes of determining whether a Fund qualifies as a
RIC. It is currently unclear, however, who will be treated as the issuer of a
foreign currency instrument or how foreign currency options, foreign currency
futures and forward foreign exchange contracts will be valued for purposes of
the diversification requirements applicable to RICs.
A forward foreign exchange contract held by the World Fund that is a
Section 1256 contract will be marked to market, as described under "Tax
Treatment of Options and Futures Transactions". However, the character of gain
or loss from such a contract will generally be ordinary under Code Section
988, as discussed below. The World Fund may, nonetheless, elect to treat the
gain or loss from certain forward foreign exchange contracts as capital. In
this case, gain or loss realized in connection with a forward foreign exchange
contract that is a Section 1256 contract will be characterized as 60%
long-term and 40% short-term capital gain or loss.
Under the Code Section 988, special rules are provided for certain
transactions in a currency other than the taxpayer's functional currency
(i.e., unless certain special rules apply, currencies other than the U. S.
dollar). In general, foreign currency gains or losses from certain debt
instruments, from certain forward contracts, from futures contracts that are
not "regulated futures contracts" and from unlisted options will be treated as
ordinary income or loss under Code Section 988. In certain circumstances, a
Fund may elect capital gain or loss treatment for such transactions. In
general, however, Code Section 988 gains or losses will increase or decrease
the amount of a Fund's investment company taxable income available to be
distributed to shareholders as ordinary income. Additionally, if Code Section
988 losses exceed other investment company taxable income during a taxable
year, a Fund would not be able to make any ordinary income dividend
distributions, and all or a portion of distributions made before the losses
were realized but in the same taxable year would be recharacterized as a
return of capital to shareholders, thereby reducing the basis of a
shareholder's Fund shares and resulting in a capital gain for any shareholder
who received a distribution greater than such shareholder's basis in the Fund
shares (assuming the shares were held as a capital asset). These rules,
however, will not apply to certain transactions entered into by a Fund solely
to reduce the risk of currency fluctuations with respect to its investments.
The foregoing is a general and abbreviated summary of the applicable
provisions of the Code and Treasury Regulations presently in effect. For the
complete provisions, reference should be made to the pertinent Code section
and the Treasury Regulations promulgated thereunder. The Code and the Treasury
Regulations are subject to change by legislative, judicial or administrative
action either prospectively or retroactively.
Ordinary income and capital gain dividends may also be subject to state
and local taxes.
Certain states exempt from state income taxation dividends paid by RICs
that are derived from interest on U.S. Government Securities. State law varies
as to whether dividend income attributable to U.S. Government Securities is
exempt from state income taxes.
Shareholders are urged to consult their tax advisors regarding specific
questions as to federal, foreign, state or local taxes. Foreign investors
should consider applicable foreign taxes in their evaluation of an investment
in the Funds.
SHAREHOLDER SERVICES
Open Account An open account is established automatically for each new
investor, unless elected otherwise, in which all income dividends and any
capital gains distributions are reinvested in additional shares, without
charge, at the then current net asset value. Purchases made in this account
will be made at the offering price on the day federal funds are available to
the Funds as described in the Prospectus.
The Funds reserve the right at any time to vary the initial and
subsequent investment minimums of any Fund.
Policyowners of National Life, Provident or Penn Mutual who invest policy
dividends may open an account in any of the Funds with a minimum initial
purchase of $50 or more of policy dividends and subsequent assignment of
dividends to the Funds.
Stock certificates will be issued upon written request and without
charge.
Except for confirmation of purchases made under the Open Account, the
cost of these shareholder services are borne by the Funds.
Automated Clearing House ("ACH") The ACH Network expedites the transfer
of monies by electronically transmitting funds between member financial
institutions. To take advantage of this convenient fund transfer method, you
must provide Sentinel Service with a pre-designated destination. There is no
charge for this service.
Distribution Options Shareholders of the Funds may elect to reinvest
automatically their income dividends and any capital gains distributions in
additional full and fractional shares of any one of the other Funds at the net
asset value of the selected Fund at the close of business on the valuation
date for the dividend, without the payment of any charge. Before exercising
this option, shareholders should read the portions of the Prospectus relating
to the selected Fund's objectives and policies. The target and original
accounts for dividends must be in different Funds.
Automatic Investment Plan See the Prospectus for information and an
application. The minimum initial investment and subsequent investment is $50.
Telephone Investment Service See the Prospectus for information and an
application.
Check Writing Service (Class A shares of the High Yield, Bond, Government
Securities, Short Maturity Government, Money Market, Tax-Free Income, New York
and Pennsylvania Funds) A special feature of the Class A shares of these Funds
is the Check Writing privilege available through State Street. Any shareholder
who would like to draw checks on his account should check the box on the
application captioned "Check Writing Service" or subsequently, make a written
request to the Funds. Checks then will be provided by State Street. These
checks may be made payable in any amount not less than $500, except for the
Money Market Fund which has a minimum amount of not less than $250.
Withdrawals by check may not be made until shares have been in the account for
at least fifteen (15) days. The price at which shares will be redeemed to
cover a check will be the net asset value determined on the day the check
clears. Potential fluctuations in net asset value of the Funds' shares should
be taken into account when writing checks. If a dividend or capital gains
distribution is paid during the period between writing and clearing of a
check, the shareholder will be entitled to the dividend or distribution, but
the net asset value of the shares will be reduced by the amount of the
dividend payment. Because shareholders cannot determine the exact redemption
price of their shares at the time a check is written, closing an account
through check writing is not possible.
Sentinel Service provides overdraft protection by automatically
transferring available funds from your other identically registered accounts
if you have available balances. A fee of $10.00 will be charged to the account
when funds are transferred from protecting account(s) to cover an overdraft.
There is no fee for check writing, but, upon notice, a fee for this
service may be charged in the future. Fees are charged for stop payments,
insufficient funds or other valid reasons.
Exchange Privilege This privilege also permits a shareholder whose
financial needs have changed to transfer an investment from a National Life
Variable Annuity account (presently the only such entity is the Variable
Annuity Account I). Such transfers from a National Life Variable Annuity
account are made without a sales charge on the basis of respective net asset
values after payment of a fee of $75 (in addition to any applicable transfer
taxes) to Sentinel Service for such transfer.
An exchange is a taxable transaction for income tax purposes and any gain
or loss realized is recognizable for such purposes.
Exchanges may be subject to certain limitations and are subject to the
Funds' policies concerning excessive trading practices, which are policies
designed to protect the Funds and their shareholders from the harmful effect
of frequent exchanges. These limitations are described below under the
captions "Right to Reject or Restrict Purchase and Exchange Orders" and
"Excessive Trading Practices".
Reinstatement Privilege Shareholders who have redeemed all or part of
their shares may reinvest all or part of the redemption proceeds at the
current net asset value without charge if a written request is received or is
postmarked within one year after the redemption. Short Maturity Government
Fund shareholders who have held their shares for 90 days or less, however, may
only use the reinstatement privilege to reinvest in the Short Maturity
Government Fund. The privilege may be exercised only once by a shareholder as
to any of the Funds except where the sole purpose of the transaction is to
transfer the shareholder's interest or a portion thereof in the Funds to a
trustee or custodian for such shareholder's Self-Employed Retirement Plan or
IRA. If the shareholder realizes a gain on redemption, the transaction is
taxable and reinvestment will not alter any capital gains tax payable. If the
shareholder realizes a loss on redemption and subsequently uses the
reinstatement privilege, some or all of the loss may not be allowed as a tax
deduction depending upon the amount reinvested.
If the reinstatement is made for the purpose of effecting a rollover into
an IRA, as described in Section 408(d)(3) of the Code, of a distribution from
a tax sheltered retirement plan which had been invested in shares of the
Funds, such reinvestment of redemption proceeds may be made any time within 60
days from the date on which the investor received the distribution.
Right To Reject Purchase and Exchange Orders. Purchases and Exchanges
should be made for investment purposes only. The Funds each reserve the right
to reject or restrict any specific purchase or exchange request. Because an
exchange request involves both a request to redeem shares of one Fund and to
purchase shares of another Fund, the Funds consider the underlying redemption
and purchase requests conditioned upon the acceptance of each of these
underlying requests. Therefore, in the event that the Funds reject an exchange
request, neither the redemption nor the purchase side of the exchange will be
processed. When a Fund determines that the level of exchanges on any day may
be harmful to its remaining shareholders, the Fund may delay the payment of
exchange proceeds for up to seven days to permit cash to be raised through the
orderly liquidation of its portfolio securities to pay the redemption
proceeds. In this case, the purchase side of the exchange will be delayed
until the exchange proceeds are paid by the redeeming Fund.
Excessive Trading Practices. Excessive, short-term (market timing)
trading practices may disrupt portfolio management strategies and harm Fund
performance. As noted above, the Funds reserve the right to reject or restrict
any purchase order (including exchanges) from any investor. To minimize harm
to the Funds and their shareholders, the Funds will exercise these rights if
an investor has a history of excessive trading, or if an investor's trading,
in the judgment of the Funds, has been or may be disruptive to a Fund. In
making this judgment, the Funds may consider trading done in multiple accounts
under common ownership or control.
TOTAL RETURN, YIELD AND TAX-EQUIVALENT YIELD INFORMATION
Each of the Funds (except the Money Market Fund) from time to time may
include its average annual total return in advertisements or information
furnished to present or prospective shareholders. The average annual total
return for each of the Funds for the one, five and ten year periods ended
November 30, 1999 were:
<TABLE>
<CAPTION>
Average Annual Total Return for the
-----------------------------------
One Year Ended Five Years Ended Ten Years Ended
November 30, 1999 November 30, 1999 November 30, 1999
----------------- ----------------- -----------------
<S> <C> <C> <C>
Common Stock Fund-A 0.6% 18.6% 13.2%
Common Stock Fund-B 1.1% 13.7%(6)
Common Stock Fund-C 4.0 1.6 (10)
Balanced Fund-A -2.6% 12.9% 10.0%
Balanced Fund-B -2.2% 9.3%(6)
Balanced Fund-C 0.4 0.8(10)
Balanced Fund-D(9) N/A N/A N/A
Mid Cap Growth Fund-A 23.9% 21.2% 12.8%
Mid Cap Growth Fund-B 25.0 19.1(11)
Small Company Fund-A -2.5% 10.9% 10.5%(2)
Small Company Fund-B -1.8% 9.9%(6)
World Fund-A 12.2% 12.1% 13.7%(2)
World Fund-B 13.1% 11.6%(6)
World Fund-C 15.8 4.2
High Yield Fund - A -1.2% 3.6%(1) N/A
High Yield Fund - B -1.51% 3.4%(1) N/A
High Yield Fund - C 0.7% -2.6
Bond Fund-A -5.9% 6.1% 6.9%
Bond Fund-B -6.7% 2.9%(6)
Gov. Sec. Fund-A -6.4% 6.1% 6.6%
Short Maturity Fund-A 2.1% 5.7%(3) N/A
Tax-Free Income Fund-A -6.7% 5.3% 6.1%(4)
New York Fund-A -7.2% 4.4%(5) N/A
Pennsylvania Fund-A -7.1% 4.9% 5.3%
Growth Index Fund-A(7) N/A N/A N/A
Growth Index Fund-B(7) N/A N/A N/A
Flex Cap Opp. Fund-A(8) N/A N/A N/A
Flex Cap Opp. Fund-B(8) N/A N/A N/A
Flex Cap Opp. Fund-C(8) N/A N/A N/A
(1) For the period June 23, 1997 (commencement of operations) through November 30, 1999.
(2) For the period from March 1, 1993 (commencement of operations) through November 30, 1999.
(3) For the period from March 24, 1995 (commencement of operations) through November 30, 1999.
(4) For the period from October 1, 1990, when Sentinel Tax-Free Income Fund commenced operations, through November 30, 1999.
(5) For the period from March 27, 1995 (commencement of operations) through November 30, 1999.
(6) For the period from April 1, 1996 (commencement of operations) through November 30, 1999.
(7) Commenced operations on September 10, 1999.
(8) Commenced operations on February 25, 2000.
(9) Commenced operations on January 4, 1999.
(10) For the period May 4, 1998 through November 30, 1999
(11) For the period January 12, 1998 through November 30, 1999.
