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THE MAINSTAY FUNDS
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STATEMENT OF ADDITIONAL INFORMATION
JANUARY 1, 1998
[AS SUPPLEMENTED FEBRUARY 2, 1998]
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The MainStay Funds (the "Trust") is an open-end management investment
company (or mutual) currently consisting of fifteen series, the following
fourteen of which are discussed herein: California Tax Free Fund, Capital
Appreciation Fund, Convertible Fund, Equity Index Fund, Government Fund, High
Yield Corporate Bond Fund, International Bond Fund, International Equity Fund,
Money Market Fund, New York Tax Free Fund, Strategic Income Fund, Tax Free Bond
Fund, Total Return Fund and Value Fund (individually or collectively referred to
as a "Fund" or the "Funds"). MainStay Management, Inc. (the "Manager") serves
as the manager for the Funds and has entered into Sub-Advisory agreements with
MacKay-Shields Financial Corporation ("MacKay-Shields") the Sub-Adviser for
thirteen of the Funds and Monitor Capital Advisors, Inc. ("Monitor"), Sub-
Adviser for the Equity Index Fund. MacKay-Shields and Monitor are sometimes
jointly referred to as the "Sub-Advisers."
This Statement of Additional Information is not a prospectus and should be
read in conjunction with the Prospectus of the Trust dated January 1, 1998, as
amended or supplemented from time to time, a copy of which may be obtained
without charge by writing to NYLIFE Distributors Inc., (the "Distributor") 300
Interpace Parkway, Parsippany, NJ 07054 or by calling 1-800-MAINSTAY (1-800-624-
6782).
No dealer, salesman or any other person has been authorized to give any
information or to make any representations, other than those contained in this
Statement of Additional Information or in the related Prospectus, in connection
with the offers contained herein, and, if given or made, such other information
or representations must not be relied upon as having been authorized by the
Funds or the Distributor. This Statement of Additional Information and the
related Prospectus do not constitute an offer by the Trust or by the Distributor
to sell or a solicitation of any offer to buy any of the securities offered
hereby in any jurisdiction to any person to whom it is unlawful to make such
offer in such jurisdiction.
Shareholder inquiries should be made by writing directly to MainStay
Shareholder Services, Inc., P.O. Box 8401, Boston, Massachusetts 02266-8401, or
by calling 1-800-MAINSTAY. In
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addition, you can make inquiries through your registered representative.
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TABLE OF CONTENTS
PAGE IN
STATEMENT OF
ADDITIONAL
INFORMATION
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ADDITIONAL INVESTMENT POLICIES OF THE MONEY MARKET FUND...... 6
INVESTMENT PRACTICES AND INSTRUMENTS COMMON TO MULTIPLE
FUNDS................................................... 9
Repurchase Agreements................................... 9
Lending of Portfolio Securities......................... 11
Bank Obligations........................................ 11
U.S. Government Securities.............................. 12
Debt Securities......................................... 13
Convertible Securities.................................. 13
Arbitrage............................................... 15
Foreign Securities...................................... 15
Foreign Currency Transactions........................... 16
Foreign Index-Linked Instruments........................ 20
Brady Bonds............................................. 21
Municipal Securities.................................... 22
Industrial Development and Pollution Control Bonds...... 27
Variable Rate Demand Notes ("VRDNs").................... 27
Floating and Variable Rate Securities................... 28
Zero Coupon Bonds....................................... 29
Standby Commitments -- Obligations with Puts Attached... 29
When-Issued Securities.................................. 30
Mortgage-Related and Other Asset-Backed Securities...... 31
Short Sales Against the Box............................. 41
Options on Securities................................... 42
Options on Foreign Currencies........................... 48
Securities Index Options................................ 50
Futures Transactions.................................... 51
Swap Agreements......................................... 62
Loan Participation Interests............................ 64
Risks Associated with Debt Securities................... 66
Risks of Investing in High Yield Securities ("Junk
Bonds")............................................... 67
HIGH YIELD CORPORATE BOND FUND
AND STRATEGIC INCOME FUND
SPECIAL CONSIDERATIONS....................................... 67
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EQUITY INDEX FUND
SPECIAL CONSIDERATIONS....................................... 68
TOTAL RETURN FUND
SPECIAL CONSIDERATIONS....................................... 68
CALIFORNIA TAX FREE FUND AND NEW YORK TAX FREE FUND
SPECIAL CONSIDERATIONS....................................... 69
Risk Factors Affecting California Municipal Securities.. 69
Risk Factors Affecting New York Municipal Securities.... 81
Overview................................................ 83
New York City........................................... 93
Special Considerations Affecting Puerto Rico............ 99
THE EQUITY INDEX FUND GUARANTEE.............................. 103
ADDITIONAL FUNDAMENTAL INVESTMENT RESTRICTIONS............... 105
ADDITIONAL NON-FUNDAMENTAL INVESTMENT RESTRICTIONS........... 105
TRUSTEES AND OFFICERS........................................ 109
THE MANAGER, THE SUB-ADVISERS AND THE DISTRIBUTOR............ 116
Management Agreement.................................... 116
Sub-Advisory Agreements................................. 117
Distribution Agreement.................................. 121
Other Services.......................................... 128
Expenses Borne by the Trust............................. 130
PORTFOLIO TRANSACTIONS AND BROKERAGE......................... 131
NET ASSET VALUE.............................................. 136
SHAREHOLDER INVESTMENT ACCOUNT............................... 139
SHAREHOLDER SERVICING AGENT.................................. 139
PURCHASES, REDEMPTION AND REPURCHASE......................... 140
Letter of Intent ("LOI")................................ 140
Suspension of Redemptions............................... 140
CDSC Waivers............................................ 141
TAX-DEFERRED RETIREMENT PLANS................................ 141
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Cash or Deferred Profit Sharing Plans Under Section
401(k) for Corporations and Self-Employed
Individuals........................................... 141
Individual Retirement Account ("IRA")................... 142
403(b)(7) Tax Sheltered Account......................... 144
General Information..................................... 144
CALCULATION OF PERFORMANCE QUOTATIONS........................ 145
TAX STATUS................................................... 154
Taxation of the Funds................................... 154
Character of Distributions to Shareholders -- General... 157
Character of Distributions to Shareholders -- The Tax-
Free Funds............................................ 159
Discount................................................ 160
Users of Bond-Financed Facilities....................... 161
Taxation of Options, Futures and Similar Instruments.... 161
Passive Foreign Investment Companies.................... 163
Foreign Currency Gains and Losses....................... 164
Commodity Investments................................... 165
Dispositions of Fund Shares............................. 165
Tax Reporting Requirements.............................. 166
Foreign Taxes........................................... 167
State and Local Taxes - General......................... 168
Explanation of Fund Distributions....................... 169
Additional Information Regarding the Equity Index Fund.. 169
Additional Information Regarding the California Tax
Free Fund and New York Tax Free Fund.................. 159
Annual Statements....................................... 171
General Information..................................... 172
ORGANIZATION AND CAPITALIZATION.............................. 173
General................................................. 173
Voting Rights........................................... 173
Shareholder and Trustee Liability....................... 173
OTHER INFORMATION........................................... 174
Independent Accountants................................. 174
Legal Counsel........................................... 174
Share Ownership of the Funds............................ 174
Code of Ethics.......................................... 177
FINANCIAL STATEMENTS......................................... 178
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ADDITIONAL INVESTMENT POLICIES OF THE MONEY MARKET FUND
Each Fund has a separate investment objective or objectives which it
pursues through separate investment policies, as described in the Prospectus.
The following discussion elaborates on the presentation of the Money Market
Fund's investment policies contained in the Prospectus.
The Fund may invest its assets in U.S. dollar-denominated securities of
U.S. or foreign issuers and in securities of foreign branches of U.S. banks,
such as negotiable certificates of deposit (Eurodollars). Since the portfolio
of the Fund may contain such securities, an investment therein involves
investment risks that are different in some respects from an investment in a
fund which invests only in debt obligations of U.S. domestic issuers. Such
risks may include future political and economic developments, the possible
imposition of foreign withholding taxes on interest income payable on the
securities held in the portfolio, possible seizure or nationalization of foreign
deposits, the possible establishment of exchange controls or the adoption of
other foreign governmental restrictions which might adversely affect the payment
of the principal of and interest on securities in the portfolio.
All of the assets of the Fund generally will be invested in obligations
which mature in 397 days or less and substantially all of these investments will
be held to maturity; however, securities collateralizing repurchase agreements
may have maturities in excess of 397 days. The Fund will, to the extent
feasible, make portfolio investments primarily in anticipation of or in response
to changing economic and money market conditions and trends. The dollar-
weighted average maturity of the Fund's portfolio may not exceed 90 days.
Consistent with the provisions of a rule of the Securities and Exchange
Commission ("SEC"), the Fund invests only in U.S. dollar-denominated money
market instruments that present minimal credit risk and, with respect to 95% of
its total assets, measured at the time of investment, that are of the highest
quality. The Sub-Adviser shall determine whether a security presents minimal
credit risk under procedures adopted by the Fund's Board of Trustees. A money
market instrument will be considered to be of the highest quality (1) if rated
in the highest rating category (i.e., Aaa or Prime-1 by Moody's, AAA or A-1 by
S&P's) by (i) any two nationally recognized statistical rating organizations
("NRSROs") or, (ii) if rated by only one NRSRO, by that NRSRO, and whose
acquisition
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is approved or ratified by the Board of Trustees; (2) if issued by an issuer
that has short-term debt obligations of comparable maturity, priority, and
security, and that are rated in the highest rating category by (i) any two
NRSRO's or, (ii) if rated by only one NRSRO, by that NRSRO, and whose
acquisition is approved or ratified by the Board of Trustees; or (3) an unrated
security that is of comparable quality to a security in the highest rating
category as determined by the Sub-Adviser and whose acquisition is approved or
ratified by the Board of Trustees. With respect to 5% of its total assets,
measured at the time of investment, the Fund may also invest in money market
instruments that are in the second-highest rating category for short-term debt
obligations (i.e., rated Aa or Prime-2 by Moody 's or AA or A-2 by S&P).
The Fund may not invest more than 5% of its total assets, measured at the
time of investment, in securities of any one issuer that are of the highest
quality, except that the Fund may exceed this 5% limitation with respect to 25%
of its total assets for up to three business days after the purchase of a
security of any one issuer and except that this limitation shall not apply to
U.S. government securities or securities subject to certain puts. The Fund may
not invest more than the greater of 1% of its total assets or one million
dollars, measured at the time of investment, in securities of any one issuer
that are in the second-highest rating category, except that this limitation
shall not apply to U.S. government securities or securities subject to certain
puts. In the event that an instrument acquired by the Fund is downgraded or
otherwise ceases to be of the quality that is eligible for the Fund, the Sub-
Adviser, under procedures approved by the Board of Trustees (or the Board of
Trustees itself if the Sub-Adviser becomes aware an unrated security is
downgraded below high quality and the Sub-Adviser does not dispose of the
security within five business days) shall promptly reassess whether such
security presents minimal credit risk and determine whether or not to retain the
instrument.
Pursuant to the rule, the Fund uses the amortized cost method of valuing
its investments, which facilitates the maintenance of the Fund's per share net
asset value at $1.00. The amortized cost method, which is normally used to value
all of the Fund's portfolio securities, involves initially valuing a security at
its cost and thereafter amortizing to maturity any discount or premium,
regardless of the impact of fluctuating interest rates on the market value of
the instrument.
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The Trustees have also established procedures designed to stabilize, to the
extent reasonably possible, the Fund's price per share as computed for the
purpose of sales and redemptions at $1.00. Such procedures include review of
the Fund's portfolio by the Trustees, at such intervals as they deem
appropriate, to determine whether the Fund's net asset value calculated by using
available market quotations or market equivalents (the determination of value by
reference to interest rate levels, quotations of comparable securities and other
factors) deviates from $1.00 per share based on amortized cost.
The extent of deviation between the Fund's net asset value based upon
available market quotations or market equivalents and $1.00 per share based on
amortized cost will be periodically examined by the Trustees. If such deviation
exceeds 1/2 of 1%, the Trustees will promptly consider what action, if any, will
be initiated. In the event the Trustees determine that a deviation exists which
may result in material dilution or other unfair results to investors or existing
shareholders, they will take such corrective action as they regard to be
necessary and appropriate, including the sale of portfolio instruments prior to
maturity to realize capital gains or losses or to shorten average portfolio
maturity; withholding part or all of dividends or payment of distributions from
capital or capital gains; redemptions of shares in kind; or establishing a net
asset value per share by using available market quotations or equivalents. In
addition, in order to stabilize the net asset value per share at $1.00, the
Trustees have the authority (1) to reduce or increase the number of shares
outstanding on a pro rata basis, and (2) to offset each shareholder's pro rata
portion of the deviation between the net asset value per share and $1.00 from
the shareholder's accrued dividend account or from future dividends.
The Fund may hold cash for the purpose of stabilizing its net asset value
per share. Holdings of cash, on which no return is earned, would tend to lower
the yield on the Fund's shares.
The Fund may also, consistent with the provisions of the rule, invest in
securities with a face maturity of more than 397 days, provided that the
security is a variable or floating rate security that meets the guidelines of
Rule 2a-7 with respect to maturity.
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INVESTMENT PRACTICES AND INSTRUMENTS COMMON TO MULTIPLE FUNDS
The Funds may engage in the following investment practices or invest in the
following instruments to the extent permitted in the Prospectus.
REPURCHASE AGREEMENTS
The Funds may enter into repurchase agreements with member banks of the
Federal Reserve System or member firms of the National Association of Securities
Dealers, Inc. that meet the repurchase agreement creditworthiness guidelines
established by the Trustees. The Equity Index Fund will enter into repurchase
agreements only with domestic banks with total assets in excess of one billion
dollars or primary government securities dealers reporting to the Federal
Reserve Bank of New York, and with respect to securities of the type in which
the Fund may invest. In addition, the International Bond and International
Equity Funds may enter into domestic or foreign repurchase agreements with
certain sellers deemed to be creditworthy pursuant to guidelines adopted by the
Trustees.
A repurchase agreement, which provides a means for a Fund to earn income on
uninvested cash for periods as short as overnight, is an arrangement under which
the purchaser (i.e., the Fund) purchases a U.S. government or other high quality
short-term debt obligation (the "Obligation") and the seller agrees, at the time
of sale, to repurchase the Obligation at a specified time (usually not more than
a week in the case of the Equity Index Fund, California Tax Free Fund and New
York Tax Free Fund) and price. Repurchase agreements with foreign banks may be
available with respect to government securities of the particular foreign
jurisdiction. The custody of the Obligation will be maintained by the Fund's
Custodian. The value of the purchased securities, including any accrued
interest, will at all times exceed the value of the repurchase agreement. The
repurchase price may be higher than the purchase price, the difference being
income to the Fund, or the purchase and repurchase prices may be the same, with
interest at a stated rate due to the Fund together with the repurchase price
upon repurchase. In either case, the income to the Fund is unrelated to the
interest rate on the Obligation subject to the repurchase agreement.
The income on repurchase agreements may be subject to federal and state
income taxes when distributed by a Fund as a
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dividend to shareholders. Subject to applicable limitations, the Tax Free Bond
Fund will enter into repurchase agreements as a means of earning income on its
cash reserves when, in the judgment of the Sub-Adviser, shareholders would
benefit more from receiving taxable income thereon than from earning no income
or tax-free income at a lower rate on such reserves.
For purposes of the 1940 Act, a repurchase agreement is deemed to be a loan
from the Fund to the seller of the Obligation. It is not clear whether a court
would consider the Obligation purchased by the Fund subject to a repurchase
agreement as being owned by the Fund or as being collateral for a loan by the
Fund to the seller. In the event of the commencement of bankruptcy or
insolvency proceedings with respect to the seller of the Obligation before
repurchase of the Obligation under a repurchase agreement, the Fund may
encounter delays and incur costs before being able to sell the security. Delays
may involve loss of interest or decline in price of the Obligation. If the court
characterizes the transaction as a loan and the Fund has not perfected a
security interest in the Obligation, the Fund may be required to return the
Obligation to the seller's estate and be treated as an unsecured creditor of the
seller. As an unsecured creditor, the Fund would be at risk of losing some or
all of the principal and income involved in the transaction. As with any
unsecured debt instrument purchased for the Funds, the Sub-Advisers seek to
minimize the risk of loss from repurchase agreements by analyzing the
creditworthiness of the obligor, in this case the seller of the Obligation.