</TABLE>
The above amounts were computed by assuming a hypothetical initial
payment of $1,000. From this $1,000 the maximum sales load of $50 (5.0% of the
public offering price for the Class A shares of the Common Stock, Balanced,
Mid Cap Growth, Small Company and World Funds; $40 (4.0% of the public
offering price for the Class A shares of the Bond, Government Securities,
Tax-Free Income, New York and Pennsylvania Funds); and $10 (1% for the Class A
shares of the Short Maturity Government Fund) was deducted. It then was
assumed that all of the dividends and distributions by each of the Funds over
the relevant time period were reinvested. It then was assumed that at the end
of the one-, five- or ten-year period, after taking into account all
applicable recurring and nonrecurring expenses, the entire amount was
redeemed. The average annual total return then was calculated by calculating
the annual rate required for the initial payment to grow to the amount which
would have been received upon redemption (i.e., the average annual compound
rate of return). For the Class B shares, the maximum offering price is equal
to the net asset value, and it is assumed that the investment is redeemed at
the end of the period. No information is shown for the Class D shares of the
Balanced Fund and the Class A and B shares of the Growth Index Fund, since
they had less than one year of results as of November 30, 1999, or for the
Class A, B and C shares of the Flex Cap Opportunity Fund, which had not begun
operations as of November 30, 1999.
Each Fund's average annual total return and current yield will vary
depending upon market conditions, the securities comprising such Fund's
portfolio, such Fund's operating expenses and the amount of net capital gains
or losses realized by such Fund during the period. An investment in any of the
Funds will fluctuate and an investor's shares, when redeemed, may be worth
more or less than their original cost.
Each of the Funds also from time to time may advertise its total return
for specified periods without subtracting the sales load, to illustrate better
the performance of money already invested in the Fund during those periods.
On occasion, the Funds may compare their average annual total return
figures to mutual fund averages such as those compiled by Lipper Analytical
Services, Inc., and to market indices such as the Dow Jones Industrial
Average, the Standard & Poor's 500, the Standard & Poors 500 BARRA Growth
Index, the Standard & Poors 500 BARRA Value Index, the Standard and Poors 400
Midcap Index, the Russell 2000 Index and the Shearson Lehman Aggregate Bond
Index.
The High Yield, Bond, Tax-Free Income, Pennsylvania, New York, Government
Securities and Short Maturity Government Funds' annualized yields for the
30-day period ended November 30, 1999 were:
Class A Shares Class B Shares Class C shares
-------------- -------------- --------------
High Yield 9.51% 9.25% 9.717%
Bond Fund 6.55% 5.93%
Tax-Free Income 4.68% NA
Pennsylvania 4.63% N/A
New York 5.28% N/A
Gov.'t Securities 6.74% N/A
Short Maturity 6.18% N/A
The average daily number of shares outstanding during the period that were
eligible to receive dividends were:
Class A Shares Class B Shares Class C Shares
-------------- -------------- --------------
High Yield 3,110,715 6,500,475 386,340
Bond Fund 13,704,465 3,413,556
Tax-Free Income 6,849,094 N/A
Pennsylvania 2,526,913 N/A
New York 1,444,874 N/A
Gov.'t Securities 6,879,850 N/A
Short Maturity 7,193,612 N/A
Income was computed by totalling the interest earned on all debt obligations
during the 30-day period and subtracting from that amount the total of all
recurring expenses incurred during the period. The 30-day yield then was
annualized on a bond equivalent basis assuming semi-annual reinvestment and
compounding of net investment income.
These Funds also may show yield to those already invested in the Funds by
using the net asset value per share instead of the maximum offering price per
share in the above calculations, which has the effect of raising the quoted
yields. Using net asset values, the yields of the Class A shares of the High
Yield, Bond, Tax-Free Income, Pennsylvania, New York, Government Securities
and Short Maturity Government Funds as of November 30, 1999 were $9.91%,
6.83%, 4.88%, 4.82%, 5.51%, 7.02% and 6.25%, respectively.
In addition, the Tax-Free Income, Pennsylvania and New York Funds may
quote tax-equivalent yield in advertisements. The calculation of
tax-equivalent yield is done by multiplying the tax-exempt part of the Fund's
yield by an amount which is one minus a stated tax rate, and adding the result
to that part, if any, of the Fund's yield that is taxable. As of November 30,
1999, the tax-equivalent yield of the Tax-Free Income Fund was 8.08 %, the
tax-equivalent yield of the Pennsylvania Fund was 8.21%, and the
tax-equivalent yield of the New York Fund was 9.79%. For purposes of the above
tax-equivalent yield calculations the assumed federal tax rate is 39.6%. In
the case of the New York and Pennsylvania Funds, the assumed combined federal
and state tax rates are 43.74% and 41.29%, respectively.
The Money Market Fund normally computes its annualized yield by
determining the net income for a seven-day base period for a hypothetical
pre-existing account having a balance of one share at the beginning of the
base period, dividing the net income by the net asset value of the account at
the beginning of the base period to obtain the base period return, multiplying
the result by 365 and then dividing by seven. In accordance with regulations
adopted by the SEC, the Money Market Fund is required to disclose its
annualized yield for certain seven-day base periods in a standardized manner
which does not take into consideration any realized or unrealized gains or
losses on portfolio securities. The SEC also permits the calculation of a
standardized effective or compounded yield. This is computed by compounding
the unannualized base period return which is done by adding one to the base
period return, raising the sum to a power equal to 365 divided by seven and
subtracting one from the result.
The yield quoted should not be considered a representation of the yield
of the Money Market Fund in the future since the yield is not fixed. Actual
yields will depend not only on the type, quality and maturities of the
investments held by the Money Market Fund and changes in interest rates on
such investments, but also on changes in the Money Market Fund's expenses
during the period.
Yield information may be useful in reviewing the performance of the Money
Market Fund and for providing a basis for comparison with other investment
alternatives. However, the Money Market Fund's yield fluctuates, unlike bank
deposits or other investments which typically pay a fixed yield for a stated
period of time.
GENERAL INFORMATION
Copies of the Amended and Restated Articles of Incorporation and the
By-Laws of the Company, each as amended and supplemented, the Amended and
Restated Declaration of Trust and the Code of Regulations of the Pennsylvania
Fund, and various agreements referred to in the Prospectus and this Statement
of Additional Information are filed with the registration statement at the SEC
to which reference is made for their full terms. Such documents and other
information filed with the SEC may be obtained from the SEC upon payment of
the fees prescribed by the Rules of the SEC and are also now available at the
SEC's Internet Web site at http://www.sec.gov. All cash and securities of the
Funds, except for U.S. Government Securities which are represented only in
book entry form at the Federal Reserve Bank, are held by State Street or in a
central depository system in the name of State Street Bank & Trust - Kansas
City, 801 Pennsylvania Avenue, Kansas City, Missouri 64105 as the Funds'
Custodian. State Street is also Dividend Disbursing Agent for the Funds'
shares. Sentinel Service is Transfer Agent and Registrar for the Funds'
shares. All correspondence regarding the Funds should be mailed to Sentinel
Administrative Service Company, P.O. Box 1499, Montpelier, Vermont 05601-1499.
The independent accountants for the Funds are PricewaterhouseCoopers LLP,
located at 1177 Avenue of the Americas, New York, New York 10036. The
independent accountants are responsible for auditing the annual financial
statements of the Company and the Pennsylvania Fund.
Counsel for the Funds is Brown & Wood LLP, One World Trade Center, New
York, New York 10048-0557.
FINANCIAL STATEMENTS
Audited financial statements for the Company and for the Pennsylvania
Fund at November 30, 1999 and for the year then ended are incorporated by
reference to the Funds' 1999 Annual Report to Shareholders.
<PAGE>
Appendix A
Description of Moody's Investor Service, Inc.'s ("Moody's")
Municipal Bond Ratings
Long-Term Ratings
Debt Ratings--U.S. Tax-Exempt Municipals
There are nine basic rating categories for long-term obligations. They range
from Aaa (highest quality) to C (lowest quality). Moody's applies numerical
modifiers 1, 2, and 3 in each generic rating classification from Aa to Caa.
The Modifier 1 indicates that the issue ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the
modifier3 indicates that the issue ranks in the lower end of its generic
category. Advance refunded issues that are secured by escrowed funds held in
cash, held in trust, reinvested in direct non-callable United States
government obligations or non-callable obligations unconditionally guaranteed
by the U.S. government are identified with a # (hatchmark) symbol, eg. # Aaa.
Aaa Bonds that are rated Aaa are judged to be of the best quality. They carry
the smallest degree of investment risk and are generally referred to as "gilt
edge." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues.
Aa Bonds that are rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high
grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present that make the long-term risks appear somewhat larger than in Aaa
securities.
A Bonds that are rated A possess many favorable investment attributes and are
to be considered as upper medium grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
that suggest a susceptibility to impairment some time in the future.
Baa Bonds that are rated Baa are considered as medium grade obligations, i.e.,
they are neither highly protected nor poorly secured. Interest payments and
principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba Bonds that are rated Ba are judged to have speculative elements; their
future cannot be considered as well assured. Often the protection of interest
and principal payments may be very moderate, and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B Bonds that are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or maintenance of
other terms of the contract over any long period of time may be small.
Caa Bonds that are rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal
or interest.
Ca Bonds that are rated Ca represent obligations that are speculative in a
high degree. Such issues are often in default or have other marked
shortcomings.
C Bonds that are rated C are the lowest rated class of bonds, and issues so
rated can be regarded as having extremely poor prospects of ever attaining any
real investment standing.
Con. (...) Bonds for which the security depends upon the completion of some
act or the fulfillment of some condition are rated conditionally. These are
bonds secured by: (a) earnings of projects under construction, (b) earnings of
projects unseasoned in operating experience, (c) rentals that begin when
facilities are completed, or (d) payments to which some other limiting
condition attaches. Parenthetical rating denotes probable credit stature upon
completion of construction or elimination of basis of condition.
Description of Standard & Poor's Municipal Issue Ratings
Municipal Issue Rating Definitions
A Standard & Poor's issue credit rating is a current opinion of the
creditworthiness of an obligor with respect to a specific financial
obligation, a specific class of financial obligations, or a specific financial
program. It takes into consideration the creditworthiness of guarantors,
insurers, or other forms of credit enhancement on the obligation. The issue
credit rating is not a recommendation to purchase, sell, or hold a financial
obligation, inasmuch as it does not comment as to market price or suitability
for a particular investor.
Issue credit ratings are based on current information furnished by the
obligors or obtained by Standard & Poor's from other sources it considers
reliable. Standard & Poor's does not perform an audit in connection with any
credit rating and may, on occasion, rely on unaudited financial information.
Credit ratings may be changed, suspended, or withdrawn as a result of changes
in, or unavailability of, such information, or based on other circumstances.
Issue credit ratings can be either
Long-term Issue Credit Ratings
Issue credit ratings are based in varying degrees, on the following
considerations:
1. Likelihood of payment - capacity and willingness of the obligor to
meet its financial commitment on an obligation in accordance with
the terms of the obligation;
2. Nature of and provisions of the obligation; and
3. Protection afforded by, and relative position of, the obligation in
the event of bankruptcy, reorganization, or other arrangement under
the laws of bankruptcy and other laws affecting creditors' rights.
The issue ratings definitions are expressed in terms of default risk. As such,
they pertain to senior obligations of an entity. Junior obligations are
typically rated lower than senior obligations, to reflect the lower priority
in bankruptcy, as noted above.
AAA
An obligation rated 'AAA' has the highest rating assigned by Standard &
Poor's. The obligor's capacity to meet its financial commitment on the
obligation is extremely strong.
AA
An obligation rated 'AA' differs from the highest-rated obligations only in
small degree. The obligor's capacity to meet its financial commitment on the
obligation is very strong.
A
An obligation rated 'A' is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in
higher-rated categories. However, the obligor's capacity to meet its financial
commitment on the obligation is still strong.
BBB
An obligation rated 'BBB' exhibits adequate protection parameters. However,
adverse economic conditions or changing circumstances are more likely to lead
to a weakened capacity of the obligor to meet its financial commitment on the
obligation.
BB, B, CCC, CC, And C
Obligations rated 'BB', 'B', 'CCC', 'CC', and 'C' are regarded as having
significant speculative characteristics. 'BB' indicates the least degree of
speculation and 'C' the highest. While such obligations will likely have some
quality and protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.
BB
An obligation rated 'BB' is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or exposure
to adverse business, financial, or economic conditions, which could lead to
the obligor's inadequate capacity to meet its financial commitment on the
obligation.
B
An obligation rated 'B' is more vulnerable to nonpayment than obligations
rated 'BB', but the obligor currently has the capacity to meet its financial
commitment on the obligation. Adverse business, financial, or economic
conditions will likely impair the obligor's capacity or willingness to meet
its financial commitment on the obligation.
CCC
An obligation rated 'CCC' is currently vulnerable to nonpayment and is
dependent upon favorable business, financial, and economic conditions for the
obligor to meet its financial commitment on the obligation. In the event of
adverse business, financial, or economic conditions, the obligor is not likely
to have the capacity to meet its financial commitment on the obligation.
CC
An obligation rated 'CC' is currently highly vulnerable to nonpayment.
C
The 'C' rating may be used to cover a situation where a bankruptcy petition
has been filed or similar action has been taken, but payments on this
obligation are being continued.
D
An obligation rated 'D' is in payment default. The 'D' rating category is used
when payments on an obligation are not made on the date due even if the
applicable grace period has not expired, unless Standard & Poor's believes
that such payments will be made during such grace period. The 'D' rating also
will be used upon the filing of a bankruptcy petition or the taking of a
similar action if payments on an obligation are jeopardized.
Plus (+) or minus (-)
The ratings from 'AA' to 'CCC' may be modified by the addition of a plus or
minus sign to show relative standing within the major rating categories.
c
The 'c' subscript is used to provide additional information to investors that
the bank may terminate its obligation to purchase tendered bonds if the
long-term credit rating of the issuer is below an investment-grade level
and/or the issuer's bonds are deemed taxable.
p
The letter 'p' indicates that the rating is provisional. A provisional rating
assumes the successful completion of the project financed by the debt being
rated and indicates that payment of debt service requirements is largely or
entirely dependent upon the successful, timely completion of the project. This
rating, however, while addressing credit quality subsequent to completion of
the project, makes no comment on the likelihood of or the risk of default upon
failure of such completion. The investor should exercise his own judgment with
respect to such likelihood and risk.
*
Continuance of the ratings is contingent upon Standard & Poor's receipt of an
executed copy of the escrow agreement or closing documentation confirming
investments and cash flows.
r
The 'r' highlights derivative, hybrid, and certain other obligations that
Standard & Poor's believes may experience high volatility or high variability
in expected returns as a result of noncredit risks. Examples of such
obligations are securities with principal or interest return indexed to
equities, commodities, or currencies; certain swaps and options; and
interest-only and principal-only mortgage securities. The absence of an 'r'
symbol should not be taken as an indication that an obligation will exhibit no
volatility or variability in total return.
N.R.
Not rated.
Debt obligations of issuers outside the United States and its territories are
rated on the same basis as domestic corporate and municipal issues. The
ratings measure the creditworthiness of the obligor but do not take into
account currency exchange and related uncertainties.
Bond Investment Quality Standards
Under present commercial bank regulations issued by the Comptroller of the
Currency, bonds rated in the top four categories ('AAA', 'AA', 'A', 'BBB',
commonly known as investment-grade ratings) generally are regarded as eligible
for bank investment. Also, the laws of various states governing legal
investments impose certain rating or other standards for obligations eligible
for investment by savings banks, trust companies, insurance companies, and
fiduciaries in general.
<PAGE>
APPENDIX B
SPECIAL CONSIDERATIONS RELATING TO NEW YORK
The following information is a brief summary of factors affecting the economy
of New York City (the "City") or New York State (the "State" or "New York").
Other factors will affect issuers. The summary is based primarily upon one or
more of the most recent publicly available offering statements relating to
debt offerings of State issuers, however, it has not been updated. The Fund
has not independently verified this information.
The State, some of its agencies, instrumentalities and public authorities and
certain of its municipalities have sometimes faced serious financial
difficulties that could have an adverse effect on the sources of payment for
or the market value of the New York Municipal Bonds in which the Fund invests.
New York City
General. More than any other municipality, the fiscal health of the City has a
significant effect on the fiscal health of the State. The City's current
financial plan assumes that, after strong growth in 1999 and 2000, moderate
economic growth will exist through calendar year 2004, with moderating job
growth and wage increases.
For each of the 1981 through 1999 fiscal years, the City had an operating
surplus, before discretionary and other transfers, and achieved balanced
operating results as reported in accordance with generally accepted accounting
principles ("GAAP"), after discretionary and other transfers. The City has
been required to close substantial gaps between forecast revenues and forecast
expenditures in order to maintain balanced operating results. There can be no
assurance that the City will continue to maintain balanced operating results
as required by State law without tax or other revenue increases or reductions
in City services or entitlement programs, which could adversely affect the
City's economic base.
The Mayor is responsible for preparing the City's financial plan, including
the City's financial plan for the 2000 through 2003 fiscal years released on
June 14, 1999 (the "2000-2003 Financial Plan", "Financial Plan" or "City
Financial Plan"). The City's projections set forth in the City Financial Plan
are based on various assumptions and contingencies that are uncertain and may
not materialize. Changes in major assumptions could significantly affect the
City's ability to balance its budget as required by State law and to meet its
annual cash flow and financing requirements.
As required by law, the City prepares a four-year annual financial plan, which
is reviewed and revised on a quarterly basis and which includes the City's
capital, revenue and expense projections and outlines proposed gap-closing
programs for years with projected budget gaps. The City Financial Plan
projects a surplus in the 2000 fiscal year, before discretionary transfers,
and budget gaps for each of the 2001, 2002 and 2003 fiscal years. This pattern
of current year surplus operating results and projected subsequent year budget
gaps has been consistent through the entire period since 1982, during which
the City has achieved surplus operating results, before discretionary
transfers, for each fiscal year.
City's Financing Program. Implementation of the City Financial Plan is
dependent upon the City's ability to market its securities successfully. The
City's program for financing capital projects for fiscal years 2000 through
2003 contemplates the issuance of $7.449 billion of general obligation bonds
and $3.35 billion of bonds to be issued by the New York City Transitional
Finance Authority (the "Transitional Finance Authority"). In addition, the
Financial Plan anticipates access to approximately $2.4 billion in financing
capacity of the TSASC, Inc. ("TSASC"), the debt of which is secured by
revenues derived from the settlement of litigation with tobacco companies
selling cigarettes in the United States. The Transitional Finance Authority
and TSASC were created to assist the City in financing its capital program
while keeping City indebtedness within the forecast level of the
constitutional restrictions on the amount of debt the City is authorized to
incur.
Limitations on sources of capital funding first affect the City's capital
program by limiting the amount of capital contract liability within which the
City may enter to the amount of authorized long-term financing then available.
By this standard, the City will have fully invoked its own, the Transitional
Finance Authority's and TSASC's financing capacity to support contract
liability (and therefore would be unable to enter into new capital contracts)
during the City's fiscal year 2001, which begins on July 1, 2000. The City
expects that it will be required to postpone part of its capital program from
the latter part of fiscal year 2001 to fiscal year 2002. In fiscal year 2002,
a State constitutional amendment increasing the City's capacity to issue
general obligation debt could become effective. If a constitutional amendment
increasing the City's general obligation debt limit does not pass, an
additional $2.2 billion of financing capacity for the City would be needed for
the period from January 2002 through the end of the City's ten-year capital
strategy in fiscal year 2009. In that case, the Transitional Finance
Authority's debt-incurring power would need to be increased or some other
financing mechanism would need to be established. In addition, the City issues
revenue notes and tax anticipation notes to finance its seasonal working
capital requirements (See "Seasonal Financing Requirements" within). The
success of projected public sales of City bonds and notes, New York City
Municipal Water Finance Authority (the "Water Authority") bonds and
Transitional Finance Authority and other bonds will be subject to prevailing
market conditions. The City's planned capital and operating expenditures are
dependent upon the sale of its general obligation bonds and notes, as well as
Water Authority, Transitional Finance Authority and TSASC bonds.
2000-2003 Financial Plan. On June 14, 1999, the City released the Financial
Plan for the 2000 through 2003 fiscal years, which relates to the City and
certain entities which receive funds from the City. The Financial Plan
projects revenues and expenditures for the 2000 fiscal year balanced in
accordance with GAAP, and project gaps of $1.8 billion, $1.9 billion and $1.8
billion for fiscal years 2001 through 2003, respectively.
The Financial Plan includes a proposed discretionary transfer in fiscal year
2000 to pay debt service due in fiscal year 2001 totaling $429 million, and a
proposed discretionary transfer in fiscal year 2001 to pay debt service due in
fiscal year 2002 totaling $345 million.
In addition, the Financial Plan sets forth gap-closing actions to eliminate a
previously projected gap for the 2000 fiscal year and to reduce projected gaps
for fiscal years 2001 through 2003. The gap-closing actions for the 2000
through 2003 fiscal years include: (i) additional City agency actions totaling
$502 million, $371 million, $293 million and $283 million for fiscal years
2000 through 2003, respectively; (ii) additional Federal aid of $75 million in
each of fiscal years 2000 through 2003, which include the proposed restoration
of $25 million of Federal revenue sharing and $50 million of increased Federal
Medicaid aid; and (iii) additional State actions totaling approximately $125
million in each of fiscal years 2000 through 2003. The Financial Plan also
reflects a tax reduction program, which includes the elimination of the City's
non-residents earning tax, the extension of current tax reductions for owners
of cooperative and condominium apartments and a proposed income tax credit for
low income wage earners.
Assumptions. The 2000-2003 Financial Plan is based on numerous assumptions,
including the condition of the City's and the region's economies and modest
employment growth and the concomitant receipt of economically sensitive tax
revenues in the amounts projected. The 2000-2003 Financial Plan is subject to
various other uncertainties and contingencies relating to, among other
factors, the extent, if any, to which wage increases for City employees exceed
the annual wage costs assumed for the 1999 through 2003 fiscal years;
continuation of projected interest earnings assumptions for pension fund
assets and current assumptions with respect to wages for City employees
affecting the City's required pension fund contributions; the willingness and
ability of the State to provide the aid contemplated by the Financial Plan and
to take various other actions to assist the City; the ability of Health and
Hospitals Corporation (the "HHC"), the Board of Education (the "BOE") and
other such agencies to maintain balanced budgets; the willingness of the
Federal government to provide the amount of Federal aid contemplated in the
Financial Plan; the impact on City revenues and expenditures of Federal and
State welfare reform and any future legislation affecting Medicare or other
entitlement programs; adoption of the City's budgets by the City Council in
substantially the forms submitted by the Mayor; the ability of the City to
implement cost reduction initiatives, and the success with which the City
controls expenditures; the impact of conditions in the real estate market on
real estate tax revenues; and unanticipated expenditures that may be incurred
as a result of the need to maintain the City's infrastructure. Certain of
these assumptions have been questioned by the City Comptroller and other
public officials.
The Financial Plan assumes: (i) approval by the Governor and the State
Legislature of the extension of the 14% personal income tax surcharge, (which
has subsequently been extended to December 31, 2001 through enacted
legislation), and which is projected to provide revenue of $572 million, $585
million, $600 million and $638 million in the 2000 through 2003 fiscal years,
respectively; (ii) collection of projected rent payments for the City's
airports, totaling $365 million, $185 million and $155 million in the 2001
through 2003 fiscal years, respectively, a substantial portion of which may
depend on the successful completion of negotiations with The Port Authority of
New York and New Jersey (the "Port Authority") or the enforcement of the
City's rights under the existing leases through pending legal action; (iii)
State and Federal approval of the State and Federal gap-closing actions
proposed by the City in the Financial Plan; and (iv) receipt of the tobacco
settlement funds providing revenues or expenditure offsets in annual amounts
ranging between $250 million and $300 million. In addition, the economic and
financial condition of the City may be affected by various financial, social,
economic and political factors which could have a material effect on the City.