Apart from the risk of bankruptcy or insolvency proceedings, there is also the
risk that the seller may fail to repurchase the security. However, if the
market value of the Obligation subject to the repurchase agreement becomes less
than the repurchase price (including accrued interest), the Fund will direct the
seller of the Obligation to deliver additional securities so that the market
value of all securities subject to the repurchase agreement equals or exceeds
the repurchase price.
The Strategic Income Fund, California Tax Free Fund and New York Tax Free
Fund may enter into reverse repurchase agreements. A Fund will maintain a
segregated account consisting of liquid assets to cover its obligations under
reverse repurchase agreements. Each of the California Tax Free Fund and New
York Tax Free Fund will limit its investments in reverse repurchase agreements
and other borrowing to no more than 10% of its total assets. The Strategic
Income Fund will limit its investments in
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reverse repurchase agreements to no more than 5% of its total assets.
LENDING OF PORTFOLIO SECURITIES
Each Fund, except the Tax Free Bond Fund and the Money Market Fund, may
seek to increase its income by lending portfolio securities. Under guidelines
adopted by the Funds' Board, such loans may be made to institutions, such as
broker-dealers, and are required to be secured continuously by collateral in
cash or U.S. government securities maintained on a current basis at an amount at
least equal to the market value of the securities loaned. The Fund would have
the right to call a loan and obtain the securities loaned at any time generally
on less than five days' notice. For the duration of a loan, the Fund would
continue to receive the equivalent of the interest or dividends paid by the
issuer on the securities loaned and would also receive compensation from the
investment of the collateral. The Fund would not, however, have the right to
vote any securities having voting rights during the existence of the loan, but
the Fund would call the loan in anticipation of an important vote to be taken
among holders of the securities or of the giving or withholding of their consent
on a material matter affecting the investment. The Trust, on behalf of certain
of the Funds, has entered into an agency agreement with Merrill Lynch Portfolio
Services, Inc. which acts as the Funds' agent in making loans of portfolio
securities and short-term money market investments of the cash collateral
received, under the supervision and control of the Funds' Sub-Advisers.
As with other extensions of credit there are risks of delay in recovery of,
or even loss of rights in, the collateral should the borrower of the securities
fail financially or breach its agreement with a Fund. However, the loans would
be made only to firms deemed by the Sub-Adviser to be creditworthy and approved
by the Board, and when, in the judgment of the Sub-Adviser, the consideration
which can be earned currently from securities loans of this type justifies the
attendant risk. The value of securities loaned will not exceed 33% of the value
of the total assets of the lending Fund. In addition, pursuant to guidelines
adopted by the Board, each Fund is prohibited from lending more than 5% of its
total assets to any one counterparty.
BANK OBLIGATIONS
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Time deposits are nonnegotiable deposits maintained in a banking
institution for a specified period of time at a stated interest rate. Time
deposits which may be held by the Funds will not benefit from insurance from the
Bank Insurance Fund or the Savings Association Insurance Fund administered by
the Federal Deposit Insurance Corporation.
Certificates of deposit are certificates evidencing the obligation of a
bank to repay funds deposited with it for a specified period of time.
Bankers' acceptances are credit instruments evidencing the obligation of a
bank to pay a draft drawn on it by a customer. These instruments reflect the
obligation both of the bank and of the drawer to pay the full amount of the
instrument upon maturity.
Investments in the obligations of banks are deemed to be "cash equivalents"
if, at the date of investment, the banks have capital surplus and individual
profits (as of the date of their most recently published financials) in excess
of $100,000,000, or if, with respect to the obligations of other banks and
savings and loan associations, such obligations are federally insured. The
Equity Index Fund will not be subject to the above restriction to the extent it
invests in bank obligations of United States banks (including foreign branches)
which have more than $1 billion in total assets at the time of investment and
are members of the Federal Reserve System or are examined by the Comptroller of
the Currency or whose deposits are insured by the Federal Deposit Insurance
Corporation. The Equity Index Fund also may invest in certificates of deposit
of savings and loan associations (federally or state chartered and federally
insured) having total assets in excess of $1 billion.
U.S. GOVERNMENT SECURITIES
Securities issued or guaranteed by the U.S. government or its agencies or
instrumentalities include U.S. Treasury securities, which differ only in their
interest rates, maturities and times of issuance. Treasury bills have initial
maturities of one year or less; Treasury notes have initial maturities of one to
ten years; and Treasury bonds generally have initial maturities of greater than
ten years. Some obligations issued or guaranteed by U.S. government agencies
and instrumentalities, for example, Government National Mortgage Association
("GNMA") pass-
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through certificates, are supported by the full faith and credit of the U.S.
Treasury; others, such as those of the Federal Home Loan Banks, by the right of
the issuer to borrow from the Treasury; others, such as those issued by the
Federal National Mortgage Association ("FNMA"), by the discretionary authority
of the U.S. government to purchase certain obligations of the agency or
instrumentality; and others, such as those issued by the Student Loan Marketing
Association, only by the credit of the agency or instrumentality. While the U.S.
government provides financial support to such U.S. government-sponsored agencies
or instrumentalities, no assurance can be given that it will always do so, and
it is not so obligated by law. See "Mortgage-Related and Other Asset-Backed
Securities." The Equity Index Fund will invest in such securities only when it
is satisfied that the credit risk with respect to the issuer is minimal.
DEBT SECURITIES
Debt securities may have fixed, variable or floating (including inverse
floating) rates of interest. To the extent that a Fund invests in debt
securities, it will be subject to certain risks. The value of the debt
securities held by a Fund, and thus the NAV of the shares of a Fund, generally
will fluctuate depending on a number of factors, including, among others,
changes in the perceived creditworthiness of the issuers of those securities,
movements in interest rates, the average maturity of a Fund's investments,
changes in relative values of the currencies in which a Fund's investments are
denominated relative to the U.S. dollar, and the extent to which a Fund hedges
its interest rate, credit and currency exchange rate risks. Generally, a rise
in interest rates will reduce the value of fixed income securities held by a
Fund, and a decline in interest rates will increase the value of fixed income
securities held by a Fund.
CONVERTIBLE SECURITIES
The Capital Appreciation Fund, Convertible Fund, High Yield Corporate Bond
Fund, International Bond Fund, International Equity Fund, Strategic Income Fund,
Total Return Fund and Value Fund may invest in securities convertible into
common stock or the cash value of a single equity security or a basket or index
of equity securities. Such investments may be made, for example, if the Sub-
Adviser believes that a company's convertible securities are undervalued in the
market. Convertible securities
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eligible for inclusion in the Funds' portfolios include convertible bonds,
convertible preferred stocks, warrants or notes or other debt instruments that
may be exchanged for cash payable in an amount that is linked to the value of a
particular security, basket of securities, index or indices of securities or
currencies.
Convertible securities, until converted, have the same general
characteristics as other fixed income securities insofar as they generally
provide a stable stream of income with generally higher yields than those of
equity securities of the same or similar issuers. By permitting the holder to
exchange his investment for common stock or the cash value of a security or a
basket or index of securities, convertible securities may also enable the
investor to benefit from increases in the market price of the underlying
securities. Therefore, convertible securities generally offer lower interest or
dividend yields than non-convertible securities of similar quality.
As with all fixed income securities, the market value of convertible
securities tends to decline as interest rates increase and, conversely, tends to
increase as interest rates decline. The unique feature of the convertible
security is that as the market price of the underlying common stock declines, a
convertible security tends to trade increasingly on a yield basis, and so may
not experience market value declines to the same extent as the underlying common
stock. When the market price of the underlying common stock increases, the
price of a convertible security increasingly reflects the value of the
underlying common stock and may rise accordingly. While no securities
investment is without some risk, investments in convertible securities generally
entail less risk than investments in the common stock of the same issuer.
Holders of fixed income securities (including convertible securities) have
a claim on the assets of the issuer prior to the holders of common stock in case
of liquidation. However, convertible securities are typically subordinated to
similar non-convertible securities of the same issuer.
Accordingly, convertible securities have unique investment characteristics
because (i) they have relatively high yields as compared to common stocks, (ii)
they have defensive characteristics since they provide a fixed return even if
the market price of the underlying common stock declines, and (iii)
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they provide the potential for capital appreciation if the market price of the
underlying common stock increases.
A convertible security may be subject to redemption at the option of the
issuer at a price established in the charter provision or indenture pursuant to
which the convertible security is issued. If a convertible security held by a
Fund is called for redemption, the Fund will be required to surrender the
security for redemption, convert it into the underlying common stock or cash or
sell it to a third party.
ARBITRAGE
Each Fund, except the California Tax Free Fund, Equity Index Fund,
International Bond Fund, International Equity Fund, New York Tax Free Fund and
Tax Free Bond Fund, may sell in one market a security which it owns and
simultaneously purchase the same security in another market, or it may buy a
security in one market and simultaneously sell it in another market, in order to
take advantage of differences between the prices of the security in the
different markets. Although the Funds do not actively engage in arbitrage, such
transactions may be entered into only with respect to debt securities and will
occur only in a dealer's market where the buying and selling dealers involved
confirm their prices to the Fund at the time of the transaction, thus
eliminating any risk to the assets of a Fund.
FOREIGN SECURITIES
Except for the California Tax Free Fund, Government Fund, New York Tax Free
Fund and Tax Free Bond Fund, each Fund may invest, without limit, subject to the
other investment policies applicable to the Fund, in U.S. dollar-denominated and
non-dollar-denominated foreign debt and equity securities and in certificates of
deposit issued by foreign banks and foreign branches of U.S. banks. Under
current SEC rules relating to the use of the amortized cost method of portfolio
securities valuation, the Money Market Fund is restricted to purchasing U.S.
dollar-denominated securities, but it is not otherwise precluded from purchasing
securities of foreign issuers.
Investors should carefully consider the appropriateness of foreign
investing in light of their financial objectives and goals. While foreign
markets may present unique investment opportunities, foreign investing involves
risks not associated
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with domestic investing. Securities markets in other countries are not always as
efficient as those in the U.S. and are sometimes less liquid and more volatile.
Other risks involved in investing in the securities of foreign issuers include
differences in accounting, auditing and financial reporting standards; limited
publicly available information; the difficulty of assessing economic trends in
foreign countries; generally higher commission rates on foreign portfolio
transactions; the possibility of nationalization, expropriation or confiscatory
taxation; adverse changes in investment or exchange control regulations (which
may include suspension of the ability to transfer currency from a country);
government interference, including government ownership of companies in certain
sectors, wage and price controls, or imposition of trade barriers and other
protectionist measures; difficulties in invoking legal process abroad and
enforcing contractual obligations; political, social or economic instability
which could affect U.S. investments in foreign countries; and potential
restrictions on the flow of international capital. Additionally, foreign
securities and dividends and interest payable on those securities may be subject
to foreign taxes, including foreign withholding taxes, and other foreign taxes
may apply with respect to securities transactions. Additional costs associated
with an investment in foreign securities may include higher transaction, custody
and foreign currency conversion costs. In the event of litigation relating to a
portfolio investment, the Funds may encounter substantial difficulties in
obtaining and enforcing judgments against non-U.S. resident individuals and
companies. Investment in emerging market countries presents risks in greater
degree than, and in addition to, those presented by investment in foreign
issuers in general.
FOREIGN CURRENCY TRANSACTIONS
Many of the foreign securities in which the Funds invest will be
denominated in foreign currencies. Changes in foreign exchange rates will
affect the value of securities denominated or quoted in foreign currencies.
Exchange rate movements can be large and can endure for extended periods of
time, affecting either favorably or unfavorably the value of the Funds' assets.
However, each Fund, except the California Tax Free Fund, the Equity Index Fund,
the Government Fund, the Money Market Fund, the New York Tax Free Fund and the
Tax Free Bond Fund, may, to the extent it invests in foreign securities, enter
into forward foreign currency transactions in order to protect against
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uncertainty in the level of future foreign currency exchange rates. Each of
these Funds may enter into contracts to purchase foreign currencies to protect
against an anticipated rise in the U.S. dollar price of securities it intends to
purchase and may enter into contracts to sell foreign currencies to protect
against the decline in value of its foreign currency-denominated portfolio
securities due to a decline in the value of the foreign currencies against the
U.S. dollar. In addition, a Fund may use one currency (or a basket of
currencies) to hedge against adverse changes in the value of another currency
(or a basket of currencies) when exchange rates between the two currencies are
correlated.
Foreign currency transactions in which the Funds may engage include forward
foreign currency contracts, currency exchange transactions on a spot (i.e.,
----
cash) basis, put and call options on foreign currencies and foreign exchange
futures contracts. A forward foreign currency exchange contract involves an
obligation to purchase or sell a specific currency at a future date, which may
be any fixed number of days (usually less than one year) from the date of the
contract agreed upon by the parties, at a price set at the time of the contract.
These contracts are traded in the interbank market conducted directly between
traders (usually large commercial banks) and their customers. A forward
contract generally has no deposit requirement, and no commissions are charged at
any stage for trades. Although foreign exchange dealers do not charge a fee for
conversion, they do realize a profit based on the difference (the spread)
between the price at which they are buying and selling various currencies.
Normally, consideration of the prospect for currency parities will be
incorporated in a longer term investment decision made with regard to overall
diversification strategies. However, the Sub-Adviser believes that it is
important to have the flexibility to enter into such forward contracts when it
determines that the best interest of a Fund will be served by entering into such
a contract. Generally, the Sub-Adviser believes that the best interest of a
Fund will be served if a Fund is permitted to enter into forward contracts under
specified circumstances. First, when a Fund enters into, or anticipates
entering 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. By entering into a forward contract for the purchase or sale, for a
fixed amount of U.S. dollars, of the amount of foreign currency involved in the
underlying security transaction, a Fund will be able to insulate
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itself from a possible loss resulting from a change in the relationship between
the U.S. dollar and the subject foreign currency during the period between the
date on which the security is purchased or sold and the date on which payment is
made or received, although a Fund would also forego any gain it might have
realized had rates moved in the opposite direction. This technique is sometimes
referred to as a "settlement" hedge or "transaction" hedge.
Second, when the Sub-Adviser believes that the currency of a particular
foreign country may suffer a substantial decline against the U.S. dollar, it 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 a Fund's portfolio
securities denominated in such foreign currency. Such a hedge (sometimes
referred to as a "position" hedge) will tend to offset both positive and
negative currency fluctuations, but will not offset changes in security values
caused by other factors. The Fund also may hedge the same position by using
another currency (or a basket of currencies) expected to perform in a manner
substantially similar to the hedged currency ("proxy hedge"). The precise
matching of the forward contract amounts and the value of the securities
involved will not generally be possible since the future value of such
securities in foreign currencies will change as a consequence of market
movements in the value of those securities between the date the forward contract
is entered into and the date it matures. With respect to positions that
constitute "transaction" or "position" hedges (including "proxy" hedges), a Fund
will not enter into forward contracts to sell currency or maintain a net
exposure to such contracts if the consummation of such contracts would obligate
the Fund to deliver an amount of foreign currency in excess of the value of the
Fund's portfolio securities or other assets denominated in that currency (or the
related currency, in the case of a "proxy" hedge).
Finally, a Fund may enter into forward contracts to shift its investment
exposure from one currency into another currency that is expected to perform
inversely with respect to the hedged currency relative to the U.S. dollar. This
type of strategy, sometimes known as a "cross-currency" hedge, will tend to
reduce or eliminate exposure to the currency that is sold, and increase exposure
to the currency that is purchased, much as if the Fund had sold a security
denominated in one currency and purchased an equivalent security denominated in
another. "Cross-currency" hedges protect against losses resulting from a
decline in the
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hedged currency, but will cause the Fund to assume the risk of fluctuations in
the value of the currency it purchases.
At the consummation of the forward contract, a Fund may either make
delivery of the foreign currency or terminate its contractual obligation to
deliver the foreign currency by purchasing an offsetting contract obligating it
to purchase at the same maturity date the same amount of such foreign currency.
If a Fund chooses to make delivery of the foreign currency, it may be required
to obtain such currency for delivery through the sale of portfolio securities
denominated in such currency or through conversion of other assets of the Fund
into such currency. If a Fund engages in an offsetting transaction, the Fund
will realize a gain or a loss to the extent that there has been a change in
forward contract prices. Closing purchase transactions with respect to forward
contracts are usually effected with the currency trader who is a party to the
original forward contract.