Municipal Unions. The Financial Plan reflects the costs of the settlements and
arbitration awards with certain municipal unions and other bargaining units,
which together represent approximately 98% of the City's workforce, and
assumes that the City will reach agreement with its remaining municipal unions
under terms which are generally consistent with such settlements and
arbitration awards. These contracts are approximately five years in length and
have a total cumulative net increase of 13%. Assuming the City reaches similar
settlements with its remaining municipal unions, the cost of all settlements
for all City-funded employees would exceed $2 billion annually, during fiscal
years 2000 through 2003. The Financial Plan provides no additional wage
increases for City employees after their contracts expire in fiscal years 2000
and 2001.
Intergovernmental Aid. The City depends on aid from the State both to enable
the City to balance its budget and to meet its cash requirements. There can be
no assurance that there will not be reductions in State aid to the City from
amounts projected; that State budgets will be adopted by the April 1 statutory
deadline, or interim appropriations enacted; or that any such reductions or
delays will not have adverse effects on the City's cash flow or expenditures.
In addition, the Federal budget negotiation process could result in reductions
or delays in the receipt of Federal grants which could have additional adverse
effects on the City's cash flow or revenues.
Year 2000 Computer Matters (as of November 3, 1999). The year 2000 presents
potential operational problems for computerized data files and computer
programs which may recognize the year 2000 as the year 1900, resulting in
possible system failures or miscalculations. The Mayor's Office of Operations
has stated that work has been completed, and all or part of the necessary
testing has been performed, on approximately 99% of the mission-critical and
high priority systems of Mayoral agencies. The City's computer systems may not
all be year 2000 compliant in a timely manner and there could be an adverse
impact on City operations or revenues as a result. The City is developing
contingency plans for all mission-critical and high priority systems of
Mayoral agencies to be used if such systems are not year 2000 compliant. The
City is also in the process of contacting its significant third party vendors
regarding the status of their compliance. Such compliance is not within the
City's control, and therefore the City cannot assure that there will not be
any adverse effects on the City resulting from any failure of these third
parties.
Certain Reports. The City's financial plans have been the subject of extensive
public comment and criticism. From time to time, the staff of the New York
State Financial Control Board (the "Control Board"), the Office of the State
Deputy Comptroller (the "OSDC"), the City Comptroller, the City's Independent
Budget Office (the "IBO") and others issue reports and make public statements
regarding the City's financial condition, commenting on, among other matters,
the City's financial plans, projected revenues and expenditures and actions by
the City to eliminate projected operating deficits. Some of these reports and
statements have warned that the City may have underestimated certain
expenditures and overestimated certain revenues and have suggested that the
City may not have adequately provided for future contingencies. Certain of
these reports have analyzed the City's future economic and social conditions
and have questioned whether the City has the capacity to generate sufficient
revenues in the future to meet the costs of its expenditure increases and to
provide necessary services.
On July 14, 1999, the City Comptroller issued a report on the adopted budget
for fiscal year 2000 and the Financial Plan. Taking into account the risks and
additional resources identified in the report, the report projected a surplus
for fiscal year 2000 of between $223 million and $891 million, including the
$429 million surplus allocated to the Budget Stabilization Account. In
addition, taking into account the risks and additional resources identified in
the report and the budget gaps projected in the Financial Plan, the report
projected budget gaps of between $1.8 billion and $3.5 billion, $1.7 billion
and $3.6 billion, and $1.7 billion and $4.1 billion in fiscal years 2001
through 2003, respectively.
With respect to fiscal years 2000 through 2003, the report identified baseline
risks of between $338 million and $998 million, $654 million and $2.4 billion,
$600 million and $2.4 billion and $719 million and $2.9 billion, respectively,
depending upon whether (i) the State approves the extension of the 14%
personal income tax surcharge; (ii) the City incurs additional labor costs as
a result of the expiration of labor contracts starting in fiscal year 2001
which, if settled at the current forecast level of inflation, would result in
additional costs totaling $345 million in fiscal year 2001, $713 million in
fiscal year 2002 and $1.1 billion in fiscal year 2003; (iii) the State
approves the continuation in fiscal years 2000 through 2003 of temporary State
Medicaid cost containment; and (iv) the City receives $300 million, $250
million, $300 million and $300 million in fiscal years 2000 through 2003,
respectively, from the tobacco settlement. Additional risks identified in the
report for fiscal years 2000 through 2003 include payments from the Port
Authority relating to the City's claim for back rentals, which are the subject
of arbitration; State and Federal gap-closing actions proposed in the
Financial Plan; possible increased overtime expenditures; the sale of the New
York City Coliseum in fiscal year 2001; the writedown of outstanding education
aid receivables of approximately $100 million in each of fiscal years 2002 and
2003; and a possible $149 million shortfall in tax revenues in fiscal year
2003. The report noted that these risks may be offset by additional resources
of between $659 million and $873 million in fiscal years 2000 through 2003 due
to the potential for higher than forecast tax revenues, lower than forecast
payables for prior years, possible debt service savings, additional State
education aid, the possible failure to spend funds for the construction of
three sports facilities and lower pension costs resulting from excess earnings
on pension assets in the 1999 fiscal year.
In his report, the City Comptroller also noted that possible changes to the
assumptions and methods used to compute actuarial liabilities, including
changes in the mortality, disability, investment return and wage assumptions,
could increase the City's pension expenditures by up to $600 million annually,
and that the Financial Plan has provided reserves of $65 million, $250
million, $300 million and $260 million in fiscal years 2000 through 2003 to
absorb some of the anticipated cost increases. The report further noted that
the City Comptroller's forecast is contingent on the continued growth of the
City economy and that the fear of renewed inflationary pressures has created
uncertainty in the bond market which may dampen economic growth in the future.
The report also indicated that a possible negotiated settlement of a class
action, filed on behalf of approximately 65,000 persons challenging the
Department of Corrections policy of strip searching detainees arrested for
nonfelony offenses, may expose the City to substantial costs from the
settlement of litigation. The report noted that, while settlement negotiations
with representatives of the class are being conducted and, therefore,
estimates of the potential cost of this litigation cannot be determined, the
City has recently settled four cases for $25,000 each.
On August 25, 1998, the City Comptroller issued a report reviewing the current
condition of the City's major physical assets and the capital expenditures
required to bring them to a state of good repair. The report's findings relate
only to current infrastructure and do not address future capacity or
technology needs. The report estimated that the expenditure of approximately
$91.83 billion would be required over the next decade to bring the City's
infrastructure to a systematic state of good repair and address new capital
needs already identified. The report stated that the City's current Ten-Year
Capital Strategy, together with funding received from other sources, is
projected to provide approximately $52.08 billion. The report noted that the
City's ability to meet all capital obligations is limited by law, as well as
funding capacity, and that the issue for the City is how best to set
priorities and manage limited resources.
On July 15, 1999, the staff of the OSDC issued a report on the Financial Plan.
With respect to fiscal year 2000, the report identified a possible gap of $13
million, reflecting revenues which could exceed projections in the Financial
Plan by $290 million, a $200 million shortfall in anticipated Federal and
State assistance, a possible $70 million increase in overtime costs and the
writedown of approximately $33 million of outstanding education aid
receivables. With respect to fiscal years 2001 through 2003, the report
identified net risks of $530 million, $447 million and $266 million which,
when added to gaps projected in the Financial Plan, would result in gaps of
$2.4 billion, $2.3 billion and $2.1 billion in fiscal years 2001 through 2003,
respectively. The risks identified in the report included a $200 million
shortfall in anticipated Federal and State assistance in each of fiscal years
2001 through 2003, the potential for increased overtime costs, the writedown
of outstanding State education aid receivables of approximately $100 million
in each of fiscal years 2002 and 2003, $100 million of unspecified asset sales
in fiscal year 2002 and delays in the receipt of Port Authority lease payments
assumed in the Financial Plan. However, the report noted that tax revenues
could be greater than forecast by the City by $155 million, $210 million and
$255 million in fiscal years 2001 through 2003, respectively. The report also
identified a number of other issues, including a possible delay in the receipt
of the City's share of the proceeds under the settlement with the nation's
tobacco companies; the extension of the 14% personal income tax surcharge; the
possibility of pension costs being $250 million greater than assumed in the
Financial Plan in each of fiscal years 2001 through 2003, as a result of
changed actuarial assumptions; and the potential for wage increases which, at
the projected inflation rate, would increase gaps by $285 million, $635
million and $1.0 billion in fiscal years 2001 through 2003, respectively. The
report also noted the possibility that the Federal Reserve will raise interest
rates and slow the economy, which could depress Wall Street profits below the
levels projected by the City and have the potential to seriously impact the
City's nonproperty tax revenue forecasts.
On July 15, 1999, the staff of the Control Board issued a report reviewing the
Financial Plan. The report noted that the City is likely to end fiscal year
2000 in balance. However, the report identified risks of $562 million, $293
million, $640 million and $499 million for fiscal years 2000 through 2003,
respectively, which, when combined with the City's projected gaps, results in
estimated gaps of $562 million, $2.1 billion, $2.5 billion and $2.3 billion
for fiscal years 2000 through 2003, respectively, before making provision for
any increased labor costs which may occur when the current contracts with City
employees expire in calendar year 2000. The report noted the possibility that
non-property taxes in fiscal year 2000 could be $250 million greater than
forecast in the Financial Plan. However, the report also identified risks for
fiscal years 2000 through 2003, which include (i) the possibility that the
City may decide to fund the $63 million annual cost of teachers' salary
supplementation for fiscal years 2000 through 2003, which the State failed to
fund in the 1999 fiscal year, and an additional risk of approximately $100
million in each of fiscal years 2002 and 2003 for BOE resulting from the
write-down of funds owed to BOE by the State which have been outstanding for
ten or more years; (ii) the receipt of assumed rental payments from the Port
Authority relating to the City's claim for back rents, which are the subject
of arbitration; (iii) a possible delay in the receipt of $300 million from the
tobacco settlement in fiscal years 2000 and 2001; (iv) $200 million of Federal
and State gap-closing actions assumed in the Financial Plan for each of fiscal
years 2000 through 2003; and (v) $177 million in fiscal year 2000 from the
lapse of State Medicaid cost containment, which has been extended subsequent
to the report.
In its report, the staff of the Control Board noted that total debt service is
expected to increase from 9.2% of total revenues and 15.8% of tax revenues in
the 1999 fiscal year to 11.6% of total revenues and 19% of tax revenues in
fiscal year 2003, and that the City's capital plant will require additional
resources at the same time that a rising debt service burden must be
contained. With respect to HHC, the report noted that HHC revenues are
expected to fall during the Financial Plan period, primarily due to falling
Medicaid receipts, that HHC will face increasing financial pressure when the
State implements mandatory Medicaid managed care beginning in fiscal year 2000
and that the eventual size of the projected gaps for HHC in fiscal years 2002
and 2003 may change substantially from current projections, as the revenue
impact of proposed State and Federal reforms, growth in managed care and
shifting utilization patterns remain largely uncertain. Finally, the report
noted that, given the length of the current expansion, there is an increasing
probability that a recession related to the end of the long bull market will
occur by the end of the Financial Plan period, and it is likely that the next
downturn, if and when it occurs, will have a disproportionately great impact
on the City because of its dependence on income flows from financial services.
Seasonal Financing Requirements. The City since 1981 has fully satisfied its
seasonal financing needs in the public credit markets, repaying all short-term
obligations within their fiscal year of issuance. The City has issued $750
million of short-term obligations in the 2000 fiscal year to finance the
City's cash flow needs for the 2000 fiscal year. The City issued $500 million
of short-term obligations in the 1999 fiscal year to finance the City's cash
flow needs for the 1999 fiscal year. The City issued $1.075 billion in
short-term obligations in fiscal year 1998 to finance the City's projected
cash flow needs for the 1998 fiscal year. The City issued $2.4 billion of
short-term obligations in fiscal year 1997. Seasonal financing requirements
for the 1996 fiscal year increased to $2.4 billion from $2.2 billion and $1.75
billion in the 1995 and 1994 fiscal years, respectively. The delay in the
adoption of the State's budget in certain past fiscal years has required the
City to issue short-term notes in amounts exceeding those expected early in
such fiscal years.