A Fund's dealing in forward contracts will be limited to the transactions
described above. Of course, a Fund is not required to enter into such
transactions with regard to its foreign currency-denominated securities and will
not do so unless deemed appropriate by the Sub-Adviser. A Fund generally will
not enter into a forward contract with a term of greater than one year.
In cases of transactions which constitute "transaction" hedges, or
"position" hedges (including "proxy" hedges) or "cross-currency" hedges that
involve purchase and sale of two different foreign currencies directly through
the same foreign currency contract, a Fund may deem its forward currency hedge
position to be covered by underlying Fund portfolio securities or may establish
a Segregated Account with its Custodian in an amount equal to the value of the
Fund's total assets committed to the consummation of the subject hedge. The
Segregated Account will consist of liquid assets. In the case of "anticipatory"
hedges and "cross-currency" hedges that involve the purchase and sale of two
different foreign currencies indirectly through separate forward currency
contracts, the Fund will establish a Segregated Account with its Custodian as
described above. In the event a Fund establishes a Segregated Account, the Fund
will mark-to-market the value of the assets in the Segregated Account. If the
value of the liquid assets placed in the Segregated Account declines, additional
liquid assets will be placed in the account by the Fund on a daily basis so that
the value of the
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account will equal the amount of the Fund's commitments with respect to such
contracts.
It should be realized that this method of protecting the value of a Fund's
portfolio securities against a decline in the value of a currency does not
eliminate fluctuations in the underlying prices of the securities. It simply
establishes a rate of exchange which can be achieved at some future point in
time. It also reduces any potential gain which may have otherwise occurred had
the currency value increased above the settlement price of the contract. The
Funds cannot assure that the techniques discussed above will be successful.
Successful use of forward contracts depends on the investment manager's skill in
analyzing and predicting relative currency values. Forward contracts alter a
Fund's exposure to currency exchange rate activity and could result in losses to
the Fund if currencies do not perform as investment managers anticipate. A Fund
may also incur significant costs when converting assets from one currency to
another. Contracts to sell foreign currency would limit any potential gain
which might be realized by a Fund if the value of the hedged currency increases.
The Sub-Adviser believes active currency management can be employed as an
overall portfolio risk management tool. For example, in their view, foreign
currency management can provide overall portfolio risk diversification when
combined with a portfolio of foreign securities, and the market risks of
investing in specific foreign markets can at times be reduced by currency
strategies which may not involve the currency in which the foreign security is
denominated.
A Fund's foreign currency transactions may be limited by the requirements
of Subchapter M of the Code for qualification as a regulated investment company.
FOREIGN INDEX-LINKED INSTRUMENTS
As part of its investment program, and to maintain greater flexibility, the
International Bond Fund, International Equity Fund and Strategic Income Fund
may, subject to compliance with each Fund's limitations applicable to its
investment in debt securities, invest in instruments issued by the U.S. or a
foreign government or by private issuers that return principal and/or pay
interest to investors in amounts which are linked to the level of a particular
foreign index ("foreign index-linked instruments").
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Foreign index-linked instruments have the investment characteristics of
particular securities, securities indexes, futures contracts or currencies. Such
instruments may take a variety of forms, such as debt instruments with interest
or principal payments determined by reference to the value of a currency or
commodity at a future point in time.
A foreign index may be based upon the exchange rate of a particular
currency or currencies or the differential between two currencies, or the level
of interest rates in a particular country or countries, or the differential in
interest rates between particular countries. In the case of foreign index-
linked instruments linking the interest component to a foreign index, the amount
of interest payable will adjust periodically in response to changes in the level
of the foreign index during the term of the foreign index-linked instrument.
BRADY BONDS
Each of the Convertible Fund, High Yield Corporate Bond Fund, International
Bond Fund, Strategic Income Fund and Total Return Fund may invest a portion of
its assets in Brady Bonds, which are securities created through the exchange of
existing commercial bank loans to sovereign entities for new obligations in
connection with debt restructurings. Brady Bonds may be collateralized or
uncollateralized and are issued in various currencies (primarily the U.S.
dollar). Brady bonds are not considered U.S. government securities.
U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed
rate par bonds or floating rate discount bonds, are generally collateralized in
full as to principal by U.S. Treasury zero coupon bonds having the same maturity
as the Brady Bonds. Interest payments on these Brady Bonds generally are
collateralized on a one-year or longer rolling-forward basis by cash or
securities in an amount that, in the case of fixed rate bonds, is equal to at
least one year of interest payments or, in the case of floating rate bonds,
initially is equal to at least one year's interest payments based on the
applicable interest rate at that time and is adjusted at regular intervals
thereafter. Certain Brady Bonds are entitled to "value recovery payments" in
certain circumstances, which in effect constitute supplemental interest payments
but generally are not collateralized. Brady Bonds are often viewed as having
three or four valuation components: (i) the collateralized repayment of
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principal at final maturity; (ii) the collateralized interest payments; (iii)
the uncollateralized interest payments; and (iv) any uncollateralized repayment
of principal at maturity (these uncollateralized amounts constitute the
"residual risk").
Brady Bonds involve various risk factors including the history of defaults
with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds. There can be no assurance that Brady Bonds in
which the Fund may invest will not be subject to restructuring arrangements or
to requests for new credit, which may cause the Fund to suffer a loss of
interest or principal on any of its holdings.
MUNICIPAL SECURITIES
Municipal securities generally are understood to include debt obligations
issued by, or on behalf of, states, territories and possessions of the United
States and their political sub-divisions, agencies and instrumentalities and the
District of Columbia, to obtain funds for various public purposes, including
construction of a wide range of public facilities, refunding of outstanding
obligations, payment of general operating expenses and extensions of loans to
public institutions and facilities. The yields on municipal securities depend
upon a variety of factors, including general economic and monetary conditions,
general money market conditions, general conditions of the municipal securities
market, the financial condition of the issuer, the size of a particular
offering, the maturity of the obligations offered and the rating of the issue or
issues. Municipal securities also may be subject to the provisions of
bankruptcy, insolvency and other laws affecting the rights and remedies of
creditors, such as the Federal Bankruptcy Code, and laws, if any, which may be
enacted by Congress or state legislatures extending the time for payment of
principal or interest, or both, or imposing other constraints upon enforcement
of such obligations or upon the ability of municipalities to levy taxes. There
is also the possibility that, as a result of litigation or other conditions, the
power or ability of any one or more issuers to pay, when due, the principal of,
and interest on, its or their municipal securities may be materially and
adversely affected.
Tax Anticipation Notes are used to finance working capital needs of
municipalities and are issued in anticipation of various seasonal tax revenues,
to be payable from these specific future
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taxes. They are usually general obligations of the issuer, secured by the taxing
power for the payment of principal and interest.
Revenue Anticipation Notes are issued in expectation of receipt of other
kinds of revenue, such as federal revenues. They, also, are usually general
obligations of the issuer.
Bond Anticipation Notes are normally issued to provide interim financial
assistance until long-term financing can be arranged. The long-term bonds then
provide funds for the repayment of the notes.
Construction Loan Notes are sold to provide construction financing for
specific projects. After successful completion and acceptance, many projects
receive permanent financing through the FHA under the FNMA or GNMA.
Project Notes are instruments sold by the Department of Housing and Urban
Development ("HUD") but issued by a state or local housing agency to provide
financing for a variety of programs. They are backed by the full faith and
credit of the U.S. government, and generally carry a term of one year or less.
Short-Term Discount Notes (tax-exempt commercial paper) are short-term (365
days or less) promissory notes issued by municipalities to supplement their cash
flow.
Municipal Bonds, which meet longer-term capital needs and generally have
maturities of more than one year when issued, have two principal
classifications: general obligation bonds and revenue bonds. Issuers of
general obligation bonds include states, counties, cities, towns and regional
districts. The proceeds of these obligations are used to fund a wide range of
public projects, including construction or improvement of schools, highways and
roads, and water and sewer systems. The basic security behind general
obligation bonds is the issuer's pledge of its full faith, credit and taxing
power for the payment of principal and interest. The taxes that can be levied
for the payment of debt service may be limited or unlimited as to the rate or
amount of special assessments.
A revenue bond is not secured by the full faith, credit and taxing power of
an issuer. Rather, the principal security for a revenue bond is generally the
net revenue derived from a particular facility, group of facilities or, in some
cases, the
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proceeds of a special excise or other specific revenue source. Revenue bonds are
issued to finance a wide variety of capital projects, including: electric, gas,
water, and sewer systems; highways, bridges, and tunnels; port and airport
facilities; colleges and universities; and hospitals. Although the principal
security behind these bonds may vary, many provide additional security in the
form of a debt service reserve fund which may be used to make principal and
interest payments on the issuer's obligations. Housing finance authorities have
a wide range of security and credit enhancement guarantees available to them,
including partially or fully insured mortgages, rent subsidized and/or
collateralized mortgages, and/or the net revenues from housing or other public
projects. Some authorities are provided further security in the form of a
state's assurance (although without obligation) to make up deficiencies in the
debt service reserve fund.
An entire issue of Municipal Bonds may be purchased by one or a small
number of institutional investors such as the Funds. Thus, the issue may not be
said to be publicly offered. Unlike securities which must be registered under
the Securities Act of 1933 prior to offer and sale, unless an exemption from
such registration is available, Municipal Bonds which are not publicly offered
may nevertheless be readily marketable. A secondary market exists for Municipal
Bonds which were not publicly offered initially.
The Tax Free Bond Fund may invest more than 25% of its total assets in
Municipal Bonds the issuers of which are located in the same state and may
invest more than 25% of its total assets in Municipal Bonds the security of
which is derived from any one of the following categories: hospitals and health
facilities; turnpikes and toll roads; ports and airports; colleges and
universities; public housing authorities; general obligations of states and
localities; lease rental obligations of states and local authorities; state and
local housing finance authorities; municipal utilities systems; bonds that are
secured or backed by the Treasury or other U.S. government guaranteed
securities; or industrial development and pollution control bonds. There could
be economic, business or political developments which might affect all Municipal
Bonds of a similar type. However, the Fund believes that the most important
consideration affecting risk is the quality of Municipal Bonds.
The Tax Free Bond Fund may engage in short-term trading (selling securities
held for brief periods of time, usually less
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than three months) if the Sub-Adviser believes that such transactions, net of
costs including taxes, if any, would improve the overall return on its
portfolio. The needs of different classes of lenders and borrowers and their
changing preferences and circumstances have in the past caused market
dislocations unrelated to fundamental creditworthiness and trends in interest
rates which have presented market trading opportunities. There can be no
assurance that such dislocations will occur in the future or that the Fund will
be able to take advantage of them.
There are, in addition, a variety of hybrid and special types of municipal
obligations, such as municipal lease obligations, as well as numerous
differences in the security of Municipal Bonds both within and between the two
principal classifications described above. Municipal lease obligations are
municipal securities that may be supported by a lease or an installment purchase
contract issued by state and local government authorities to acquire funds to
obtain the use of a wide variety of equipment and facilities such as fire and
sanitation vehicles, computer equipment and other capital assets. These
obligations, which may be secured or unsecured, are not general obligations and
have evolved to make it possible for state and local governments to obtain the
use of property and equipment without meeting constitutional and statutory
requirements for the issuance of debt. Thus, municipal lease obligations have
special risks not normally associated with Municipal Bonds. These obligations
frequently contain "non-appropriation" clauses that provide that the
governmental issuer of the obligation has no obligation to make future payments
under the lease or contract unless money is appropriated for such purposes by
the legislative body on a yearly or other periodic basis. In addition to the
"nonappropriation" risk, many municipal lease obligations have not yet developed
the depth of marketability associated with Municipal Bonds; moreover, although
the obligations may be secured by the leased equipment, the disposition of the
equipment in the event of foreclosure might prove difficult. For the purpose of
each Fund's investment restrictions, the identification of the "issuer" of
Municipal Bonds which are not General Obligation Bonds is made by the Sub-
Adviser on the basis of the characteristics of the Municipal Bonds as described
above, the most significant of which is the source of funds for the payment of
principal of and interest on such Bonds.
In order to limit certain of these risks, the California Tax Free Fund, New
York Tax Free Fund and Tax Free Bond Fund will not
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invest more than 10% (15% in the case of the Strategic Income Fund) of its total
assets in municipal lease obligations that are illiquid (along with all other
illiquid securities). The liquidity of municipal lease obligations purchased by
the Funds will be determined pursuant to guidelines approved by the Board of
Trustees. Factors considered in making such determinations may include: the
frequency of trades and quotes for the obligation; the number of dealers willing
to purchase or sell the security and the number of other potential buyers; the
willingness of dealers to undertake to make a market in the security; the nature
of marketplace trades; the obligation's rating; and, if the security is unrated,
the factors generally considered by a rating agency.
There may be other types of municipal securities that become available
which are similar to the foregoing described municipal securities in which each
Fund may invest.
INCOME LEVEL AND CREDIT RISK Municipal obligations are subject to the
----------------------------
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the Federal Bankruptcy Code, and laws, if any,
which may be enacted by Congress or state legislatures extending the time for
payment of principal or interest, or both, or imposing other constraints upon
enforcement of such obligations or upon municipalities to levy taxes. There is
also the possibility that as a result of litigation or other conditions, the
power or ability of any one or more issuers to pay, when due, principal or
interest on its or their municipal obligations may be materially affected.
Although the Funds' quality standards are designed to minimize the credit risk
of investing in Municipal Bonds, that risk cannot be entirely eliminated.
TAX CONSIDERATIONS With respect to the California Tax Free Fund, New York
------------------
Tax Free Fund and Tax Free Bond Fund, income derived by a Fund from taxable
investments, including but not limited to securities lending transactions,
repurchase transactions, options and futures transactions, and investments in
commercial paper, bankers' acceptances and certificates of deposit will be
taxable for federal, state and local income tax purposes when distributed to
shareholders. Income derived by a Fund from interest on direct obligations of
the U.S. government will be taxable for federal income tax purposes when
distributed to shareholders but, provided that the Fund meets the requirements
of state law and properly designates distributions
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to shareholders, such distributions may be excludable from income for state
personal income tax purposes. A portion of original issue discount relating to
stripped Municipal Bonds and their coupons may also be treated as taxable income
under certain circumstances.
The Tax Reform Act of 1986 ("TRA") limited the types and volume of
Municipal Bonds qualifying for the federal income tax exemption for interest,
and the Code treats tax-exempt interest on certain Municipal Bonds as a tax
preference item included in the alternative minimum tax base for corporate and
noncorporate shareholders. In addition, all tax-exempt interest may result in
or increase a corporation's liability under the corporate alternative minimum
tax, because a portion of the difference between corporate "adjusted current
earnings" and alternative minimum taxable income is treated as a tax preference
item. Further, an issuer's failure to comply with the detailed and numerous
requirements imposed by the Code after bonds have been issued may cause the
retroactive revocation of the tax-exempt status of certain Municipal Bonds after
their issuance. The Funds intend to monitor developments in the municipal bond
market to determine whether any defensive action should be taken.
INDUSTRIAL DEVELOPMENT AND POLLUTION CONTROL BONDS
Industrial Development Bonds which pay tax-exempt interest are, in most
cases, revenue bonds and are issued by, or on behalf of, public authorities to
raise money to finance various privately operated facilities for business,
manufacturing, housing, sports, and pollution control. These bonds are also
used to finance public facilities such as airports, mass transit systems, ports,
and parking. The payment of the principal and interest on such bonds is solely
dependent on the ability of the facility's user to meet its financial
obligations and the pledge, if any, of the real and personal property so
financed as security for such payments. These bonds are generally not secured
by the taxing power of the municipality but are secured by the revenues of the
authority derived from payments by the industrial user.
Industrial Development and Pollution Control Bonds, although nominally
issued by municipal authorities, are generally not secured by the taxing power
of the municipality but are secured by the revenues of the authority derived
from payments by the industrial user. Industrial Development Bonds issued after
the effective date of the TRA, as well as certain other bonds, are
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now classified as "private activity bonds." Some, but not all, private activity
bonds issued after that date qualify to pay tax-exempt interest.
VARIABLE RATE DEMAND NOTES ("VRDNS")
The California Tax Free Fund, New York Tax Free Fund and Tax Free Bond Fund
may invest in tax-exempt obligations which contain a floating or variable
interest rate adjustment formula and an unconditional right of demand to receive
payment of the unpaid principal balance plus accrued interest upon a short
notice period prior to specified dates, generally at 30, 60, 90, 180 or 365-day
intervals. The interest rates are adjustable at various intervals to the
prevailing market rate for similar investments, such adjustment formula being
calculated to maintain the market value of the VRDN at approximately the par
value of the VRDN on the adjustment date. The adjustments are typically based
upon the prime rate of a bank or some other appropriate interest rate adjustment
index.
The California Tax Free Fund, New York Tax Free Fund and Tax Free Bond Fund
may also invest in VRDNs in the form of participation interests ("Participating
VRDNs") in variable rate tax-exempt obligations held by a financial institution,
typically a commercial bank ("Institution"). Participating VRDNs provide a Fund
with a specified undivided interest (up to 100%) of the underlying obligation
and the right to demand payment of the unpaid principal balance plus accrued
interest on the Participating VRDNs from the Institution upon a specified number
of days' notice, not to exceed seven days. In addition, the Participating VRDN
is backed up by an irrevocable letter of credit or guaranty of the Institution.
A Fund has an undivided interest in the underlying obligation and thus
participates on the same basis as the Institution in such obligation, except
that the Institution typically retains fees out of the interest paid or the
obligation for servicing the obligation, providing the letter of credit and
issuing the repurchase commitment.
FLOATING AND VARIABLE RATE SECURITIES
Floating and variable rate securities provide for a periodic adjustment in
the interest rate paid on the obligations. The terms of such obligations must
provide that interest rates are adjusted periodically based upon an interest
rate adjustment index as provided in the respective obligations. The adjustment
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intervals may be regular, and range from daily up to annually, or may be based
on an event, such as a change in the prime rate.
The interest rate on a floating rate debt instrument ("floater") is a
variable rate which is tied to another interest rate, such as a money-market
index or Treasury bill rate. The interest rate on a floater resets
periodically, typically every six months. While, because of the interest rate
reset feature, floaters provide the Funds with a certain degree of protection
against rises in interest rates, the Funds will participate in any declines in
interest rates as well.
The interest rate on a leveraged inverse floating rate debt instrument
("inverse floater") resets in the opposite direction from the market rate of
interest to which the inverse floater is indexed. An inverse floater may be
considered to be leveraged to the extent that its interest rate varies by a
magnitude that exceeds the magnitude of the change in the index rate of
interest. The higher degree of leverage inherent in inverse floaters is
associated with greater volatility in their market values. Accordingly, the
duration of an inverse floater may exceed its stated final maturity. Certain
inverse floaters may be deemed to be illiquid securities for purposes of the
Funds' limitations on investments in such securities.
ZERO COUPON BONDS
The Funds, except the Equity Index Fund, may purchase zero coupon bonds,
which are debt obligations issued without any requirement for the periodic
payment of interest. Zero coupon bonds are issued at a significant discount
from face value. The discount approximates the total amount of interest the
bonds would accrue and compound over the period until maturity at a rate of
interest reflecting market rate at the time of issuance. Because interest on
zero coupon bonds is not distributed on a current basis but is, in effect,
compounded, zero coupon bonds tend to be subject to greater market risk than
interest paying securities of similar maturities. The discount represents
income, a portion of which the Funds must accrue and distribute every year even
though a Fund receives no payment on the investment in that year. Zero coupon
bonds tend to be more volatile than conventional debt securities.
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STANDBY COMMITMENTS -- OBLIGATIONS WITH PUTS ATTACHED
The California Tax Free Fund, New York Tax Free Fund, Strategic Income Fund
and Tax Free Bond Fund may purchase municipal securities together with the right
to resell the securities to the seller at an agreed-upon price or yield within a
specified period prior to the maturity date of the securities. Although it is
not a put option in the usual sense, such a right to resell is commonly known as
a "put" and is also referred to as a "standby commitment." Each Fund may pay
for a standby commitment either separately, in cash, or in the form of a higher
price for the securities which are acquired subject to the standby commitment,
thus increasing the cost of securities and reducing the yield otherwise
available from the same security. The Sub-Adviser understands that the Internal
Revenue Service (the "IRS") has issued a revenue ruling to the effect that,
under specified circumstances, a registered investment company will be the owner
of tax-exempt municipal obligations acquired subject to a put option. The IRS
has also issued private letter rulings to certain taxpayers (which do not serve
as precedent for other taxpayers) to the effect that tax-exempt interest
received by a regulated investment company with respect to such obligations will
be tax-exempt in the hands of the company and may be distributed to its
shareholders as exempt-interest dividends. The IRS has subsequently announced
that it will not ordinarily issue advance ruling letters as to the identity of
the true owner of property in cases involving the sale of securities or
participation interests therein if the purchaser has the right to cause the
security, or the participation interest therein, to be purchased by either the
seller or a third party. Each of the California Tax Free Fund, New York Tax
Free Fund and Tax Free Bond Fund intends to take the position that it is the
owner of any municipal obligations acquired subject to a standby commitment and
that tax-exempt interest earned with respect to such municipal obligations will
be tax-exempt in its hands; however, no assurance can be given that this
position would prevail if challenged. In addition, there is no assurance that
standby commitments will be available to a Fund, nor has the California Tax Free
Fund, New York Tax Free Fund or Tax Free Bond Fund assumed that such commitments
would continue to be available under all market conditions.
A standby commitment may not be used to affect a Fund's valuation of the
municipal security underlying the commitment. Any consideration paid by a Fund
for the standby commitment,
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whether paid in cash or by paying a premium for the underlying security, which
increases the cost of the security and reduces the yield otherwise available
from the same security, will be accounted for by the Fund as unrealized
depreciation until the standby commitment is exercised or has expired.
WHEN-ISSUED SECURITIES
The Funds may from time to time purchase securities on a "when-issued"
basis. Debt securities, including municipal bonds, are often issued in this
manner. The price of such securities, which may be expressed in yield terms, is
fixed at the time a commitment to purchase is made, but delivery of and payment
for the when-issued securities take place at a later date. Normally, the
settlement date occurs within one month of the purchase (60 days for municipal
bonds and notes). During the period between purchase and settlement, no payment
is made by the Fund and no interest accrues to the Fund. To the extent that
assets of a Fund are held in cash pending the settlement of a purchase of
securities, that Fund would earn no income; however, it is the Trust's intention
that each Fund will be fully invested to the extent practicable and subject to
the policies stated herein. Although when-issued securities may be sold prior to
the settlement date, the Trust intends to purchase such securities with the
purpose of actually acquiring them unless a sale appears desirable for
investment reasons.
At the time the Trust makes the commitment on behalf of a Fund to purchase
a security on a when-issued basis, it will record the transaction and reflect
the amount due and the value of the security in determining the Fund's net asset
value. The market value of the when-issued security may be more or less than
the purchase price payable at the settlement date. The Trustees do not believe
that a Fund's net asset value or income will be exposed to additional risk by
the purchase of securities on a when-issued basis. Each Fund will establish a
segregated account in which it will maintain liquid assets at least equal in
value to commitments for when-issued securities. Such segregated securities
either will mature or, if necessary, be sold on or before the settlement date.
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<PAGE>
MORTGAGE-RELATED AND OTHER ASSET-BACKED SECURITIES
Each Fund may buy Mortgage-related securities. Mortgage-related securities
are interests in pools of residential or commercial mortgage loans or leases,
including mortgage loans made by savings and loan institutions, mortgage
bankers, commercial banks and others. Pools of mortgage loans are assembled as
securities for sale to investors by various governmental, government-related and
private organizations (see "Mortgage Pass-Through Securities"). The Funds, to
the extent permitted in the Prospectus, may also invest in debt securities which
are secured with collateral consisting of mortgage-related securities (see
"Collateralized Mortgage Obligations"), and in other types of mortgage-related
securities. Like other fixed-income securities, when interest rates rise, the
value of a mortgage-related security generally will decline; however, when
interest rates are declining, the value of a mortgage-related security with
prepayment features may not increase as much as other fixed-income securities.
MORTGAGE PASS-THROUGH SECURITIES Interests in pools of mortgage-related
--------------------------------
securities differ from other forms of debt securities, which normally provide
for periodic payment of interest in fixed amounts with principal payments at
maturity or specified call dates. Instead, mortgage pass-through securities
provide a monthly payment which consists of both interest and principal
payments. In effect, these payments are a "pass-through" of the monthly
payments made by the individual borrowers on their residential mortgage loans,
net of any fees paid to the issuer or guarantor of such securities. Additional
payments are caused by repayments of principal resulting from the sale of the
underlying residential property, refinancing or foreclosure, net of fees or
costs which may be incurred. Some mortgage-related securities (such as
securities issued by the GNMA) are described as "modified pass-through." These
securities entitle the holder to receive all interest and principal payments
owed on the mortgage pool, net of certain fees, at the scheduled payment dates
regardless of whether or not the mortgagor actually makes the payment. Some
mortgage pass-through certificates may include securities backed by adjustable-
rate mortgages which bear interest at a rate that will be adjusted periodically.
Early repayment of principal on mortgage pass-through securities (arising
from prepayments of principal due to sale of the underlying property,
refinancing, or foreclosure, net of fees
B-32
<PAGE>
and costs which may be incurred) may expose a Fund to a lower rate of return
upon reinvestment of principal. Also, if a security subject to prepayment has
been purchased at a premium, in the event of prepayment the value of the premium
would be lost.
Payment of principal and interest on some mortgage pass-through securities
(but not the market value of the securities themselves) may be guaranteed by the
full faith and credit of the U.S. government (in the case of securities
guaranteed by GNMA); or guaranteed by agencies or instrumentalities of the U.S.
Government (in the case of securities guaranteed by FNMA or FHLMC, which are
supported only by the discretionary authority of the U.S. government to purchase
the agency's obligations).
The principal governmental guarantor of mortgage-related securities is the
GNMA. GNMA is a wholly owned U.S. government corporation within the U.S.
Department of Housing and Urban Development ("HUD"). GNMA is authorized to
guarantee, with the full faith and credit of the U.S. government, the timely
payment of principal and interest on securities issued by institutions approved
by GNMA (such as savings and loan institutions, commercial banks and mortgage
bankers) and backed by pools of FHA-insured or VA-guaranteed mortgages.
Government-related guarantors (i.e., not backed by the full faith and
credit of the U.S. government) include the FNMA and the FHLMC. FNMA is a
government-sponsored corporation owned entirely by private stockholders. It is
subject to general regulation by the Secretary of Housing and Urban Development
and acts as a government instrumentality under authority granted by Congress.
FNMA purchases conventional (i.e., not insured or guaranteed by any government
agency) residential mortgages from a list of approved seller/servicers which
include state and federally chartered savings and loan associations, mutual
savings banks, commercial banks and credit unions and mortgage bankers. Pass-
through securities issued by FNMA are guaranteed as to timely payment of
principal and interest by FNMA but are not backed by the full faith and credit
of the U.S. government. FNMA is authorized to borrow from the U.S. Treasury to
meet its obligations.
FHLMC was created by Congress in 1970 for the purpose of increasing the
availability of mortgage credit for residential housing. It is a government-
sponsored corporation and acts as a government instrumentality under authority
granted by Congress.
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<PAGE>
FHLMC was formerly owned by the twelve Federal Home Loan Banks and is now owned
entirely by private stockholders. FHLMC issues Participation Certificates
("Pcs") which represent interests in conventional mortgages from FHLMC's
national portfolio. FHLMC guarantees the timely payment of interest and
collection of principal, but Pcs are not backed by the full faith and credit of
the U.S. government.
If either fixed or variable rate pass-through securities issued by the U.S.
government or its agencies or instrumentalities are developed in the future, the
Funds reserve the right to invest in them.
Commercial banks, savings and loan institutions, private mortgage insurance
companies, mortgage bankers and other secondary market issuers also create pass-
through pools of conventional residential mortgage loans. Such issuers may, in
addition, be the originators and/or servicers of the underlying mortgage loans
as well as the guarantors of the mortgage-related securities. Pools created by
such non-governmental issuers generally offer a higher rate of interest than
government and government-related pools because there are no direct or indirect
government or agency guarantees of payments in the former pools. However, timely
payment of interest and principal of these pools may be supported by various
forms of insurance or guarantees, including individual loan, title, pool and
hazard insurance and letters of credit. The insurance and guarantees are issued
by governmental entities, private insurers and the mortgage poolers. Such
insurance and guarantees and the creditworthiness of the issuers thereof will be
considered in determining whether a mortgage-related security meets the Funds'
investment quality standards. There can be no assurance that the private
insurers or guarantors can meet their obligations under the insurance policies
or guarantee arrangements. The Funds may buy mortgage-related securities
without insurance or guarantees if, through an examination of the loan
experience and practices of the originator/servicers and poolers, the Sub-
Adviser determines that the securities meet the Funds' quality standards.
PRIVATELY ISSUED MORTGAGE-RELATED SECURITIES The mortgage-related
--------------------------------------------
securities in which the Funds may invest may be: (i) privately issued securities
which are collateralized by pools of mortgages in which each mortgage is
guaranteed as to payment of principal and interest by an agency or
instrumentality of the U.S. government; (ii) privately issued securities which
are
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<PAGE>
collateralized by pools of mortgages in which payment of principal and interest
is guaranteed by the issuer and such guarantee is collateralized by U.S.
government securities; and (iii) other privately issued securities in which the
proceeds of the issuance are invested in mortgage-backed securities and payment
of the principal and interest is supported by the credit of an agency or
instrumentality of the U.S. government.
The California Tax Free Fund, New York Tax Free Fund and Equity Index Fund,
however, may not invest in non-government mortgage pass-through securities.
Although the market for such securities is becoming increasingly liquid,
securities issued by certain private organizations may not be readily
marketable. No Fund will purchase mortgage-related securities or any other
assets which in the Sub-Advisers' opinion are illiquid if, as a result, more
than 10% (15% in the case of the International Equity, International Bond and
Strategic Income Funds) of the value of the Fund's total assets will be
illiquid.
COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS) A CMO is a hybrid between a
------------------------------------------
mortgage-backed bond and a mortgage pass-through security. Interest and prepaid
principal is paid, in most cases, semiannually. CMOs may be collateralized by
whole mortgage loans, but are more typically collateralized by portfolios of
mortgage pass-through securities guaranteed by GNMA, FHLMC, or FNMA and their
income streams.
CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life will depend upon the prepayment
experience of the collateral. CMOs are structured into multiple classes, each
bearing a different stated maturity - actual maturing and average life will
depend upon the prepayment experience of the collateral. CMOs provide for a
modified form of call protection through a de facto breakdown of the underlying
--------
pool of mortgages according to how quickly the loans are repaid. Monthly
payment of principal received from the pool of underlying mortgages, including
prepayments, is first returned to investors holding the shortest maturity class.
Investors holding the longer maturity classes receive principal only after the
first class has been retired. An investor is partially guarded against a sooner
than desired return of principal because of the sequential payments.
In a typical CMO transaction, a corporation ("issuer") issues multiple
series (e.g., A, B, C, Z) of CMO bonds ("Bonds").
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<PAGE>
Proceeds of the Bond Offering are used to purchase mortgages or mortgage pass-
through certificates ("Collateral"). The Collateral is pledged to a third-party
trustee as security for the Bonds. Principal and interest payments from the
Collateral are used to pay principal on the Bonds in the order A, B, C, Z. The
Series A, B, and C Bonds all bear current interest. Interest on the Series Z
Bond is accrued and added to principal and a like amount is paid as principal on
the Series A, B or C Bond currently being paid off. When the Series A, B and C
Bonds are paid in full, interest and principal on the Series Z Bond begins to be
paid currently. With some CMOs, the issuer serves as a conduit to allow loan
originators (primarily builders or savings and loan associations) to borrow
against their loan portfolios.
FHLMC COLLATERALIZED MORTGAGE OBLIGATIONS FHLMC CMOs are debt obligations
-----------------------------------------
of FHLMC issued in multiple classes having different maturity dates which are
secured by the pledge of a pool of conventional mortgage loans purchased by
FHLMC. Unlike FHLMC Pcs, payments of principal and interest on the CMOs are
made semiannually, as opposed to monthly. The amount of principal payable on
each semiannual payment date is determined in accordance with FHLMC's mandatory
sinking fund schedule, which, in turn, is equal to approximately 100% of FHA
prepayment experience applied to the mortgage collateral pool. All sinking fund
payments in the CMOs are allocated to the retirement of the individual classes
of bonds in the order of their stated maturities. Payment of principal on the
mortgage loans in the collateral pool in excess of the amount of FHLMC's minimum
sinking fund obligation for any payment date are paid to the holders of the CMOs
as additional sinking fund payments. Because of the "pass-through" nature of
all principal payments received on the collateral pool in excess of FHLMC's
minimum sinking fund requirement, the rate at which principal of the CMOs is
actually repaid is likely to be such that each class of bonds will be retired in
advance of its scheduled maturity date.