Ratings. As of November 3, 1999, Moody's rated the City's outstanding general
obligation bonds A3, Standard & Poor's rated such bonds A- and Fitch rated
such bonds A. In July 1995, Standard & Poor's revised downward its ratings on
outstanding general obligation bonds of the City from A- to BBB+. In July
1998, Standard & Poor's revised its rating of City bonds upward to A-. Moody's
rating of City bonds was revised in February 1998 to A3 from Baa1. On March 8,
1999, Fitch revised its rating of City bonds upward to A. Such ratings reflect
only the view of Moody's, Standard & Poor's and Fitch, from which an
explanation of the significance of such ratings may be obtained. There is no
assurance that such ratings will continue for any given period of time or that
they will not be revised downward or withdrawn entirely. Any such downward
revision or withdrawal could have an adverse effect on the market prices of
City bonds.
Outstanding Indebtedness. As of September 30, 1999, the City and the Municipal
Assistance Corporation for the City of New York had respectively approximately
$26.3 and $2.8 billion of outstanding net long-term debt. As of September 30,
1999, the Water Authority had approximately $8.6 billion aggregate principal
amount of outstanding bonds, inclusive of subordinate second resolution bonds,
and a $600 million commercial paper program.
Water, Sewer and Waste. Debt service on Water Authority obligations is secured
by fees and charges collected from the users of the City's water and sewer
system. State and Federal regulations require the City's water supply to meet
certain standards to avoid filtration. The City's water supply now meets all
technical standards and the City has taken the position that increased
regulatory, enforcement and other efforts to protect its water supply, will
prevent the need for filtration. On May 6, 1997, the U.S. Environmental
Protection Agency granted the City a filtration avoidance waiver through April
15, 2002 in response to the City's adoption of certain watershed regulations.
The estimated incremental cost to the City of implementing this Watershed
Memorandum of Agreement, beyond investments in the watershed which were
planned independently, is approximately $400 million. The City has estimated
that if filtration of the upstate water supply system is ultimately required,
the construction expenditures required could be between $4 billion and $5
billion.
Legislation has been passed by the State which prohibits the disposal of solid
waste in any landfill located within the City after December 31, 2001. The
Financial Plan includes the estimated costs of phasing out the use of
landfills located within the City. A suit has been commenced against the City
by private individuals under the Resource Conservation and Recovery Act
seeking to compel the City to take certain measures or, alternatively, to
close the Fresh Kills landfill. If as a result of such litigation, the City is
required to close the landfill earlier than required by State legislation, the
City could incur additional costs during the Financial Plan period. Pursuant
to court order, the City is currently required to recycle 3,400 tons per day
of solid waste and is required to recycle 4,250 tons per day by July 2001. The
City as of November 3, 1999 was recycling slightly over 2,600 tons per day of
solid waste. The City may seek to obtain amendments to Local Law No. 19 to
modify this requirement. If the City is unable to obtain such amendments and
is required to fully implement Local Law No. 19, the City may incur
substantial costs.
Litigation. The City is a defendant in a significant number of lawsuits. Such
litigation includes, but is not limited to, routine litigation incidental to
the performance of its governmental and other functions, actions commenced and
claims asserted against the City arising out of alleged constitutional
violations, alleged torts, alleged breaches of contracts and other alleged
violations of law and condemnation proceedings and other tax and miscellaneous
actions. While the ultimate outcome and fiscal impact, if any, on the City of
the proceedings and claims are not currently predictable, adverse
determinations in certain of them might have a material adverse effect upon
the City's ability to carry out the City Financial Plan. The City has
estimated that its potential future liability on account of outstanding claims
against it as of June 30, 1999 amounted to approximately $3.5 billion.
New York State
Current Economic Outlook. The information in this section was obtained from
the State's Annual Information Statement, updated as of February 3, 2000.
Growth in domestic consumption, which has been a major driving force behind
the nation's strong economic performance in recent years, is expected to slow
in 2000 as consumer confidence retreats from historic highs and the stock
market ceases to provide added stimulus to consumption spending. Real Gross
Domestic Product ("GDP") growth is projected to be 4.0 percent in 1999. In
2000 and 2001, real GDP growth is expected to be 3.5 percent and 2.9 percent,
respectively.
The forecast of the State's economy shows continued growth projected in the
2000 and 2001 calendar years for employment, wages and personal income,
although the growth in employment will moderate from the 1999 pace. Personal
income is estimated to have grown by 4.7 percent in 1999, fueled in part by a
large increase in financial sector bonus payments at the year's end. Total
bonus payments are projected to increase by 11 percent in 2000 and 10.5
percent in 2001. Overall employment growth is expected to continue at a more
modest pace than in 1999, reflecting the slower growth in the national
economy, continued spending restraint by government employers, and
restructuring in the manufacturing, health care, social service, and banking
sectors.
Many uncertainties exist in any forecast of the national and State economies.
Given the recent volatility in the international and domestic financial
markets, such uncertainties are particularly present at this time. The timing
and impact of changes in economic conditions are difficult to estimate with a
high degree of accuracy. Unforeseeable events may occur. The actual rate of
change in any, or all, of the concepts that are forecasted may differ
substantially and adversely from the outlook described herein.
Overall employment growth in the State is projected to be 2.3 percent in 1999,
1.7 percent in 2000 and 1.3 percent in 2001. On the national level, employment
growth is projected to be 2.2 percent for 1999, 1.7 percent for 2000 and 1.5
percent for 2001.
On an average annual basis, the State unemployment rate is projected to be 5.1
percent in each of 1999, 2000 and 2001. For the nation as a whole, the
unemployment rate is projected to be 4.2 percent for 1999, 4.1 percent for
2000 and 4.2 percent for 2001.
Personal income in the State is projected to grow by 4.7 percent in 1999, 5.5
percent in 2000 and 4.8 percent in 2001. For the nation, personal income is
projected to grow by 5.8 percent, 5.5 percent and 5.0 percent for 1999, 2000
and 2001, respectively.
The New York Economy. New York is the third most populous state in the nation
and has a relatively high level of personal wealth. The State's economy is
diverse, with a comparatively large share of the nation's finance, insurance,
transportation, communications and services employment, and a very small share
of the nation's farming and mining activity. The services sector accounts for
more than three of every ten nonagricultural jobs in New York and has a
noticeably higher proportion of total jobs than does the rest of the nation.
Manufacturing employment continues to decline in importance in New York, as in
most other states, and New York's economy is less reliant on this sector than
is the nation. Wholesale and retail trade is the second largest sector in
terms of nonagricultural jobs in New York but is considerably smaller when
measured by income share. The finance, insurance and real estate sector is far
more important in the State than in the nation as a whole. Although this
sector accounts for under one-tenth of all nonagricultural jobs in the State,
it contributes about one-fifth of all nonfarm labor and proprietors' income.
Farming is an important part of large regions of the State, although it
constitutes a very minor part of total State output. Federal, State and local
government together are the third largest sector in terms of nonagricultural
jobs, with the bulk of the employment accounted for by local governments. The
State is likely to be less affected than the nation as a whole during an
economic recession that is concentrated in manufacturing and construction, but
likely to be more affected during a recession that is concentrated in the
service-producing sector. The 1999-2000 Fiscal Year. The State's 1999-2000
fiscal year began on April 1, 1999 and ends on March 31, 2000. On March 31,
1999, the State adopted the debt service portion of the State budget for the
1999-2000 fiscal year; four months later, on August 4, 1999, it enacted the
remainder of the budget. The Governor approved the budget as passed by the
Legislature. Prior to passing the budget in its entirety for the 1999-2000
fiscal year, the State enacted appropriations that permitted the State to
continue its operations. Following the enactment of the budget, the State
prepared a Financial Plan for the 1999-2000 fiscal year (the "1999-2000
Financial Plan" or the "State Financial Plan") that sets forth projected
receipts and disbursements based on the actions taken by the Legislature.
General Fund receipts, including transfers from other funds, are projected to
be $37.341 billion. General Fund disbursements, including transfers to other
funds, are estimated at $37.063 billion. The 1999-2000 Financial Plan projects
the State to close the 1999-2000 fiscal year with a closing balance of $1.17
billion in the General Fund after a tax refund reserve transaction. The
balance is comprised of $548 million in the Tax Stabilization Reserve Fund
after a $75 million deposit in 1999-2000; $265 million in the Community
Projects Fund, which pays for Legislative initiatives; $250 million in the
Debt Reduction Reserve Fund (DRRF); and $107 million in the Contingency
Reserve Fund (which guards against litigation risks).
In additional to the General Fund closing balance of $1.17 billion, the State
will have a projected $3.09 billion in the tax refund reserve account at the
end of 1999-2000. The refund reserve account is used to adjust personal income
tax collections across fiscal years to pay for tax refunds, as well as to
accomplish other Financial Plan objectives. The projected balance of $3.09
billion is comprised of $1.82 billion in tax reduction reserves from the
1998-99 surplus; $683 million from the 1999-2000 surplus; $521 million from
the Local Government Assistance Corporation (see Local Government Assistance
Corporation within) that may be used to pay tax refunds during 2000-01 but
must be on deposit at the close of the fiscal year; $50 million in collective
bargaining reserves from 1999-2000; and $25 million in reserves for tax
credits.
Receipts. General Fund receipts include $33.783 billion in tax receipts,
$1.474 billion in miscellaneous receipts and $2.084 billion in transfers from
other funds. The transfer of the $1.82 billion surplus recorded in the
1998-1999 fiscal year to the 1999-2000 fiscal period has the effect of
exaggerating the growth in State receipts from year to year by depressing
reported 1998-1999 figures and inflating 1999-2000 figures.
Personal income taxes are imposed on the income of individuals, estates and
trusts and are based, with certain modifications, on Federal definitions of
income and deductions. Potential changes to Federal tax law could alter the
Federal definitions of income on which certain State taxes rely. Such changes
could have a significant impact on State revenues in the future. Net General
Fund personal income tax collections (after refund reserve transactions) are
projected to reach $20.71 billion in the 1999-2000 fiscal year. In contrast,
net total General Fund personal income tax receipts (i.e. gross receipts less
refunds) are estimated to be $22.693 billion. To make a portion of these
receipts and other funds available for use in the 2000-2001 fiscal year, the
Governor proposes to deposit $3.09 billion in the tax refund reserve at the
close of the 1999-2000 fiscal year. This action has the effect of decreasing
reported receipts in the 1999-2000 fiscal year, while increasing available
receipts in the 2000-2001 fiscal year.
User taxes and fees are comprised of three-quarters of the State's four
percent sales and use tax, cigarette, alcoholic beverage, container, and auto
rental taxes, and a portion of the motor fuel excise levies. This category
also includes receipts from the motor vehicle registration fees and alcoholic
beverage license fees. Dedicated transportation funds outside of the General
Fund receive a portion of motor fuel tax and motor vehicle registration fees
and all of the highway use taxes. User taxes and fees are projected to total
$7.44 billion in 1999-2000.
Business taxes include franchise taxes based generally on net income of
general business, bank and insurance corporations, as well as
gross-receipts-based taxes on utilities and gallonage-based petroleum business
taxes. Business tax receipts are expected to total approximately $4.57 billion
in 1999-2000.
Transfers from other funds to the General Fund consist primarily of tax
revenues in excess of debt service requirements, including the one percent
sales tax used to support payments to the Local Government Assistance
Corporation (see Local Government Assistance Corporation within). Transfers
from other funds are expected to total approximately $2.08 billion.
Miscellaneous receipts include investment income, abandoned property receipts,
medical provider assessments, minor federal grants, receipts from public
authorities, and certain other license and fee revenues. Miscellaneous
receipts are expected to total $1.47 billion in the 1999-2000 fiscal year.
Other taxes include the estate and gift tax, the real property gains tax and
pari-mutuel taxes. Taxes in this category are projected to total approximately
$1.05 billion for 1999-2000. Disbursements. Grants to Local Governments are
projected to constitute approximately 69.0 percent of all 1999-2000 fiscal
year General Fund disbursements, and includes payments to local governments,
non-profit providers and entitlement benefits to individuals. It is projected
to be approximately $25.60 billion for the 1999-2000 fiscal year.
State Operations is projected to constitute approximately 17.9 percent of all
1999-2000 fiscal year General Fund disbursements. State Operations reflects
the costs of running the Executive, Legislative and Judicial branches of
government, including the prison system, mental hygiene institutions, and the
State University system (SUNY). It is projected to be approximately $6.63
billion for the 1999-2000 fiscal year. The State's overall workforce, as of
the State's Annual Information Statement, dated August 24, 1999, is projected
to remain stable at approximately 191,300 persons.