If collection of principal (including prepayments) on the mortgage loans
during any semiannual payment period is not sufficient to meet FHLMC's minimum
sinking fund obligation on the next sinking fund payment date, FHLMC agrees to
make up the deficiency from its general funds.
Criteria for the mortgage loans in the pool backing the CMOs are identical
to those of FHLMC Pcs. FHLMC has the right to
B-36
<PAGE>
substitute collateral in the event of delinquencies and/or defaults.
OTHER MORTGAGE-RELATED SECURITIES Other mortgage-related securities
---------------------------------
include securities other than those described above that directly or indirectly
represent a participation in, or are secured by and payable from, mortgage loans
on real property, including CMO residuals or stripped mortgage-backed
securities, and may be structured in classes with rights to receive varying
proportions of principal and interest. Other mortgage-related securities may be
equity or debt securities issued by agencies or instrumentalities of the U.S.
government or by private originators of, or investors in, mortgage loans,
including savings and loan associations, homebuilders, mortgage banks,
commercial banks, investment banks, partnerships, trusts and special purpose
entities of the foregoing.
CMO RESIDUALS CMO residuals are derivative mortgage securities issued by
-------------
agencies or instrumentalities of the U.S. government or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
homebuilders, mortgage banks, commercial banks, investment banks and special
purpose entities of the foregoing.
The cash flow generated by the mortgage assets underlying a series of CMOs
is applied first to make required payments of principal and interest on the CMOs
and second to pay the related administrative expenses of the issuer. The
residual in a CMO structure generally represents the interest in any excess cash
flow remaining after making the foregoing payments. Each payment of such excess
cash flow to a holder of the related CMO residual represents income and/or a
return of capital. The amount of residual cash flow resulting from a CMO will
depend on, among other things, the characteristics of the mortgage assets, the
coupon rate of each class of CMO, prevailing interest rates, the amount of
administrative expenses and the prepayment experience on the mortgage assets.
In particular, the yield to maturity on CMO residuals is extremely sensitive to
prepayments on the related underlying mortgage assets, in the same manner as an
interest-only ("IO") class of stripped mortgage-backed securities. See
"Stripped Mortgage-Backed Securities." In addition, if a series of a CMO
includes a class that bears interest at an adjustable rate, the yield to
maturity on the related CMO residual will also be extremely sensitive to changes
in the level of the index upon which interest rate adjustments
B-37
<PAGE>
are based. As described below with respect to stripped mortgage-backed
securities, in certain circumstances a portfolio may fail to recoup fully its
initial investment in a CMO residual.
CMO residuals are generally purchased and sold by institutional investors
through several investment banking firms acting as brokers or dealers. The CMO
residual market has only very recently developed and, accordingly, CMO residuals
currently may not have the liquidity of other more established securities
trading in other markets. Transactions in CMO residuals are generally completed
only after careful review of the characteristics of the securities in question.
In addition, CMO residuals may or, pursuant to an exemption therefrom, may not
have been registered under the Securities Act of 1933, as amended. CMO
residuals, whether or not registered under such Act, may be subject to certain
restrictions on transferability, and may be deemed "illiquid" and subject to a
Fund's limitations on investment in illiquid securities.
Under certain circumstances, a Fund's investment in residual interests in
"real estate mortgage investment conduits" ("REMICs") may cause shareholders of
that Fund to be deemed to have taxable income in addition to their Fund
dividends and distributions and such income may not be eligible to be reduced
for tax purposes by certain deductible amounts, including net operating loss
deductions. In addition, in some cases, the Fund may be required to pay taxes
on certain amounts deemed to be earned from a REMIC residual. Prospective
investors may wish to consult their tax advisors regarding REMIC residual
investments by a Fund.
CMOs and REMICs may offer a higher yield than U.S. government securities,
but they may also be subject to greater price fluctuation and credit risk. In
addition, CMOs and REMICs typically will be issued in a variety of classes or
series, which have different maturities and are retired in sequence. Privately
issued CMOs and REMICs are not government securities nor are they supported in
any way by any governmental agency or instrumentality. In the event of a
default by an issuer of a CMO or a REMIC, there is no assurance that the
collateral securing such CMO or REMIC will be sufficient to pay principal and
interest. It is possible that there will be limited opportunities for trading
CMOs and REMICs in the over-the-counter market, the depth and liquidity of which
will vary from time to time. Holders of "residual" interests in REMICs
(including the
B-38
<PAGE>
Fund) could be required to recognize potential phantom income, as could
shareholders (including unrelated business taxable income for tax-exempt
shareholders) of funds that hold such interests. The Fund will consider this
rule in determining whether to invest in residual interests.
GOVERNMENT FUND The Government Fund may invest in securities
---------------
collateralized by mortgages or pools of mortgages the issuer of which has
qualified to be treated as a "REMIC". CMOs and REMICs may offer a higher yield
than U.S. government securities, but they may also be subject to greater price
fluctuation and credit risk. In addition, CMOs and REMICs typically will be
issued in a variety of classes or series, which have different maturities and
are retired in sequence. Privately issued CMOs and REMICs are not government
securities nor are they supported in any way by any governmental agency or
instrumen tality. In the event of a default by an issuer of a CMO or a REMIC,
there is no assurance that the collateral securing such CMO or REMIC will be
sufficient to pay principal and interest. It is possible that there will be
limited opportunities for trading CMOs and REMICs in the over-the-counter
market, the depth and liquidity of which will vary from issue to issue and from
time to time. Holders of "residual" interests in REMICs (including the Fund)
could be required to recognize potential phantom income, as could shareholders
(including unrelated business taxable income for tax-exempt shareholders) of
funds that hold such interests. The Government Fund will consider this rule in
determining whether to invest in residual interests.
The Government Fund will not invest in any privately issued CMOs that do
not meet the requirements of Rule 3a-7 under the 1940 Act if, as a result of
such investment, more than 5% of the Fund's net assets would be invested in any
one CMO, more than 10% of the Fund's net assets would be invested in CMOs and
other investment company securities in the aggregate, or the Fund would hold
more than 3% of any outstanding issue of CMOs.
STRIPPED MORTGAGE-BACKED SECURITIES Stripped mortgage-backed securities
-----------------------------------
("SMBS") are derivative multi-class mortgage securities. SMBS may be issued by
agencies or instrumentalities of the U.S. government, or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks and special purpose entities
of the foregoing.
B-39
<PAGE>
SMBS are usually structured with two classes that receive different
proportions of the interest and principal distributions on a pool of mortgage
assets. A common type of SMBS will have one class receiving some of the
interest and most of the principal from the mortgage assets, while the other
class will receive most of the interest and the remainder of the principal. In
the most extreme case, one class will receive all of the interest (the interest-
only or "IO" class), while the other class will receive all of the principal
(the principal-only or "PO" class). The yield to maturity on an IO class is
extremely sensitive to the rate of principal payments (including prepayments) on
the related underlying mortgage assets, and a rapid rate of principal payments
may have a material adverse effect on a Fund's yield to maturity from these
securities. If the underlying mortgage assets experience greater than
anticipated prepayments of principal, a Fund may fail to fully recoup its
initial investment in these securities even if the security is in one of the
highest rating categories.
Although SMBS are purchased and sold by institutional investors through
several investment banking firms acting as brokers or dealers, these securities
were only recently developed. As a result, established trading markets have not
yet developed and, accordingly, these securities may be deemed "illiquid" and
subject to a Fund's limitations on investment in illiquid securities.
RISKS ASSOCIATED WITH MORTGAGE-BACKED SECURITIES The value of some
------------------------------------------------
mortgage-backed securities in which the Funds may invest may be particularly
sensitive to changes in prevailing interest rates, and, like the other
investments of the Funds, the ability of a Fund to successfully utilize these
instruments may depend in part upon the ability of an Sub-Adviser to forecast
interest rates and other economic factors correctly. If a Sub-Adviser
incorrectly forecasts such factors and has taken a position in mortgage-backed
securities that is or becomes contrary to prevailing market trends, the Funds
could be exposed to the risk of a loss.
Investment in mortgage-backed securities poses several risks, including
prepayment, market, and credit risk. Prepayment risk reflects the chance that
borrowers may prepay their mortgages faster than expected, thereby affecting the
investment's average life and perhaps its yield. Whether or not a mortgage loan
is prepaid is almost entirely controlled by the
B-40
<PAGE>
borrower. Borrowers are most likely to exercise their prepayment options at a
time when it is least advantageous to investors, generally prepaying mortgages
as interest rates fall, and slowing payments as interest rates rise. Besides the
effect of prevailing interest rates, the rate of prepayment and refinancing of
mortgages may also be affected by home value appreciation, ease of the
refinancing process and local economic conditions.
Market risk reflects the chance that the price of the security may
fluctuate over time. The price of mortgage-backed securities may be
particularly sensitive to prevailing interest rates, the length of time the
security is expected to be outstanding, and the liquidity of the issue. In a
period of unstable interest rates, there may be decreased demand for certain
types of mortgage-backed securities, and a Fund invested in such securities and
wishing to sell them may find it difficult to find a buyer, which may in turn
decrease the price at which they may be sold.
Credit risk reflects the chance that a Fund may not receive all or part of
its principal because the issuer or credit enhancer has defaulted on its
obligations. Obligations issued by U.S. government-related entities are
guaranteed as to the payment of principal and interest, but are not backed by
the full faith and credit of the U.S. government. The performance of private
label mortgage-backed securities, issued by private institutions, is based on
the financial health of those institutions.
OTHER ASSET-BACKED SECURITIES Several types of asset-backed securities
-----------------------------
have already been offered to investors, including CARS/SM/ ("Certificates for
Automobile Receivables/SM/"). CARS/SM/ represent undivided fractional interests
in a trust ("trust") whose assets consist of a pool of motor vehicle retail
installment sales contracts and security interests in the vehicles securing the
contracts. Payments of principal and interest on CARS/SM/ are passed-through
monthly to certificate holders, and are guaranteed up to certain amounts and for
a certain time period by a letter of credit issued by a financial institution
unaffiliated with the trustee or originator of the trust. An investor's return
on CARS/SM/ may be affected by early prepayment of principal on the underlying
vehicle sales contracts. If the letter of credit is exhausted, the trust may be
prevented from realizing the full amount due on a sales contract because of
state law requirements and restrictions relating to foreclosure sales of
vehicles and the obtaining of
B-41
<PAGE>
deficiency judgments following such sales or because of depreciation, damage or
loss of a vehicle, the application of federal and state bankruptcy and
insolvency laws, or other factors. As a result, certificate holders may
experience delays in payments or losses if the letter of credit is exhausted.
The Sub-Advisers expect that other asset-backed securities (unrelated to
mortgage loans) will be offered to investors in the future. Consistent with its
investment objectives and policies, a Fund also may invest in other types of
asset-backed securities.
SHORT SALES AGAINST THE BOX
A short sale is a transaction in which a Fund sells through a broker a
security it does not own in anticipation of a possible decline in market price.
A short sale "against the box" is a short sale in which, at the time of the
short sale, a Fund owns or has the right to obtain securities equivalent in kind
and amount. Each of the Funds will only enter into short sales against the box.
A Fund may enter into a short sale against the box among other reasons, to hedge
against a possible market decline in the value of the security owned by the
Fund. If the value of a security sold short against the box increases, the Fund
would suffer a loss when it purchases or delivers to the selling broker the
security sold short. The proceeds of the short sale are retained by the broker
pursuant to applicable margin rules. In addition, the Fund may segregate
assets, equal in value to 50% of the value of the short sale, in a special
account with the Fund's custodian. The segregated assets are pledged to the
broker pursuant to applicable margin rules. If a broker with which the Fund has
open short sales, were to become bankrupt, a Fund could experience losses or
delays in recovering gains on short sales. The Funds will only enter into short
sales against the box with brokers the Sub-Advisers believe are creditworthy.
Short sales against the box will be limited to no more than 25% of a Fund's
total assets.
OPTIONS ON SECURITIES
WRITING CALL OPTIONS Any Fund, except the Money Market Fund and the Tax
--------------------
Free Bond Fund, may sell ("write") covered call options on the portfolio
securities of such Fund in an attempt to enhance investment performance. The
California Tax Free Fund and New York Tax Free Fund may purchase and sell both
put and call options on debt securities in standardized contracts traded on
B-42
<PAGE>
national securities exchanges, boards of trade, or similar entities, or quoted
on NASDAQ, and agreements, sometimes called "cash puts," which may accompany the
purchase of a new issue of bonds from a dealer. A call option sold by a Fund is
a short-term contract, having a duration of nine months or less, which gives the
purchaser of the option the right to buy, and imposes on the writer of the
option--in return for a premium received--the obligation to sell, the underlying
security at the exercise price upon the exercise of the option at any time prior
to the expiration date, regardless of the market price of the security during
the option period. A call option may be covered by, among other things, the
writer owning the underlying security throughout the option period, or by
holding, on a share-for-share basis, a call on the same security as the call
written, where the exercise price of the call held is equal to or less than the
price of the call written, or greater than the exercise price of a call written
if the difference is maintained by the Fund in liquid assets in a segregated
account with its custodian.
A Fund will write covered call options both to reduce the risks associated
with certain of its investments and to increase total investment return through
the receipt of premiums. In return for the premium income, the Fund will give
up the opportunity to profit from an increase in the market price of the
underlying security above the exercise price so long as its obligations under
the contract continue, except insofar as the premium represents a profit.
Moreover, in writing the call option, the Fund will retain the risk of loss
should the price of the security decline, which loss the premium is intended to
offset in whole or in part. A Fund, in writing call options, must assume that
the call may be exercised at any time prior to the expiration of its obligations
as a writer, and that in such circumstances the net proceeds realized from the
sale of the underlying securities pursuant to the call may be substantially
below the prevailing market price. Covered call options and the securities
underlying such options will be listed on national securities exchanges, except
for certain transactions in options on debt securities and foreign securities.
During the option period, the covered call writer has, in return for the
premium received on the option, given up the opportunity to profit from a price
increase in the underlying securities above the exercise price, but, as long as
its obligation as a writer continues, has retained the risk of loss should the
price of the underlying security decline.
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<PAGE>
A Fund may protect itself from further losses due to a decline in value of
the underlying security or from the loss of ability to profit from appreciation
by buying an identical option, in which case the purchase cost may offset the
premium. In order to do this, the Fund makes a "closing purchase transaction"--
the purchase of a call option on the same security with the same exercise price
and expiration date as the covered call option which it has previously written
on any particular security. The Fund will realize a gain or loss from a closing
purchase transaction if the amount paid to purchase a call option in a closing
transaction is less or more than the amount received from the sale of the
covered call option. Also, because increases in the market price of a call
option will generally reflect increases in the market price of the underlying
security, any loss resulting from the closing out of a call option is likely to
be offset in whole or in part by unrealized appreciation of the underlying
security owned by the Fund. When a security is to be sold from the Fund's
portfolio, the Fund will first effect a closing purchase transaction so as to
close out any existing covered call option on that security.
A closing purchase transaction may be made only on a national or foreign
securities exchange (an "Exchange") which provides a secondary market for an
option with the same exercise price and expiration date, except as discussed
below. There is no assurance that a liquid secondary market on an Exchange or
otherwise will exist for any particular option, or at any particular time, and
for some options no secondary market on an Exchange or otherwise may exist. If
the Fund is unable to effect a closing purchase transaction involving an
exchange-traded option, the Fund will not sell the underlying security until the
option expires or the Fund delivers the underlying security upon exercise. A
closing purchase transaction for an over-the-counter option may be made only
with the other party to the option. Once an option writer has received an
exercise notice, it cannot effect a closing purchase transaction in order to
terminate its obligation under the option and must deliver or purchase the
underlying securities at the exercise price.
Each Fund pays brokerage commissions and dealer spreads in connection with
writing covered call options and effecting closing purchase transactions, as
well as for purchases and sales of underlying securities. The writing of
covered call options could result in significant increases in a Fund's portfolio
turnover rate, especially during periods when market prices of the underlying
securities appreciate. Subject to the limitation
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<PAGE>
that all call and put option writing transactions be covered, the Funds may, to
the extent determined appropriate by the Sub-Advisers, engage without limitation
in the writing of options on U.S. government securities. Subject to the
limitation that all call and put option writing transactions be covered, and
limitations imposed on regulated investment companies under federal tax law, the
International Bond Fund and International Equity Fund may, to the extent
determined appropriate by the Sub-Adviser, engage without limitation in the
writing of options on their portfolio securities.
WRITING PUT OPTIONS Each Fund, except the Money Market Fund and the Tax
-------------------
Free Bond Fund, may also write covered put options. Put options written by a
Fund are agreements by a Fund, for a premium received by the Fund, to purchase
specified securities at a specified price if the option is exercised during the
option period. A put option written by the Fund is "covered" if the Fund
maintains liquid assets with a value equal to the exercise price in a segregated
account with its custodian. A put option is also "covered" if the Fund holds on
a share-for-share basis a put on the same security as the put written, where the
exercise price of the put held is equal to or greater than the exercise price of
the put written, or less than the exercise price of the put written if the
difference is maintained by the Fund in liquid assets in a segregated account
with its custodian.
The premium which the Funds receive from writing a put option will reflect,
among other things, the current market price of the underlying security, the
relationship of the exercise price to such market price, the historical price
volatility of the underlying security, the option period, supply and demand and
interest rates.
A covered put writer assumes the risk that the market price for the
underlying security will fall below the exercise price, in which case the writer
could be required to purchase the security at a higher price than the then-
current market price of the security. In both cases, the writer has no control
over the time when it may be required to fulfill its obligation as a writer of
the option.
The Funds may effect a closing purchase transaction to realize a profit on
an outstanding put option or to prevent an outstanding put option from being
exercised. The Funds also may effect a closing purchase transaction, in the
case of a put
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option, to permit the Funds to maintain their holdings of the deposited U.S.
Treasury obligations, to write another put option to the extent that the
exercise price thereof is secured by the deposited U.S. Treasury obligations, or
to utilize the proceeds from the sale of such obligations to make other
investments.
If a Fund is able to enter into a closing purchase transaction, the Fund
will realize a profit or loss from such transaction if the cost of such
transaction is less or more than the premium received from the writing of the
option respectively. After writing a put option, the Fund may incur a loss equal
to the difference between the exercise price of the option and the sum of the
market value of the underlying security plus the premium received from the sale
of the option.
In addition, the Funds may also write straddles (combinations of covered
puts and calls on the same underlying security). The extent to which the Funds
may write covered put and call options and enter into so-called "straddle"
transactions involving put or call options may be limited by the requirements of
the Internal Revenue Code of 1986, as amended (the "Code") for qualification as
a regulated investment company and the Trust's intention that each Fund qualify
as such. Subject to the limitation that all call and put option writing
transactions be covered, the Funds may, to the extent determined appropriate by
the Sub-Advisers, engage without limitation in the writing of options on U.S.
government securities.
PURCHASING OPTIONS Each Fund, except Money Market Fund and the Tax Free
------------------
Bond Fund, may purchase put or call options which are traded on an Exchange or
in the over-the-counter market. Options traded in the over-the-counter market
may not be as actively traded as those listed on an Exchange. Accordingly, it
may be more difficult to value such options and to be assured that they can be
closed out at any time. The Funds will engage in such transactions only with
firms the Sub-Advisers deem to be of sufficient creditworthiness so as to
minimize these risks.
The Funds may purchase put options on securities to protect their holdings
in an underlying or related security against a substantial decline in market
value. Securities are considered related if their price movements generally
correlate with one another. A Fund would buy a put option in anticipation of a
decline in the market value of such securities. The purchase of a put option
would entitle the Fund, in exchange for the premium
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paid, to sell a security at a specified price upon exercise of the option during
the option period. The purchase of put options on securities held in the
portfolio or related to such securities will enable a Fund to preserve, at least
partially, unrealized gains occurring prior to the purchase of the option on a
portfolio security without actually selling the security. In addition, the Fund
will continue to receive interest or dividend income on the security. The put
options purchased by the Fund may include, but are not limited to, "protective
puts" in which the security to be sold is identical or substantially identical
to a security already held by the Fund or to a security which the Fund has the
right to purchase. The Fund would ordinarily recognize a gain if the value of
the securities decreased during the option period below the exercise price
sufficiently to cover the premium. The Fund would recognize a loss if the value
of the securities remained above the difference between the exercise price and
the premium.
The Funds may also purchase call options on securities the Funds intend to
purchase to protect against substantial increases in prices of such securities
pending their ability to invest in an orderly manner in such securities. The
purchase of a call option would entitle the Fund, in exchange for the premium
paid, to purchase a security at a specified price upon exercise of the option
during the option period. The Fund would ordinarily realize a gain if the value
of the securities increased during the option period above the exercise price
sufficiently to cover the premium. The Fund would have a loss if the value of
the securities remained below the sum of the premium and the exercise price
during the option period. In order to terminate an option position, the Funds
may sell put or call options identical to those previously purchased, which
could result in a net gain or loss depending on whether the amount received on
the sale is more or less than the premium and other transaction costs paid on
the put or call option when it was purchased.
MARRIED PUTS. Each Fund, except the Equity Index Fund, Money Market Fund
------------
and Tax Free Bond Fund may engage in a strategy known as "married puts." This
strategy is most typically used when the Fund owns a particular common stock or
security convertible into common stock and wishes to effect a short sale against
the box (see "short sales against the box") but for various reasons is unable to
---
do so. The Fund may then enter into a series of stock and related option
transactions to achieve the economic equivalent of a short sale against the box.
To
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implement this trading strategy, the Fund will simultaneously execute with the
same broker a purchase of shares of the common stock and an "in the money" over-
the-counter put option to sell the common stock to the broker and generally will
write an over-the-counter "out of the money" call option in the same stock with
the same exercise price as the put option. The options are linked and may not be
exercised, transferred or terminated independently of the other.
Holding the put option places the Fund in a position to profit on the
decline in price of the security just as it would by effecting a short sale and
to, thereby, hedge against possible losses in the value of a security or
convertible security held by the Fund. The writer of the put option may require
that the Fund write a call option, which would enable the broker to profit in
the event the price of the stock rises above the exercise price of the call
option (see "writing call options" above). In the event the stock price were to
---
increase above the strike or exercise price of the option, the Fund would suffer
a loss unless it first terminated the call by exercising the put.
SPECIAL RISKS ASSOCIATED WITH OPTIONS ON SECURITIES Exchange markets in
---------------------------------------------------
U.S. government securities options are a relatively new and untested concept,
and it is impossible to predict the amount of trading interest that may exist in
such options. The same types of risk apply to over-the-counter trading in
options. There can be no assurance that viable markets will develop or continue
in the United States or abroad.
A Fund's purpose in selling covered options is to realize greater income
than would be realized on portfolio securities transactions alone. A Fund may
forego the benefits of appreciation on securities sold pursuant to call options,
or pay a higher price for securities acquired pursuant to put options written by
the Fund. If a put or call option purchased by a Fund is not sold when it has
remaining value, and if the market price of the underlying security, in the case
of a put, remains equal to or greater than the exercise price, or, in the case
of a call, remains less than or equal to the exercise price, the Fund will not
be able to exercise profitably the option and will lose its entire investment in
the option. Also, the price of a put or call option purchased to hedge against
price movements in a related security may move more or less than the price of
the related security. The Capital Appreciation Fund, Convertible Fund,
Government Fund, High Yield Corporate Bond Fund, Money
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Market Fund, Total Return Fund and Value Fund will not purchase a put or call
option if, as a result, the amount of premiums paid for all put and call options
then outstanding would exceed 10% of the value of the Fund's total assets.
The Fund would ordinarily realize a gain if the value of the securities
increased during the option period above the exercise price sufficiently to
cover the premium. The Fund would have a loss if the value of the securities
remained below the sum of the premium paid and the exercise price during the
option period. The ability of a Fund to successfully utilize options may depend
in part upon the ability of the Sub-Adviser to forecast interest rates and other
economic factors correctly.
The hours of trading for options on securities may not conform to the hours
during which the underlying securities are traded. To the extent that the
options markets close before the markets for the underlying securities,
significant price and rate movements can take place in the underlying markets
that cannot be reflected in the options markets.
OPTIONS ON FOREIGN CURRENCIES
Each Fund, except the California Tax Free Fund, the Equity Index Fund, the
Government Fund, the Money Market Fund, the New York Tax Free Fund and the Tax
Free Bond Fund, may, to the extent that it invests in foreign securities,
purchase and write options on foreign currencies for hedging purposes in a
manner similar to that of the Fund's transactions in currency futures contracts
or forward contracts. For example, a decline in the dollar value of a foreign
currency in which portfolio securities are denominated will reduce the dollar
value of such securities, even if their value in the foreign currency remains
constant. In order to protect against such declines in the value of portfolio
securities, a Fund may purchase put options on the foreign currency. If the
value of the currency does decline, that Fund will have the right to sell such
currency for a fixed amount of dollars which exceeds the market value of such
currency, resulting in a gain that may offset, in whole or in part, the negative
effect of currency depreciation on the value of the Fund's securities
denominated in that currency.
Conversely, if a rise in the dollar value of a currency in which securities
to be acquired are denominated is projected, thereby increasing the cost of such
securities, a Fund may
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<PAGE>
purchase call options on such currency. If the value of such currency does
increase, the purchase of such call options would enable the Fund to purchase
currency for a fixed amount of dollars which is less than the market value of
such currency, resulting in a gain that may offset, at least partially, the
effect of any currency-related increase in the price of securities the Fund
intends to acquire. As in the case of other types of options transactions,
however, the benefit a Fund derives from purchasing foreign currency options
will be reduced by the amount of the premium and related transaction costs. In
addition, if currency exchange rates do not move in the direction or to the
extent anticipated, a Fund could sustain losses on transactions in foreign
currency options which would deprive it of a portion or all of the benefits of
advantageous changes in such rates.
A Fund may also write options on foreign currencies for hedging purposes.
For example, if a Fund anticipates a decline in the dollar value of foreign
currency-denominated securities due to declining exchange rates, it could,
instead of purchasing a put option, write a call option on the relevant
currency. If the expected decline occurs, the option will most likely not be
exercised, and the decrease in value of portfolio securities will be offset by
the amount of the premium received by the Fund.
Similarly, instead of purchasing a call option to hedge against an
anticipated increase in the dollar cost of securities to be acquired, a Fund
could write a put option on the relevant currency. If rates move in the manner
projected, the put option will expire unexercised and allow the Fund to offset
such increased cost up to the amount of the premium. As in the case of other
types of options transactions, however, the writing of a foreign currency option
will constitute only a partial hedge up to the amount of the premium, and only
if rates move in the expected direction. If unanticipated exchange rate
fluctuations occur, the option may be exercised and a Fund would be required to
purchase or sell the underlying currency at a loss which may not be fully offset
by the amount of the premium. As a result of writing options on foreign
currencies, a Fund also may be required to forgo all or a portion of the
benefits which might otherwise have been obtained from favorable movements in
currency exchange rates.
A call option written on foreign currency by a Fund is "covered" if that
Fund owns the underlying foreign currency subject to the call or securities
denominated in that currency or
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<PAGE>
has an absolute and immediate right to acquire that foreign currency without
additional cash consideration (or for additional cash consideration held in a
segregated account by its custodian) upon conversion or exchange of other
foreign currency held in its portfolio. A call option is also covered if a Fund
holds a call on the same foreign currency for the same principal amount as the
call written where the exercise price of the call held (a) is equal to or less
than the exercise price of the call written or (b) is greater than the exercise
price of the call written if the amount of the difference is maintained by a
Fund in liquid assets in a segregated account with its custodian.
As with other kinds of options transactions, the writing of an option on
foreign currency will constitute only a partial hedge up to the amount of the
premium received and a Fund could be required to purchase or sell foreign
currencies at disadvantageous exchange rates, thereby incurring losses. The
purchase of an option on foreign currency may constitute an effective hedge
against exchange rate fluctuations, although, in the event of rate movements
adverse to a Fund's position, a Fund may forfeit the entire amount of the
premium plus related transaction costs. Options on foreign currencies to be
written or purchased by a Fund will be traded on U.S. and foreign exchanges or
over-the-counter.
A Fund also may use foreign currency options to protect against potential
losses in positions denominated in one foreign currency against another foreign
currency in which the Fund's assets are or may be denominated. There can be no
assurance that a liquid market will exist when a Fund seeks to close out an
option position. Furthermore, if trading restrictions or suspensions are
imposed on the options markets, a Fund may be unable to close out a position.
Currency options traded on U.S. or other exchanges may be subject to
position limits which may limit the ability of a Fund to reduce foreign currency
risk using such options. Over-the-counter options differ from traded options in
that they are two-party contracts with price and other terms negotiated between
buyer and seller and generally do not have as much market liquidity as
exchanged-traded options. Foreign currency exchange-traded options generally
settle in cash, whereas options traded over-the-counter may settle in cash or
result in delivery of the underlying currency upon exercise of the option.
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<PAGE>
SECURITIES INDEX OPTIONS
The Funds may purchase call and put options on securities indexes (only
call options on the S&P 500 Composite Price Index in the case of the Equity
Index Fund) for the purpose of hedging against the risk of unfavorable price
movements which may adversely affect the value of a Fund's securities. The
Equity Index Fund may purchase call options on the S&P 500 Index to protect
against increases in the prices of securities underlying the Index that the
Equity Index Fund intends to purchase pending its ability to invest in such
securities in an orderly manner.
Unlike a securities option, which gives the holder the right to purchase or
sell specified securities at a specified price, an option on a securities index
gives the holder the right to receive a cash "exercise settlement amount" equal
to (i) the difference between the value of the underlying securities index on
the exercise date and the exercise price of the option, multiplied by (ii) a
fixed "index multiplier." In exchange for undertaking the obligation to make
such a cash payment, the writer of the securities index option receives a
premium.
A securities index fluctuates with changes in the market values of the
securities included in the index. For example, some securities index options
are based on a broad market index such as the S&P 500 Composite Price Index or
the N.Y.S.E. Composite Index, or a narrower market index such as the S&P 100
Index. Indexes may also be based on an industry or market segment such as the
AMEX Oil and Gas Index or the Computer and Business Equipment Index. Options on
stock indexes are currently traded on the following exchanges, among others:
The Chicago Board Options Exchange, New York Stock Exchange, and American Stock
Exchange. Options on other types of securities indexes, which do not currently
exist, including indexes on debt securities, may be introduced and traded on
exchanges in the future. If such options are introduced, the Funds will not
purchase them until they have appropriately amended or supplemented the
Prospectus or Statement of Additional Information, or both.
The effectiveness of hedging through the purchase of securities index
options will depend upon the extent to which price movements in the portion of
the securities portfolio being hedged correlate with price movements in the
selected securities index. Perfect correlation is not possible because the
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<PAGE>
securities held or to be acquired by a Fund will not exactly match the
securities represented in the securities indexes on which options are based. In
addition, the purchase of securities index options involves essentially the same
risks as the purchase of options on futures contracts. The principal risk is
that the premium and transaction costs paid by a Fund in purchasing an option
will be lost as a result of unanticipated movements in prices of the securities
comprising the securities index on which the option is based. Gains or losses
on a Fund's transactions in securities index options depend on price movements
in the securities market generally (or, for narrow market indexes, in a
particular industry or segment of the market) rather than the price movements of
individual securities held by a Fund. In this respect, purchasing a securities
index put (or call) option is analogous to the purchase of a put (or call) on a
securities index futures contract.
A Fund may sell securities index options prior to expiration in order to
close out its positions in securities index options which it has purchased. A
Fund may also allow options to expire unexercised.