General State Charges is projected to constitute approximately 5.6 percent of
all 1999-2000 fiscal year General Fund disbursements. This category accounts
primarily for the costs of providing fringe benefits to State employees and
retirees of the Executive, Legislature and Judiciary. It includes employer
contributions for pensions, social security, health insurance, workers'
compensation and unemployment insurance. This category also covers State
payments-in-lieu-of-taxes to local governments for certain State-owned lands,
and the costs of defending lawsuits against the State and its public officers.
Disbursements in this category are estimated at $2.09 billion for the
1999-2000 fiscal year.
Transfers to Other Funds from the General Fund are made primarily to finance
certain portions of State capital projects spending and debt service on
long-term bonds where these costs are not funded from other sources. State
Debt Service is projected to constitute approximately 6.0 percent of all
1999-2000 fiscal year General Fund disbursements. Capital/Other is projected
to constitute approximately 1.4 percent of all such General Fund
disbursements. Long-term debt service transfers are projected at $2.23 billion
in the 1999-2000 fiscal year. Transfers for capital projects are projected to
total $143 million in 1999-2000.
2000-2001 Executive Budget Forecast and Future Fiscal Years. State law
requires the Governor to propose a balanced budget each year. The Governor
presented his 2000-2001 Executive Budget to the State Legislature on January
20, 2000 which was amended on January 31, 2000. The Executive Budget contains
financial projections for the State's 1999-2000 through 2002-2003 fiscal
years. There can be no assurance that the Legislature will enact into law the
Governor's Executive Budget, as amended, or that the State's adopted budget
projections will not differ materially and adversely from the projections set
forth in the State Division of Budget's February 3, 2000 update to the State's
Annual Information Statement for the 1999-2000 fiscal year.
The State projects a closing balance of $1.61 billion in the General Fund at
the end of the 2000-2001 fiscal year (March 31, 2001). This balance is
comprised of a $433 million reserve set aside from the 1999-2000 surplus to
finance the estimated costs of the Governor's proposed tax reduction package
in 2001-2002 and 2002-2003, $475 million in cumulative reserves for collective
bargaining, $548 million in the Tax Stabilization Reserve Fund, and $150
million in the Contingency Reserve Fund after a proposed $43 million deposit
in 2000-2001.
The State's draft 2000-2001 Financial Plan projects General Fund receipts,
including transfers from other funds, of $38.62 billion, an increase of $1.28
billion (3.4 percent) over the 1999-2000 fiscal year. After adjusting for tax
law and administrative changes, recurring growth in the General Fund tax base
is projected to be approximately 5 percent during the 2000-2001 fiscal year.
The forecast of General Fund receipts in 2000-2001 includes the next stage of
the School Tax Relief (STAR) program, as well as the continuing impact of
earlier enacted tax reductions totaling approximately $2.3 billion. The
Executive Budget, as amended, also proposes several new tax reductions that
would have only a modest cost in the 2000-2001 fiscal year, but reduce
receipts by roughly $700 million annually when they are fully phased in by the
end of the 2004-2005 fiscal year. The State's draft 2000-2001 Financial Plan
reserves $433 million from the 1999-2000 surplus to fund the estimated cost of
new tax cuts, including the reduction of gross receipts taxes on energy
companies, in the 2001-2002 and 2002-2003 fiscal years.
The Governor's Executive Budget recommends General Fund disbursements of
$37.93 billion in the 2000-2001 fiscal year, an increase of $869 million (2.3
percent) over the 1999-2000 fiscal year. The Executive Budget, as amended,
includes approximately $300 million in resources from HCRA 2000, the successor
legislation to the Health Care Reform Act of 1996. HCRA 2000 continues the
negotiated reimbursement system for non-governmental payors, and provides
funding for, among other things, graduate medical education, indigent care,
and the expansion of health insurance coverage for uninsured adults and
children. HCRA 2000 will help finance several health-related programs,
including prescription drug assistance for the elderly, supplemental Medicare
insurance, and other public health services that were previously funded from
the General Fund. Programs under HCRA 2000 will be financed with revenues
generated from the financing mechanisms continued from HCRA 1996, a share of
the State's tobacco settlement and revenue from an increased excise tax on
cigarettes.
General Fund spending for school aid is projected at $10.86 billion in the
2000-2001 fiscal year, an increase of $250 million (2.4 percent). Medicaid
spending is estimated at $5.68 billion in 2000-2001, an increase of $65
million (1.2 percent) from the 1999-2000 fiscal year. Spending growth in
Medicaid is projected at 5.5 percent, but is offset by the HCRA 2000 actions
noted above, including continuation of cost containment actions from prior
fiscal years, and efforts to maximize Federal aid that moderate spending
growth.
Spending on welfare is projected at $1.25 billion, a decrease of $11 million
from the 1999-2000 fiscal year. Since the 1994-1995 fiscal year, State
spending on welfare has fallen by one-third, driven by the State's strong
economic performance over the past four years, welfare changes initiated at
the State and federal levels, and aggressive fraud prevention measures.
Although the number of people on welfare is expected to decline from the
1999-2000 fiscal year, General Fund support in the 2000-2001 fiscal year is
expected to remain nearly unchanged primarily to satisfy federal
maintenance-of-effort requirements.
The State's Division of the Budget estimates that the draft State 2000-2001
Financial Plan utilizes $32 million in new non-recurring resources to finance
operations.
The State's Division of the Budget projects cash-basis General Fund budget
gaps of $1.23 billion in the 2001-2002 fiscal year and $2.65 billion in the
2002-2003 fiscal year. These gaps assume that the Legislature will enact the
2000-2001 Executive Budget, as amended, and accompanying legislation in its
entirety, and that reserves proposed by the Governor for current and proposed
tax reductions are used to offset these costs in the outyears.
The draft Financial Plan estimates include the use of the $1.2 billion STAR
tax reduction reserve to offset the cost of that program in 2001-2002. The
draft Financial Plan also assumes that a new $433 million tax reduction
reserve will be created to pay for the estimated costs of the Governor's
proposed 2000-2001 tax reduction, with $123 million applied in 2001-2002 and
the remaining $310 million in 2002-2003.
These projections also assume that the Debt Reduction Reserve Fund will be
used to decrease high-cost State supported debt and increase pay-as-you-go
spending for capital projects, which will produce recurring debt service
savings of $70 million annually. The gap projections contain reserves for a
possible collective bargaining agreement, and do not assume any annual
spending efficiencies to reduce the size of the gaps. If the projected budget
gap for the 2001-2002 fiscal year is closed with recurring actions, the
2002-2003 budget gap would be reduced to $1.42 billion. In recent years, the
State has closed projected budget gaps which the State Division of the Budget
estimates at $5.0 billion (1995-96), $3.9 billion (1996-97), $2.3 billion
(1997-98), and less than $1 billion (1998-99).
Special Considerations. Many complex political, social and economic forces
influence the State's economy and finances, which may in turn affect the
State's Financial Plan. These forces may affect the State unpredictably from
fiscal year to fiscal year and are influenced by governments, institutions,
and events that are not subject to the State's control. The Financial Plan is
also necessarily based upon forecasts of national and State economic activity.
Economic forecasts have frequently failed to predict accurately the timing and
magnitude of changes in the national and State economies. The projections
assume no changes in federal tax law, which could substantially alter the
current receipts forecast. Many uncertainties exist in forecasts of both the
national and the State economies, including consumer attitudes toward
spending, the extent of corporate and governmental restructuring, the
condition of the financial sector, Federal fiscal and monetary policies, the
level of interest rates, and the condition of the world economy, which could
have an adverse effect on the State. There can be no assurance that the State
economy will not experience results in the current or any future fiscal year
that are worse than predicted, with corresponding material and adverse effects
on the State's projections of receipts and disbursements.
Projections of total State receipts in the State Financial Plan are based on
the State tax structure in effect during the fiscal year and on assumptions
relating to basic economic factors and their historical relationships to State
tax receipts. Projections of total State disbursements are based on
assumptions relating to economic and demographic factors, potential collective
bargaining agreements, levels of disbursements for various services provided
by local governments (where the cost is partially reimbursed by the State),
and the results of various administrative and statutory mechanisms in
controlling disbursements for State operations.
An ongoing risk to the State Financial Plan arises from the potential impact
of certain litigation and federal disallowances now pending against the State,
which could produce adverse effects on the State's projections of receipts and
disbursements. The draft Financial Plan contains projected reserves of $150
million in 2000-01 for such events, but assumes no significant federal
disallowances or other federal actions that could affect State finances.
The Personal Responsibility and Work Opportunity Reconciliation Act of 1996
created a new Temporary Assistance to Needy Families program (TANF) partially
funded with a fixed federal block grant to states. States are required to meet
work activity participation targets for their TANF caseload and conform with
certain other federal standards or face potential sanctions in the form of a
reduced federal block grant and increased State/local funding requirements.
Any future reduction could have an adverse impact on the State's Financial
Plan. However, the State has been able to demonstrate compliance with TANF
work requirements to mid-year 1999-2000 and did not at such time expect to be
subject to associated federal fiscal penalties.
Over the long-term, uncertainties with regard to the economy present the
largest potential risk to future budget balance in New York State. For
example, a downturn in the financial markets or the wider economy is possible,
a risk that is heightened by the lengthy expansion currently underway. The
securities industry is more important to the New York economy than the
national economy as a whole, potentially amplifying the impact of an economic
downturn. A large change in stock market performance during the forecast
horizon could result in wage and unemployment levels that are significantly
different from those embodied in the Financial Plan forecast. Merging and
downsizing by firms, as a consequence of deregulation or continued foreign
competition, may also have more significant adverse effects on employment than
expected.
Despite recent budgetary surpluses recorded by the State, actions affecting
the level of receipts and disbursements, the relative strength of the State
and regional economy, and actions by the Federal Government could impact
projected budget gaps for the State. To address a potential imbalance in any
given fiscal year, the State would be required to take actions to increase
receipts and/or reduce disbursements as it enacts the budget for that year,
and under the State Constitution, the Governor is required to propose a
balanced budget each year. There can be no assurance, however, that the State
Legislature will enact the Governor's proposals or that the State's actions
will be sufficient to preserve budgetary balance in any given fiscal year or
to align recurring receipts and disbursements in any given fiscal year.
Additional risks to the Financial Plan may arise from the enactment of
legislation by the U.S. Congress. For example, Congress has recently debated
proposals under which the Federal Government would take a portion of state
reserves from the TANF block grant for use in funding other federal programs.
It has also considered proposals that would lower the State's share of mass
transit operating assistance. Finally, several proposals to alter federal tax
law that have surfaced in recent years could adversely affect State revenues,
since many State taxes depend on federal definitions of income. While Congress
has not enacted these proposals, it may do so in the future, or it may take
other actions that could have an adverse effect on State finances.
Year 2000 Computer Matters (as of February 3, 2000). To date, the State has
experienced no significant Year 2000 computer disruptions. Monitoring will
continue over the next few months to identify and correct any problems that
may arise. However, there can be no assurance that outside parties who provide
goods and services to the State will not experience computer problems related
to Year 2000 programming in the future, or that such disruptions, if they
occur, will not have an adverse impact on State operations or finances.
Prior Fiscal Years (GAAP-Basis). GAAP requires fund accounting for all
government resources and the modified accrual basis of accounting for
measuring the financial position and changes therein of governmental funds.
The modified accrual basis of accounting recognizes revenues when they become
measurable and available to finance expenditures, and expenditures when a
liability to pay for goods or services is incurred or a commitment to make aid
payments is made, regardless of when actually paid. There are four
GAAP-defined Governmental Fund types. The General Fund is the major operating
fund of the State and receives all receipts that are not required by law to be
deposited in another fund. Debt Service Funds account for the accumulation of
resources for the payment of general long-term debt service and related costs
and payments under lease-purchase and contractual-obligation financing
arrangements. Capital Project Funds account for financial resources of the
State to be used for the acquisition or construction of major capital
facilities (other than those financed by Special Revenue Funds, Proprietary
Funds and Fiduciary Funds). Special Revenue Funds account for the proceeds of
specific revenue sources (other than expendable trusts or major capital
projects), such as Federal grants, that are legally restricted to specified
purposes.