FUTURES TRANSACTIONS
The California Tax Free Fund, Convertible Fund, Government Fund, High Yield
Corporate Bond Fund, International Bond Fund, International Equity Fund, New
York Tax Free Fund, Strategic Income Fund, Tax Free Bond Fund and Total Return
Fund may purchase and sell futures contracts on debt securities and on indexes
of debt securities in order to attempt to protect against the effects of adverse
changes in interest rates, to lengthen or shorten the average maturity or
duration of a Fund's portfolio and for other appropriate risk management
purposes. For example, a Fund may purchase futures contracts as a substitute
for the purchase of longer-term debt securities to lengthen the average duration
of a Fund's portfolio of fixed-income securities. The Government Fund may enter
into futures contracts and purchase and write options on futures, which are not
U.S. government securities, in order to attempt to hedge against changes in
interest rates and to seek current income. Such futures contracts would
obligate the Fund to make or take delivery of certain debt securities or an
amount of cash upon expiration of the futures contract, although most futures
positions typically are closed out through an offsetting transaction prior to
expiration. The Capital Appreciation Fund, Convertible Fund,
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<PAGE>
Equity Index Fund, International Equity Fund, Strategic Income Fund, Total
Return Fund and Value Fund may purchase and sell stock index futures to hedge
the equity portion of those Funds' securities portfolios with regard to market
(systematic) risk (involving the market's assessment of overall economic
prospects), as distinguished from stock-specific risk (involving the market's
evaluation of the merits of the issuer of a particular security). These Funds,
and the International Bond Fund, may also purchase and sell other futures when
deemed appropriate, in order to hedge the equity or non-equity portions of their
portfolios. In addition, each Fund, except the California Tax Free Fund, Equity
Index Fund, Government Fund, Money Market Fund, New York Tax Free Fund and Tax
Free Bond Fund may, to the extent it invests in foreign securities, enter into
contracts for the future delivery of foreign currencies to hedge against changes
in currency exchange rates. Each of the Funds may also purchase and write put
and call options on futures contracts of the type into which such Fund is
authorized to enter and may engage in related closing transactions. In the
United States, all such futures on debt securities, debt index futures, stock
index futures, foreign currency futures and related options will be traded on
exchanges that are regulated by the Commodity Futures Trading Commission
("CFTC"). Subject to applicable CFTC rules, the Funds also may enter into
futures contracts traded on the following foreign futures exchanges: Frankfurt,
Tokyo, London and Paris, as long as trading on the aforesaid foreign futures
exchanges does not subject a Fund to risks that are materially greater than the
risks associated with trading on U.S. exchanges. The International Bond Fund and
International Equity Fund are not limited to the above-listed exchanges.
A futures contract is an agreement to buy or sell a security or currency
(or to deliver a final cash settlement price in the case of a contract relating
to an index or otherwise not calling for physical delivery at the end of trading
in the contracts), for a set price at a future date. When interest rates are
changing and portfolio values are falling, futures contracts can offset a
decline in the value of a Fund's current portfolio securities. When interest
rates are changing and portfolio values are rising, the purchase of futures
contracts can secure better effective rates or purchase prices for the Fund than
might later be available in the market when the Fund makes anticipated
purchases. In the United States, futures contracts are traded on boards of
trade which have been designated "contract markets" by the CFTC. Currently,
there are futures contracts based on a variety of instruments, indexes and
currencies, including
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long-term U.S. Treasury bonds, Treasury notes, GNMA certificates, three-month
U.S. Treasury bills, three-month domestic bank certificates of deposit, a
municipal bond index and various stock indexes.
When a purchase or sale of a futures contract is made by a Fund, the Fund
is required to deposit with its custodian (or broker, if legally permitted) a
specified amount of liquid assets ("initial margin"). The margin required for a
futures contract is set by the exchange on which the contract is traded and may
be modified during the term of the contract. The initial margin is in the
nature of a performance bond or good faith deposit on the futures contract which
is returned to the Fund upon termination of the contract assuming all
contractual obligations have been satisfied. Each Fund expects to earn interest
income on its initial margin deposits. A futures contract held by a Fund is
valued daily at the official settlement price of the exchange on which it is
traded. Each day the Fund pays or receives cash, called "variation margin,"
equal to the daily change in value of the futures contract. This process is
known as "marking-to-market." Variation margin does not represent a borrowing
or loan by a Fund but is instead a settlement between the Fund and the broker of
the amount one would owe the other if the futures contract expired. In
computing daily net asset value, each Fund will mark-to-market its open futures
positions.
A Fund is also required to deposit and maintain margin with respect to put
and call options on futures contracts written by it. Such margin deposits will
vary depending on the nature of the underlying futures contract (and the related
initial margin requirements), the current market value of the option, and other
futures positions held by the Fund.
Positions taken in the futures markets are not normally held until delivery
or final cash settlement is required, but are instead liquidated through
offsetting transactions which may result in a gain or a loss. While futures
positions taken by a Fund will usually be liquidated in this manner, the Fund
may instead make or take delivery of underlying securities or currencies
whenever it appears economically advantageous to the Fund to do so. A clearing
organization associated with the exchange on which futures are traded assumes
responsibility for closing-out transactions and guarantees that as between the
clearing members of an exchange, the sale and purchase obligations will be
performed with regard to all positions that remain open at the termination of
the contract.
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FUTURES ON DEBT SECURITIES A futures contract on a debt security is a
--------------------------
binding contractual commitment which, if held to maturity, will result in an
obligation to make or accept delivery, during a particular future month, of
securities having a standardized face value and rate of return. By purchasing
futures on debt securities--assuming a "long" position--a Fund will legally
obligate itself to accept the future delivery of the underlying security and pay
the agreed-upon price. By selling futures on debt securities--assuming a
"short" position--it will legally obligate itself to make the future delivery of
the security against payment of the agreed-upon price. Open futures positions
on debt securities will be valued at the most recent settlement price, unless
such price does not appear to the Sub-Advisers to reflect the fair value of the
contract, in which case the positions will be valued by or under the direction
of the Trustees.
Hedging by use of futures on debt securities seeks to establish, more
certainly than would otherwise be possible, the effective rate of return on
portfolio securities. A Fund may, for example, take a "short" position in the
futures market by selling contracts for the future delivery of debt securities
held by the Fund (or securities having characteristics similar to those held by
the Fund) in order to hedge against an anticipated rise in interest rates that
would adversely affect the value of the Fund's portfolio securities. When
hedging of this character is successful, any depreciation in the value of
portfolio securities will be substantially offset by appreciation in the value
of the futures position.
On other occasions, a Fund may take a "long" position by purchasing futures
on debt securities. This would be done, for example, when the Fund intends to
purchase particular securities and it has the necessary cash, but expects the
rate of return available in the securities markets at that time to be less
favorable than rates currently available in the futures markets. If the
anticipated rise in the price of the securities should occur (with its
concomitant reduction in yield), the increased cost to the Fund of purchasing
the securities will be offset, at least to some extent, by the rise in the value
of the futures position taken in anticipation of the subsequent securities
purchase. A Fund may also purchase futures contracts as a substitute for the
purchase of longer-term securities to lengthen the average duration of the
Fund's portfolio.
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The Fund could accomplish similar results by selling securities with long
maturities and investing in securities with short maturities when interest rates
are expected to increase or by buying securities with long maturities and
selling securities with short maturities when interest rates are expected to
decline. However, by using futures contracts as a risk management technique,
given the greater liquidity in the futures market than in the cash market, it
may be possible to accomplish the same result more easily and more quickly.
Because the only futures contracts currently available to hedge the Tax
Free Bond Fund's portfolio of municipal obligations are futures on various U.S.
government securities and futures on a municipal securities index, perfect
correlation between that Fund's futures positions and portfolio positions may be
difficult to achieve.
SECURITIES INDEX FUTURES A securities index futures contract does not
------------------------
require the physical delivery of securities, but merely provides for profits and
losses resulting from changes in the market value of the contract to be credited
or debited at the close of each trading day to the respective accounts of the
parties to the contract. On the contract's expiration date a final cash
settlement occurs and the futures positions are simply closed out. Changes in
the market value of a particular stock index futures contract reflect changes in
the specified index of equity securities on which the contract is based. A
stock index is designed to reflect overall price trends in the market for equity
securities.
Stock index futures may be used to hedge the equity portion of a Fund's
securities portfolio with regard to market (systematic) risk, as distinguished
from stock-specific risk. The Funds may enter into stock index futures to the
extent that they have equity securities in their portfolios. Similarly, the
Funds may enter into futures on debt securities indexes (including the municipal
bond index) to the extent they have debt securities in their portfolios. By
establishing an appropriate "short" position in securities index futures, a Fund
may seek to protect the value of its portfolio against an overall decline in the
market for securities. Alternatively, in anticipation of a generally rising
market, a Fund can seek to avoid losing the benefit of apparently low current
prices by establishing a "long" position in securities index futures and later
liquidating that position as particular securities are in fact acquired. To the
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extent that these hedging strategies are successful, the Fund will be affected
to a lesser degree by adverse overall market price movements, unrelated to the
merits of specific portfolio securities, than would otherwise be the case. A
Fund may also purchase futures on debt securities or indexes as a substitute for
the purchase of longer-term debt securities to lengthen the average duration of
the Fund's debt portfolio.
The Funds do not intend to use U.S. stock index futures to hedge positions
in securities of non-U.S. companies.
CURRENCY FUTURES A sale of a currency futures contract creates an
----------------
obligation by a Fund, as seller, to deliver the amount of currency called for in
the contract at a specified future time for a specified price. A purchase of a
currency futures contract creates an obligation by a Fund, as purchaser, to take
delivery of an amount of currency at a specified future time at a specified
price. A Fund may sell a currency futures contract, if the Sub-Adviser
anticipates that exchange rates for a particular currency will fall, as a hedge
against a decline in the value of the Fund's securities denominated in such
currency. If the Sub-Adviser anticipates that exchange rates will rise, the
Fund may purchase a currency futures contract to protect against an increase in
the price of securities denominated in a particular currency the Fund intends to
purchase. Although the terms of currency futures contracts specify actual
delivery or receipt, in most instances the contracts are closed out before the
settlement date without the making or taking of delivery of the currency.
Closing out of a currency futures contract is effected by entering into an
offsetting purchase or sale transaction. To offset a currency futures contract
sold by a Fund, the Fund purchases a currency futures contract for the same
aggregate amount of currency and delivery date. If the price in the sale
exceeds the price in the offsetting purchase, the Fund is immediately paid the
difference. Similarly, to close out a currency futures contract purchased by
the Fund, the Fund sells a currency futures contract. If the offsetting sale
price exceeds the purchase price, the Fund realizes a gain, and if the
offsetting sale price is less than the purchase price, the Fund realizes a loss.
A risk in employing currency futures contracts to protect against the price
volatility of portfolio securities denominated in a particular currency is that
changes in currency exchange rates or in the value of the futures position may
correlate
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imperfectly with changes in the cash prices of a Fund's securities. The degree
of correlation may be distorted by the fact that the currency futures market may
be dominated by short-term traders seeking to profit from changes in exchange
rates. This would reduce the value of such contracts for hedging purposes over a
short-term period. Such distortions are generally minor and would diminish as
the contract approached maturity. Another risk is that the Sub-Adviser could be
incorrect in its expectation as to the direction or extent of various exchange
rate movements or the time span within which the movements take place.
OPTIONS ON FUTURES For bona fide hedging and other appropriate risk
------------------
management purposes, the Funds also may purchase and write call and put options
on futures contracts which are traded on exchanges that are licensed and
regulated by the CFTC for the purpose of options trading, or, subject to
applicable CFTC rules, on foreign exchanges. It is the current policy of the
Trust that the Funds will purchase or write only options on futures contracts
that are traded on a U.S. or foreign exchange or board of trade. The Funds also
may engage in related closing transactions with respect to options on futures.
A "call" option on a futures contract gives the purchaser the right, in return
for the premium paid, to purchase a futures contract (assume a "long" position)
at a specified exercise price at any time before the option expires. A "put"
option gives the purchaser the right, in return for the premium paid, to sell a
futures contract (assume a "short" position), for a specified exercise price at
any time before the option expires.
Upon the exercise of a "call," the writer of the option is obligated to
sell the futures contract (to deliver a "long" position to the option holder) at
the option exercise price, which will presumably be lower than the current
market price of the contract in the futures market. Upon exercise of a "put,"
the writer of the option is obligated to purchase the futures contract (deliver
a "short" position to the option holder) at the option exercise price, which
will presumably be higher than the current market price of the contract in the
futures market. When an entity exercises an option and assumes a "long" futures
position, in the case of a "call," or a "short" futures position, in the case of
a "put," its gain will be credited to its futures margin account, while the loss
suffered by the writer of the option will be debited to its account. However,
as with the trading of futures, most participants in the options markets do
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not seek to realize their gains or losses by exercise of their option rights.
Instead, the writer or holder of an option will usually realize a gain or loss
by buying or selling an offsetting option at a market price that will reflect an
increase or a decrease from the premium originally paid.
Options on futures contracts can be used by a Fund to hedge substantially
the same risks and for the same duration and risk management purposes as might
be addressed or served by the direct purchase or sale of the underlying futures
contracts. If the Fund purchases an option on a futures contract, it may obtain
benefits similar to those that would result if it held the futures position
itself.
The purchase of put options on futures contracts is a means of hedging a
Fund's portfolio against the risk of rising interest rates, declining securities
prices or declining exchange rates for a particular currency. The purchase of a
call option on a futures contract represents a means of hedging against a market
advance affecting securities prices or currency exchange rates when the Fund is
not fully invested or of lengthening the average maturity or duration of a
Fund's portfolio. Depending on the pricing of the option compared to either the
futures contract upon which it is based or upon the price of the underlying
securities or currencies, it may or may not be less risky than ownership of the
futures contract or underlying securities or currencies.
In contrast to a futures transaction, in which only transaction costs are
involved, benefits received in an option transaction will be reduced by the
amount of the premium paid as well as by transaction costs. In the event of an
adverse market movement, however, the Fund will not be subject to a risk of loss
on the option transaction beyond the price of the premium it paid plus its
transaction costs, and may consequently benefit from a favorable movement in the
value of its portfolio securities or the currencies in which such securities are
denominated that would have been more completely offset if the hedge had been
effected through the use of futures.
If a Fund writes options on futures contracts, the Fund will receive a
premium but will assume a risk of adverse movement in the price of the
underlying futures contract comparable to that involved in holding a futures
position. If the option is not exercised, the Fund will realize a gain in the
amount of the premium, which may partially offset unfavorable changes in the
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value of securities held by or to be acquired for the Fund. If the option is
exercised, the Fund will incur a loss in the option transaction, which will be
reduced by the amount of the premium it has received, but which may partially
offset favorable changes in the value of its portfolio securities or the
currencies in which such securities are denominated.
The writing of a call option on a futures contract constitutes a partial
hedge against declining prices of the underlying securities or the currencies in
which such securities are denominated. If the futures price at expiration is
below the exercise price, the 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 holdings of securities or the currencies in which such
securities are denominated.
The writing of a put option on a futures contract is analogous to the
purchase of a futures contract. For example, if the Fund writes a put option on
a futures contract on debt securities related to securities that the Fund
expects to acquire and the market price of such securities increases, the net
cost to a Fund of the debt securities acquired by it will be reduced by the
amount of the option premium received. Of course, if market prices have
declined, the Fund's purchase price upon exercise may be greater than the price
at which the debt securities might be purchased in the securities market.
While the holder or writer of an option on a futures contract may normally
terminate its position by selling or purchasing an offsetting option of the same
series, a Fund's ability to establish and close out options positions at fairly
established prices will be subject to the maintenance of a liquid market. The
Funds will not purchase or write options on futures contracts unless the market
for such options has sufficient liquidity such that the risks associated with
such options transactions are not at unacceptable levels.
LIMITATIONS ON PURCHASE AND SALE OF FUTURES CONTRACTS AND OPTIONS ON
--------------------------------------------------------------------
FUTURES CONTRACTS In general, the Funds will engage in transactions in futures
- -----------------
contracts and related options only for bona fide hedging and other appropriate
risk management purposes, and not for speculation. With respect to positions in
futures and related options that do not constitute bona fide hedging positions,
a Fund will not enter into a futures contract or
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futures option contract if, immediately thereafter, the aggregate initial margin
deposits relating to such positions plus premiums paid by it for open futures
option positions, less the amount by which any such options are "in-the-money,"
would exceed 5% of the Fund's total assets. A call option is "in-the-money" if
the value of the futures contract that is the subject of the option exceeds the
exercise price. A put option is "in-the-money" if the exercise price exceeds the
value of the futures contract that is the subject of the option.
When purchasing a futures contract, a Fund will maintain with its custodian
(and mark-to-market on a daily basis) liquid assets that, when added to the
amounts deposited with a futures commission merchant as margin, are equal to the
market value of the futures contract. Alternatively, the Fund may "cover" its
position by purchasing a put option on the same futures contract with a strike
price as high or higher than the price of the contract held by the Fund.
When selling a futures contract, a Fund will maintain with its custodian
(and mark-to-market on a daily basis) liquid assets that, when added to the
amount deposited with a futures commission merchant as margin, are equal to the
market value of the instruments underlying the contract. Alternatively, the
Fund may "cover" its position by owning the instruments underlying the contract
(or, in the case of an index futures contract, a portfolio with a volatility
substantially similar to that of the index on which the futures contract is
based), or by holding a call option permitting the Fund to purchase the same
futures contract at a price no higher than the price of the contract written by
the Fund (or at a higher price if the difference is maintained in liquid assets
with the Fund's custodian).