The State completed its 1998-1999 fiscal year with a combined governmental
funds operating surplus of $1.32 billion, which included operating surpluses
in the General Fund ($1.078 billion), in the Debt Service Funds ($209 million)
and in the Capital Projects Funds ($154 million) offset, in part, by an
operating deficit in Special Revenue Funds ($117 million). The State reported
an accumulated surplus of $1.645 billion in the General Fund.
The State completed its 1997-1998 fiscal year with a combined Governmental
Funds operating surplus of $1.80 billion, which included an operating surplus
in the General Fund of $1.56 billion, in Capital Projects Funds of $232
million and in Special Revenue Funds of $49 million, offset in part by an
operating deficit of $43 million in Debt Service Funds. The State reported an
accumulated surplus of $567 million in the General Fund for the first time
since it began reporting its operations on a GAAP-basis.
The State completed its 1996-1997 fiscal year with a combined Governmental
Funds operating surplus of $2.1 billion, which included an operating surplus
in the General Fund of $1.9 billion, in the Capital Projects Funds of $98
million and in the Special Revenue Funds of $65 million, offset in part by an
operating deficit of $37 million in the Debt Service Funds. The State reported
an accumulated deficit of $995 million in the General Fund.
Prior Fiscal Years (Cash Basis). Cash basis accounting results in the
recording of receipts at the time money or checks are deposited in the State
Treasury and the recording of disbursements at the time a check is drawn,
regardless of the fiscal period to which the receipts or disbursements relate.
The State ended its 1998-1999 fiscal year on March 31, 1999 in balance on a
cash basis, with a General Fund cash surplus as reported by the State Division
of the Budget of $1.82 billion. The cash surplus was derived primarily from
higher-than-projected tax collections as a result of continued economic
growth, particularly in the financial markets and the securities industries.
General Fund receipts and transfers from other funds (net of tax refund
reserve account activity) for the 1998-1999 fiscal year totaled $36.74
billion, an increase of 6.34 percent from the 1997-1998 fiscal year levels.
General Fund disbursements and transfers to other funds totaled $36.49 billion
for the 1998-1999 fiscal year, an increase of 6.23 percent from the 1997-1998
fiscal year levels.
The State reported a General Fund closing cash balance of $892 million. The
closing fund balance excludes $2.31 billion that the State deposited into the
tax refund reserve account at the close of the 1998-1999 fiscal year to pay
for tax refunds in the 1999-2000 fiscal year. The tax refund reserve account
transaction has the effect of decreasing reported personal income tax receipts
in the 1998-1999 fiscal year, while increasing reported receipts in the
1999-2000 fiscal year.
The State ended its 1997-1998 fiscal year balanced on a cash basis, with a
reported General Fund cash surplus of $2.04 billion resulting from revenue
growth and lower spending on welfare, Medicaid, and other entitlement
programs. General Fund receipts and transfers from other funds for the
1997-1998 fiscal year (including net tax refund reserve account activity)
totaled $34.55 billion, an annual increase of $1.51 billion, or 4.57 percent
over the 1996-1997 fiscal year. General Fund disbursements and transfers to
other funds were $34.35 billion, an annual increase of $1.45 billion or 4.41
percent. The State closed a budget gap of approximately $2.3 billion for the
1997-1998 fiscal year. Gap-closing actions included cost containment in State
Medicaid, the use of the $1.4 billion 1996-1997 fiscal year budget surplus to
finance 1997-1998 fiscal year spending, control on State agency spending and
other actions.
The State ended its 1996-1997 fiscal year balanced on a cash basis, with a
1996-1997 General Fund cash surplus as reported by the State Division of the
Budget of approximately $1.4 billion that was used to finance the 1997-1998
Financial Plan. The surplus resulted primarily from higher-than-expected
revenues and lower-than-expected spending for social service programs. General
Fund receipts and transfers from other funds for the 1996-1997 fiscal year
totaled $33.04 billion, an increase of 0.7 percent from the 1995-1996 fiscal
year (excluding deposits into the tax refund reserve account). General Fund
disbursements and transfers to other funds totaled $32.90 billion for the
1996-1997 fiscal year, an increase of 0.7 percent from the 1995-1996 fiscal
year.
Local Government Assistance Corporation. In 1990, as part of a State fiscal
reform program, legislation was enacted creating the Local Government
Assistance Corporation (the "LGAC"), a public benefit corporation empowered to
issue long-term obligations to fund certain payments to local governments
traditionally funded through the State's annual seasonal borrowing. The
legislation imposed a cap on the annual seasonal borrowing of the State at
$4.7 billion, except in cases where the Governor and the legislative leaders
have certified the need for additional borrowing and provided a schedule for
reducing it to the cap. If borrowing above the cap is thus permitted in any
fiscal year, it is required by law to be reduced to the cap by the fourth
fiscal year after the limit was first exceeded. This provision capping the
seasonal borrowing was included as a covenant with LGAC's bondholders in the
resolutions authorizing such bonds. As of June 1995, LGAC had issued bonds to
provide net proceeds of $4.7 billion, completing the program. The impact of
LGAC's borrowing, as well as other changes in revenue and spending patterns,
is that the State has been able to meet its cash flow needs throughout the
fiscal year without relying on short-term seasonal borrowing.
Financing Activities. State financing activities include general obligation
debt of the State and State-guaranteed debt, to which the full faith and
credit of the State has been pledged, as well as lease-purchase and
contractual-obligation financings, moral obligation financings and other
financings through public authorities and municipalities, where the State's
obligation to make payments for debt service is generally subject to annual
appropriation by the State Legislature. As of March 31, 1999, the total amount
of outstanding general obligation debt was approximately $4.825 billion,
including $185 million in bond anticipation notes. The total amount of moral
obligation debt was $629 million (down from $1.39 billion as of March 31,
1998). $25.902 billion of bonds issued primarily in connection with
lease-purchase and contractual-obligation financing of State capital programs
were outstanding.
For purposes of analyzing the financial condition of the State, debt of the
State and of certain public authorities may be classified as State-supported
debt, which includes general obligation debt of the State, LGAC debt and lease
purchase and contractual obligations of public authorities (and
municipalities) where debt service is paid from State appropriations
(including dedicated tax sources, and other revenues such as patient charges
and dormitory facilities rentals). In addition, a broader classification,
referred to as State-related debt, includes State-supported debt, as well as
certain types of contingent obligations, including moral obligation financing,
certain contingent contractual-obligation financing arrangements, and
State-guaranteed debt, where debt service is expected to be paid from other
sources and State appropriations are contingent in that they may be made and
used only under certain circumstances.
The total amount of State-supported debt outstanding grew from 3.48 percent of
personal income in the State in the 1989-1990 fiscal year to 6.21 percent for
the 1998-1999 fiscal year while State-related debt outstanding remained
relatively stable at 6.53 percent of personal income for the same period.
Thus, State-supported debt grew at a faster rate than personal income while
State-related obligations grew at approximately the same rate. At the end of
the 1998-1999 fiscal year, there was $37.74 billion of outstanding
State-related debt and $35.84 billion of outstanding State-supported debt.
During the prior ten years, State-supported long-term debt service increased
on an average annual basis by 8.8 percent to $3.39 billion by the 1998-1999
fiscal year while all governmental funds receipts increased on an average
annual basis of 5.3 percent. This resulted in a general trend of increases in
the ratio of debt service to receipts from fiscal year 1989-1990 to fiscal
year 1998-1999.
The proposed 1999-2000 through 2004-05 Capital Program and Financing Plan was
released with the Executive Budget on January 11, 2000. The recommended
five-year Capital Program and Financing Plan reflects debt reduction
initiatives that would reduce State-supported debt and reform the State's
borrowing practices. The Executive Budget, as amended, proposes to triple the
size of the Debt Reduction Reserve Fund (DRRF) to $750 million ($250 million
from current-year deposits; $250 million from the 1999-2000 surplus; and $250
million from one-time receipts from the tobacco settlement). Two-thirds, or
$500 million, of the moneys will be used in 2000-01 to retire the State's
existing high cost debt and increase pay-as-you-go spending for previously
bond-financed programs. The balance, $250 million, will remain in DRRF in
2000-01, and will be used to further reduce debt in 2001-02. The Executive
Budget, as amended, also includes constitutional and statutory debt reform
proposals that, if enacted, would ban "back door" borrowing, impose caps on
new debt outstanding and debt service costs, and restrict the use of debt to
capital purposes only. The statutory proposal would apply to new debt issued
after April 1, 2000. The earliest the constitutional proposal can take effect,
after passage by two separately-elected Legislatures and approval by the
voters, is January 1, 2002.
Public Authorities. The fiscal stability of the State is related, in part, to
the fiscal stability of its public authorities. Public authorities are not
subject to the constitutional restrictions on the incurring of debt which
apply to the State itself, and may issue bonds and notes within the amounts
of, and as otherwise restricted by, their legislative authorization. As of
December 31, 1998, there were 17 public authorities that had outstanding debt
of $100 million or more, and the aggregate outstanding debt, including
refunding bonds, of all State public authorities was $94 billion, up from $84
billion as of December 31, 1997. The State's access to the public credit
markets could be impaired and the market price of its outstanding debt may be
adversely affected if any of its public authorities were to default on their
respective obligations.
Ratings. As of June 15, 1999, Moody's and Standard & Poor's rated the State's
outstanding general obligation bonds A2 and A, respectively. Standard & Poor's
revised its ratings upward from A- to A on August 28, 1997. Ratings reflect
only the respective views of such organizations, and explanation of the
significance of such ratings must be obtained from the rating agency
furnishing the same. There is no assurance that a particular rating will
continue for any given period of time or that any such rating will not be
revised downward or withdrawn entirely if, in the judgment of the agency
originally establishing the rating, circumstances so warrant. A downward
revision or withdrawal of such ratings may have an effect on the market price
of the New York Municipal Bonds in which the Fund invests.
Litigation. The State is a defendant in numerous legal proceedings including,
but not limited to, claims asserted against the State arising from alleged
torts, alleged breaches of contracts, condemnation proceedings and other
alleged violations of State and Federal laws. State programs are frequently
challenged on State and Federal constitutional grounds. Adverse developments
in legal proceedings or the initiation of new proceedings could affect the
ability of the State to maintain a balanced State Financial Plan in any given
fiscal year. There can be no assurance that an adverse decision in one or more
legal proceedings would not exceed the amount the State reserves for the
payment of judgments or materially impair the State's financial operations. In
its audited financial statements for the fiscal year ended March 31, 1999, the
State reported its estimated liability for awarded and anticipated unfavorable
judgments at $895 million.
Other Localities. Certain localities outside the City have experienced
financial problems and have requested and received additional State assistance
during the last several State fiscal years. The potential impact on the State
of such actions by localities is not included in the projections of the State
receipts and disbursements for the State's 1999-2000 fiscal year.
In 1997, the total indebtedness of all localities in the State, other than the
City, was approximately $21.0 billion. A small portion (approximately $80
million) of that indebtedness represented borrowing to finance budgetary
deficits and was issued pursuant to enabling State legislation.
<PAGE>
Appendix C
ECONOMIC AND FINANCIAL CONDITIONS IN PENNSYLVANIA
The following information is a brief summary of factors affecting the
economy of the Commonwealth of Pennsylvania and does not purport to be a
complete description of such factors. Other factors will affect issuers. The
summary is based upon one or more of the most recent publicly available
offering statements relating to debt offerings of Pennsylvania issuers. The
Funds have not independently verified the information.
Many factors affect the financial condition of the Commonwealth of
Pennsylvania (also referred to herein as the "Commonwealth") and its political
subdivisions, such as social, environmental and economic conditions, many of
which are not within the control of such entities. Pennsylvania and certain of
its counties, cities and school districts and public bodies (most notably the
City of Philadelphia, sometimes referred to herein as the "City") have from
time to time in the past encountered financial difficulties which have
adversely affected their respective credit standings. Such difficulties could
affect outstanding obligations of such entities, including obligations held by
the Fund.
The General Fund, the Commonwealth's largest fund, receives all tax
revenues, non-tax revenues and federal grants and entitlements that are not
specified by law to be deposited elsewhere. The majority of the Commonwealth's
operating and administrative expenses are payable from the General Fund. Debt
service on all bonded indebtedness of the Commonwealth, except that issued for
highway purposes or for the benefit of other special revenue funds, is payable
from the General Fund.
The five-year period ending with fiscal 1999 was a time of economic
growth with modest rates of growth at the beginning of the period and larger
increases during the most recent years. Throughout the period, inflation has
remained relatively low, helping to restrain expenditure growth. Favorable
economic conditions have helped total revenues and other sources rise at an
average annual rate of 5.8% (6% on a "GAAP" basis) during the five-year
period. Taxes increased at an average annual rate of 4.3% (4.2% on a "GAAP"
basis) during the period. Expenditures and other uses during the fiscal 1995
through fiscal 1999 period rose at a 4.8% (5% on a "GAAP" basis) average
annual rate.
The fund balance at June 30, 1999 (determined on a "Generally Accepted
Accounting Principles" basis) totaled $2,863.4 million, a $905 million
increase over the $1,958.9 million balance at June 30, 1998.
Operations during the 1998 fiscal year increased the unappropriated
balance of Commonwealth revenues during that period by $86.4 million to $488.7
million at June 30, 1998 (prior to reserves for transfer to the Tax
Stabilization Reserve Fund). Higher than estimated revenues, offset in part by
increased reserves for tax refunds, and by slightly lower expenditures than
budgeted were responsible for the increase. Transfers to the Tax Stabilization
Reserve Fund for fiscal 1998 operations total $223.3 million consisting of
$73.3 million representing the required transfer of 15% of the ending
unappropriated surplus balance, plus an additional $150 million authorized by
the General Assembly when it enacted the fiscal 1999 budget. With these
transfers, the balance in the Tax Stabilization Reserve Fund exceeds $668
million and represent 3.7% of fiscal 1998 revenues.
Commonwealth revenues (prior to tax refunds) during the fiscal year
totaled $18,123.2 million, $676.1 million (3.9%) above the estimate made at
the time the budget was enacted. Tax revenue received in fiscal 1998 grew 4.8%
over tax revenues received during fiscal 1997. This rate of increase includes
the effect of legislated tax reductions that affected receipts during both
fiscal years and therefore understates the actual underlying rate of growth of
tax revenue during fiscal 1998. Receipts from the personal income tax produced
the largest single component of higher revenues during fiscal 1998.
Expenditures from all fiscal 1998 appropriations of Commonwealth revenues
totaled $17,229.8 million (excluding pooled financing expenditures and net of
current year lapses). This amount represents an increase of 4.5% over
fiscal1997 appropriation expenditures. Lapses of appropriation authority
during the fiscal year totaled $161.8 million including $58.8 million from
fiscal 1998 appropriations. These appropriation lapses were used to fund
$120.5 million of supplemental fiscal 1998 appropriations.
For GAAP purposes, assets increased $705.1 million and liabilities rose
by$111.1 million during the fiscal year. These changes contributed to a
$310.3million dollar rise in the undesignated-unreserved balance for June 30,
1998 to $497.6 million, the highest level achieved since audited GAAP
reporting was instituted in 1984.
The 1999 fiscal year ended with an unappropriated surplus (prior to the
transfer to the Tax Stabilization Reserve Fund) of $702.9 million, an increase
of $214.2 million from June 30, 1998. Transfers to the Tax Stabilization
Reserve Fund total $255.4 million for fiscal year 1999 consisting of $105.4
million representing the statutory 15% of the fiscal year-end unappropriated
surplus and an additional $150 million from the unappropriated surplus
authorized by the General Assembly. The $447.5 million balance of the
unappropriated surplus was carried over to fiscal year 2000. The higher
unappropriated surplus was generated by tax revenues that were $712.0 million
(3.9%) above estimate and $61.0 million of non-tax revenue (18.4%) above
estimate. Higher than anticipated appropriation lapses also contributed to the
higher surplus. A portion of the higher revenues and appropriation lapses were
used for supplemental fiscal 1999 appropriations totaling $357.8 million.
These supplemental appropriations represent expected one-time obligations.
Including the supplemental appropriations and net of appropriation lapses,
expenditures for fiscal 1999 totaled $18,144.9 million, a 5.9% increase over
expenditures during fiscal 1998.
For GAAP purposes, assets increased $1,024 million in fiscal 1999 and
liabilities rose $119.5 million. The increase in assets over liabilities for
fiscal 1999 caused the fund balance as of June 30,1999 to increase by $904.5
million over the fund balance as of June 30,1998. The total fund balance as of
June 30, 1999 was $2,863.4, the largest fund balance since audited GAAP
reporting was instituted in 1984.
The General Fund budget for the 2000 fiscal year was approved by the
General Assembly in May 1999. The budget as adopted at that time included
appropriations from Commonwealth revenues of $19,061.5 million and estimated
revenues (net of estimated tax refunds and enacted tax changes) of $18,699.9
million. A partial draw down of the fiscal 1999 year-end balance is intended
to fund the $361.6 million difference between estimated revenues and projected
spending.
The estimate of Commonwealth revenues for fiscal 2000 is based on an
economic forecast for real gross domestic product to grow at a 1.4 % rate from
the second quarter of 1999 to the second quarter of 2000. Growth of real gross
domestic product is expected to be restrained by a slowing of the rate of
consumer spending to a level consistent with personal income gains and by
smaller gains in business investment in response to falling capacity
utilization and profits. Slowing economic growth is expected to cause the
unemployment rate to rise through the fiscal year but inflation is expected to
remain moderate. Trends for the Pennsylvania economy are expected to maintain
their close association with national economic trends. Personal income growth
is anticipated to remain slightly below that of the U.S. while the
Pennsylvania unemployment rate is anticipated to be very close to the national
rate.
Commonwealth revenues (excluding the estimated cost of enacted tax
reductions) are projected to increase by 2.8 % over fiscal 1999 receipts.
Appropriations from Commonwealth funds in the originally enacted budget
increase by 3.8 % over fiscal 1999 appropriations. Enacted tax cuts for fiscal
2000 total an estimated $380.2 million in the General fund.
Subsequent to the enactment of the fiscal 2000 budget, $153.6 million of
additional appropriations were authorized. In addition, the need for
additional appropriations during the fiscal year of approximately $58.5
million has been identified but has not yet been authorized. All additional
appropriations are anticipated to be able to be funded from lapses of
appropriation authority during the fiscal year.
Through December 1999, actual General Fund revenues have exceeded
estimated receipts by $177 million (2.1%).
According to a Pennsylvania Department of Revenue News Release, dated
January 31, 2000, the state collected $1.7 billion in General Fund revenues in
January, 2000, $112.8 million (7%) more than anticipated. Fiscal years-to-date
General Fund collections total $10.3 billion, which is $289.8 million, (2.9%)
above estimate.
On February 8, 2000, Governor Ridge delivered his proposed 2001 General
Fund budget. The proposed General Fund budget is $19.7 billion, an increase of
$399 million (2.1%). The proposed budget includes $643.5 million in tax
reductions and rebates. This is the largest proposed tax cut in Pennsylvania
history.
Pennsylvania is one of the most populous states, ranking fifth behind
California, New York, Texas and Florida. Pennsylvania is an established yet
growing state with a diversified economy. It is the headquarters for many
major corporations.
Pennsylvania has historically been identified as a heavy industry state
although that reputation has changed over the last thirty years as the coal,
steel and railroad industries declined and the Commonwealth's business
environment readjusted to reflect a more diversified economic base. This
economic readjustment was a direct result of a long-term shift in jobs,
investment and workers away from the northeast part of the nation. Currently,
the major sources of growth in Pennsylvania are in the service sector,
including trade, medical and health services, education and financial
institutions.
Nonagricultural employment in Pennsylvania over the ten year period that
ended in 1998 increased at an annual rate of 0.75%. This compares to a
0.29%rate for the Middle Atlantic region and a 1.72% rate for the United
States as a whole during the period 1989 through 1998. For the five years
ended with1998, employment in the Commonwealth has increased 7.0%. The growth
in employment during this period is higher than the 2.7% growth in the Middle
Atlantic region. The unemployment rate in Pennsylvania December, 1999 stood at
a seasonably adjusted rate of 4.1%. The seasonably adjusted national
unemployment rate for December, 1999 was also 4.1%.
The current Constitutional provisions pertaining to Commonwealth debt
permit the issuance of the following types of debt: (i) debt to suppress
insurrection or rehabilitate areas affected by disaster, (ii)
electorate-approved debt, (iii) debt for capital projects subject to an
aggregate debt limit of 1.75 times the annual average tax revenues of the
preceding five fiscal years and (iv) tax anticipation notes payable in the
fiscal year of issuance. All debt except tax anticipation notes must be
amortized in substantial and regular amounts.
Debt service on all bonded indebtedness of Pennsylvania, except that
issued for highway purposes or the benefit of other special revenue funds, is
payable from Pennsylvania's General Fund, which receives all Commonwealth
revenues that are not specified by law to be deposited elsewhere. As of June
30, 1999,the Commonwealth had $4,924.5 million of general obligation debt
outstanding.
Other state-related obligations include "moral obligations." Moral
obligation indebtedness may be issued by the Pennsylvania Housing Finance
Agency (the "PHFA"), a state-created agency which provides financing for
housing for lower and moderate income families, and The Hospitals and Higher
Education Facilities Authority of Philadelphia, a municipal authority
organized by the City of Philadelphia to, among other things, acquire and
prepare various sites for use as intermediate care facilities for the mentally
retarded. PHFA's bonds, but not its notes, are partially secured by a capital
reserve fund required to be maintained by PHFA in an amount equal to the
maximum annual debt service on its outstanding bonds in any succeeding
calendar year. PHFA is not permitted to borrow additional funds as long as any
deficiency exists in the capital reserve fund.
The Commonwealth, through several of its departments and agencies, leases
real property and equipment. Some of those leases and their respective lease
payments are, with the Commonwealth's approval, pledged as security for debt
obligations issued by certain public authorities or other entities within the
state. All lease payments payable by Commonwealth departments and agencies are
subject to and dependent upon an annual spending authorization approved
through the Commonwealth's annual budget process. The Commonwealth is not
required by law to appropriate or otherwise provide monies from which the
lease payments are to be made. The obligations to be paid from such lease
payments are not bonded debt of the Commonwealth.
Certain state-created organizations have statutory authorization to issue
debt for which state appropriations to pay debt service thereon are not
required. The debt of these organizations is funded by assets of, or revenues
derived from, the various projects financed and is not a statutory or moral
obligation of the Commonwealth. Some of these agencies, however, are
indirectly dependent on Commonwealth operating appropriations. In addition,
the Commonwealth may choose to take action to financially assist these
organizations. The Commonwealth also maintains pension plans covering all
state employees, public school employees and employees of certain
state-related organizations.
The Pennsylvania Intergovernmental Cooperation Authority (the "PICA") was
created by Commonwealth legislation in 1991 to assist Philadelphia in
remedying fiscal emergencies. PICA is designed to provide assistance through
the issuance of funding debt and to make factual findings and recommendations
to Philadelphia concerning its budgetary and fiscal affairs. At this time,
Philadelphia is operating under a five year fiscal plan approved by PICA on
June 15, 1999.
No further bonds are to be issued by PICA for the purpose of financing a
capital project or deficit as the authority for such bond sales expired
December 31, 1994. PICA's authority to issue debt for the purpose of financing
a cash flow deficit expired on December 31, 1996. Its ability to refund
existing outstanding debt is unrestricted. PICA had $1,014.1 million in
Special Revenue bonds outstanding as of June 30, 1999.
There is various litigation pending against the Commonwealth, its
officers and employees. In 1978, the Pennsylvania General Assembly approved a
limited waiver of sovereign immunity. Damages for any loss are limited to
$250,000 for each person and $1 million for each accident. The Supreme Court
held that this limitation is constitutional. Approximately 3,500 suits against
the Commonwealth remain open. An adverse decision in one or more of these
cases could adversely affect governmental operations and/or economic
conditions in Pennsylvania.
Pennsylvania Association of Rural and Small Schools (PARSS) v. Ridge
As of January 15, 2000, Pennsylvania general obligation bonds were
currently rated AA by Standard & Poor's, AA by Fitch and Aa3 by Moody's. There
can be no assurance that the economic conditions on which these ratings are
based will continue or that particular bond issues will not be adversely
affected by changes in economic or political conditions.
SF0358 (0900) Cat. No. 47130