When selling a call option on a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) liquid assets that, when
added to the amounts deposited with a futures commission merchant as margin,
equal the total market value of the futures contract underlying the call option.
Alternatively, the Fund may cover its position by entering into a long position
in the same futures contract at a price no higher than the strike price of the
call option, by owning the instruments underlying the futures contract, or by
holding a separate call option permitting the Fund to purchase the same futures
contract at a price not higher than the strike price of the call option sold by
the Fund.
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When selling a put option on a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) liquid assets that equal the
purchase price of the futures contract, less any margin on deposit.
Alternatively, the Fund may cover the position either by entering into a short
position in the same futures contract, or by owning a separate put option
permitting it to sell the same futures contract so long as the strike price of
the purchased put option is the same or higher than the strike price of the put
option sold by the Fund.
The requirements for qualification as a regulated investment company also
may limit the extent to which a Fund may enter into futures, futures options or
forward contracts. See "Tax Status."
RISKS ASSOCIATED WITH FUTURES AND FUTURES OPTIONS There are several risks
-------------------------------------------------
associated with the use of futures contracts and futures options as hedging
techniques. A purchase or sale of a futures contract may result in losses in
excess of the amount invested in the futures contract. There can be no
guarantee that there will be a correlation between price movements in the
hedging vehicle and in the Fund's securities being hedged. In addition, there
are significant differences between the securities and futures markets that
could result in an imperfect correlation between the markets, causing a given
hedge not to achieve its objectives. The degree of imperfection of correlation
depends on circumstances such as variations in speculative market demand for
futures and futures options on securities, including technical influences in
futures trading and futures options, and differences between the financial
instruments being hedged and the instruments underlying the standard contracts
available for trading in such respects as interest rate levels, maturities, and
creditworthiness of issuers. A decision as to whether, when and how to hedge
involves the exercise of skill and judgment, and even a well-conceived hedge may
be unsuccessful to some degree because of market behavior or unexpected interest
rate trends. It is also possible that, when a Fund has sold stock index futures
to hedge its portfolio against a decline in the market, the market may advance
while the value of the particular securities held in the Fund's portfolio may
decline. If this occurred, the Fund would incur a loss on the futures contracts
and also experience a decline in the value of its portfolio securities.
Futures exchanges may limit the amount of fluctuation permitted in certain
futures contract prices during a single
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trading day. The daily limit establishes the maximum amount that the price of a
futures contract may vary either up or down from the previous day's settlement
price at the end of the current trading session. Once the daily limit has been
reached in a futures contract subject to the limit, no more trades may be made
on that day at a price beyond that limit. The daily limit governs only price
movements during a particular trading day and therefore does not limit potential
losses because the limit may work to prevent the liquidation of unfavorable
positions. For example, futures prices have occasionally moved to the daily
limit for several consecutive trading days with little or no trading, thereby
preventing prompt liquidation of positions and subjecting some holders of
futures contracts to substantial losses.
In addition to the risks that apply to all options transactions, there are
several special risks relating to options on futures contracts. The ability to
establish and close out positions in such options will be subject to the
development and maintenance of a liquid market in the options. It is not
certain that such a market will develop. Although the Funds generally will
purchase only those options and futures contracts for which there appears to be
an active market, there is no assurance that a liquid market on an exchange will
exist for any particular option or futures contract at any particular time. In
the event no such market exists for particular options, it might not be possible
to effect closing transactions in such options with the result that a Fund would
have to exercise options it has purchased in order to realize any profit and
would be less able to limit its exposure to losses on options it has written.
Many of the contracts discussed above are relatively new instruments
without a significant trading history. As a result, there can be no assurance
that an active secondary market will develop or continue to exist. If the price
of a futures contract changes more than the price of the securities or
currencies, the Fund will experience either a loss or a gain on the futures
contracts which will not be completely offset by changes in the price of the
securities or currencies which are the subject of the hedge. In addition, it is
not possible to hedge fully or perfectly against currency fluctuations affecting
the value of securities denominated in foreign currencies because the value of
such securities is likely to fluctuate as a result of independent factors not
related to currency fluctuations.
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SWAP AGREEMENTS
The International Bond Fund, International Equity Fund and Strategic Income
Fund may enter into interest rate, index and currency exchange rate swap
agreements for purposes of attempting to obtain a particular desired return at a
lower cost to the Fund than if the Fund had invested directly in an instrument
that yielded that desired return or for other portfolio management purposes.
Swap agreements are two party contracts entered into primarily by institutional
investors for periods ranging from a few weeks to more than one year. In a
standard "swap" transaction, two parties agree to exchange the returns (or
differentials in rates of return) earned or realized on particular predetermined
investments or instruments. The gross returns to be exchanged or "swapped"
between the parties are calculated with respect to a "notional amount," i.e.,
----
the return on or increase in value of a particular dollar amount invested at a
particular interest rate, in a particular foreign currency, or in a "basket" of
securities representing a particular index. The "notional amount" of the swap
agreement is only a fictive basis on which to calculate the obligations which
the parties to a swap agreement have agreed to exchange. Commonly used swap
agreements include interest rate caps, under which, in return for a premium, one
party agrees to make payments to the other to the extent that interest rates
exceed a specified rate, or "cap"; interest rate floors, under which, in return
for a premium, one party agrees to make payments to the other to the extent that
interest rates fall below a specified level, or "floor"; and interest rate
collars, under which a party sells a cap and purchases a floor or vice versa in
an attempt to protect itself against interest rate movements exceeding given
minimum or maximum levels. A Fund's obligations (or rights) under a swap
agreement will generally be equal only to the net amount to be paid or received
under the agreement based on the relative values of the positions held by each
party to the agreement (the "net amount"). A Fund's obligations under a swap
agreement will be accrued daily (offset against any amounts owing to the Fund)
and any accrued but unpaid net amounts owed to a swap counterparty will be
covered by the maintenance of a segregated account consisting of liquid assets
to avoid any potential leveraging of the Fund's portfolio. A Fund will not
enter into a swap agreement with any single party if the net amount owed or to
be received under existing contracts with that party would exceed 5% of the
Fund's assets.
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Whether a Fund's use of swap agreements will be successful in furthering
its investment objective will depend on the Sub-Adviser's ability correctly to
predict whether certain types of investments are likely to produce greater
returns than other investments. Because they are two party contracts and
because they may have terms of greater than seven days, swap agreements may be
considered to be illiquid. Moreover, a Fund bears the risk of loss of the
amount expected to be received under a swap agreement in the event of the
default or bankruptcy of a swap agreement counterparty. The Sub-Adviser will
cause a Fund to enter into swap agreements only with counterparties that would
be eligible for consideration as repurchase agreement counterparties under the
Fund's repurchase agreement guidelines. Certain restrictions imposed on the
Funds by the Code may limit the Funds' ability to use swap agreements. The
swaps market is a relatively new market and is largely unregulated. It is
possible that developments in the swaps market, including potential government
regulation, could adversely affect a Fund's ability to terminate existing swap
agreements or to realize amounts to be received under such agreements.
Certain swap agreements are exempt from most provisions of the Commodity
Exchange Act ("CEA") and, therefore, are not regulated as futures or commodity
option transactions under the CEA, pursuant to regulations approved by the CFTC.
To qualify for this exemption, a swap agreement must be entered into by
"eligible participants," which include the following, provided the participants'
total assets exceed established levels: a bank or trust company, savings
association or credit union, insurance company, investment company subject to
regulation under the 1940 Act, commodity pool, corporation, partnership,
proprietorship, organization, trust or other entity, employee benefit plan,
governmental entity, broker-dealer, futures commission merchant, natural person,
or regulated foreign person. To be eligible, natural persons and most other
entities must have total assets exceeding $10 million; commodity pools and
employee benefit plans must have assets exceeding $5 million. In addition, an
eligible swap transaction must meet three conditions. First, the swap agreement
may not be part of a fungible class of agreements that are standardized as to
their material economic terms. Second, the creditworthiness of parties with
actual or potential obligations under the swap agreement must be a material
consideration in entering into or determining the terms of the swap agreement,
including pricing, cost or credit enhancement terms. Third, swap agreements may
not be entered into and traded on or through a multilateral transaction
execution facility.
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This exemption is not exclusive, and participants may continue to rely on
existing exclusions for swaps, such as the Policy Statement issued in July 1989
which recognized a safe harbor for swap transactions from regulation as futures
or commodity option transactions under the CEA or its regulations. The Policy
Statement applies to swap transactions settled in cash that (1) have
individually tailored terms, (2) lack exchange-style offset and the use of a
clearing organization or margin system, (3) are undertaken in conjunction with a
line of business, and (4) are not marketed to the public.
LOAN PARTICIPATION INTERESTS
A Fund's investment in loan participation interests may take the form of
participation interests in, assignments or novations of a corporate loan
("Participation Interests"). The Participation Interests may be acquired from
an agent bank, co-lenders or other holders of Participation Interests
("Participants"). In a novation, a Fund would assume all of the rights of the
lender in a corporate loan, including the right to receive payments of principal
and interest and other amounts directly from the borrower and to enforce its
rights as a lender directly against the borrower. As an alternative, a Fund may
purchase an assignment of all or a portion of a lender's interest in a corporate
loan, in which case, a Fund may be required generally to rely on the assigning
lender to demand payment and enforce its rights against the borrower, but would
otherwise be entitled to all of such lender's rights in the corporate loan. A
Fund also may purchase a Participation Interest in a portion of the rights of a
lender in a corporate loan. In such a case, a Fund will be entitled to receive
payments of principal, interest and fees, if any, but generally will not be
entitled to enforce its rights directly against the agent bank or the borrower;
rather a Fund must rely on the lending institution for that purpose. A Fund
will not act as an agent bank, a guarantor or sole negotiator of a structure
with respect to a corporate loan.
In a typical corporate loan involving the sale of Participation Interests,
the agent bank administers the terms of the corporate loan agreement and is
responsible for the collection of principal and interest and fee payments to the
credit of all lenders which are parties to the corporate loan agreement. The
agent bank in such cases will be qualified under the 1940 Act to serve as a
custodian for a registered investment company such as the Trust. A Fund
generally will rely on the
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agent bank or an intermediate Participant to collect its portion of the payments
on the corporate loan. The agent bank monitors the value of the collateral and,
if the value of the collateral declines, may take certain action, including
accelerating the corporate loan, giving the borrower an opportunity to provide
additional collateral or seeking other protection for the benefit of the
Participants in the corporate loan, depending on the terms of the corporate loan
agreement. Furthermore, unless under the terms of a participation agreement a
Fund has direct recourse against the borrower (which is unlikely), a Fund will
rely on the agent bank to use appropriate creditor remedies against the
borrower. The agent bank also is responsible for monitoring compliance with
covenants contained in the corporate loan agreement and for notifying holders of
corporate loans of any failures of compliance. Typically, under corporate loan
agreements, the agent bank is given broad discretion in enforcing the corporate
loan agreement, and is obligated to use only the same care it would use in the
management of its own property. For these services, the borrower compensates the
agent bank. Such compensation may include special fees paid on structuring and
funding the corporate loan and other fees paid on a continuing basis.
A financial institution's employment as an agent bank may be terminated in
the event that it fails to observe the requisite standard of care or becomes
insolvent, or has a receiver, conservator, or similar official appointed for it
by the appropriate bank regulatory authority or becomes a debtor in a bankruptcy
proceeding. A successor agent bank generally will be appointed to replace the
terminated bank, and assets held by the agent bank under the corporate loan
agreement should remain available to holders of corporate loans. If, however,
assets held by the agent bank for the benefit of a Fund were determined by an
appropriate regulatory authority or court to be subject to the claims of the
agent bank's general or secured creditors, a Fund might incur certain costs and
delays in realizing payment on a corporate loan, or suffer a loss of principal
and/or interest. In situations involving intermediate Participants similar risks
may arise.
When a Fund acts as co-lender in connection with a participation interest
or when a Fund acquires a participation interest the terms of which provide that
a Fund will be in privity of contract with the corporate borrower, a Fund will
have direct recourse against the borrower in the event the borrower fails to pay
scheduled principal and interest. In all other
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cases, a Fund will look to the agent bank to enforce appropriate credit remedies
against the borrower. In acquiring participation interests a Fund will conduct
analysis and evaluation of the financial condition of each such co-lender and
participant to ensure that the participation interest meets a Fund's qualitative
standards. There is a risk that there may not be a readily available market for
loan participation interests and, in some cases, this could result in a Fund
disposing of such securities at a substantial discount from face value or
holding such security until maturity. When a Fund is required to rely upon a
lending institution to pay the Fund principal, interest, and other amounts
received by the lending institution for the loan participation, the Fund will
treat both the borrower and the lending institution as an "issuer" of the loan
participation for purposes of certain investment restrictions pertaining to the
diversification and concentration of the Fund's portfolio. The Funds consider
loan participation interests not subject to puts to be illiquid.
RISKS ASSOCIATED WITH DEBT SECURITIES
To the extent that a Fund invests in debt securities, it will be subject to
certain risks. The value of the debt securities held by a Fund, and thus the
net asset value of the shares of beneficial interest of the Fund, generally will
fluctuate depending on a number of factors, including, among others, changes in
the perceived creditworthiness of the issuers of those securities, movements in
interest rates, the average maturity of the Fund's investments, changes in the
relative values of the currencies in which the Fund's investments are
denominated relative to the U.S. dollar, and the extent to which the Fund hedges
its interest rate, credit and currency exchange rate risks. Generally, a rise
in interest rates will reduce the value of fixed income securities held by a
Fund, and a decline in interest rates will increase the value of fixed income
securities held by a Fund.
RISKS OF INVESTING IN HIGH YIELD SECURITIES ("JUNK BONDS")
High yield bonds may be more susceptible to real or perceived adverse
economic and competitive industry conditions than higher grade bonds. The
prices of high yield bonds have been found to be less sensitive to interest-rate
changes than more highly rated investments, but more sensitive to adverse
economic downturns or individual corporate developments. A
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projection of an economic downturn or of a period of rising interest rates, for
example, could cause a decline in high yield bond prices because the advent of a
recession could lessen the ability of a highly leveraged company to make
principal and interest payments on its debt securities.
Adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of high yield bonds,
especially in a thinly traded market.
Legislation designed to limit the use of high yield bonds in corporate
transactions may have a material adverse effect on a Fund's net asset value and
investment practices. In addition, there may be special tax considerations
associated with investing in high yield bonds structured as zero coupon or
payment-in-kind securities. A Fund records the interest on these securities
annually as income even though it receives no cash interest until the security's
maturity or payment date. Also, distributions on account of such interest
generally will be taxable to shareholders even if the Fund does not distribute
cash to them. Therefore, in order to pay taxes on this interest, shareholders
may have to redeem some of their shares to pay the tax or the Fund may have to
sell some of its assets to reduce the Fund's assets and may thereby increase its
expense ratio and decrease its rate of return.
HIGH YIELD CORPORATE BOND FUND
AND STRATEGIC INCOME FUND
SPECIAL CONSIDERATIONS
Corporate debt securities may bear fixed, contingent, or variable rates of
interest and may involve equity features, such as conversion or exchange rights
or warrants for the acquisition of stock of the same or a different issuer,
participations based on revenues, sales or profits, or the purchase of common
stock in a unit transaction (where corporate debt securities and common stock
are offered as a unit).
When and if available, debt securities may be purchased at a discount from
face value. However, the Funds do not intend to hold such securities to
maturity for the purpose of achieving potential capital gains, unless current
yields on these securities remain attractive. From time to time, each Fund may
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purchase securities not paying interest or dividends at the time acquired if, in
the opinion of the Sub-Adviser, such securities have the potential for future
income (or capital appreciation, if any).
Since shares of the Funds represent an investment in securities with
fluctuating market prices, the value of shares of each Fund will vary as the
aggregate value of the Funds' portfolio securities increases or decreases.
Moreover, the value of the debt securities that each Fund purchases may
fluctuate more than the value of higher rated debt securities. These lower
rated fixed income securities generally tend to reflect short-term corporate and
market developments to a greater extent than higher rated securities which react
primarily to fluctuations in the general level of interest rates. Changes in
the value of securities subsequent to their acquisition will not affect cash
income or yields to maturity to the Funds but will be reflected in the net asset
value of the Funds' shares.
EQUITY INDEX FUND
SPECIAL CONSIDERATIONS
The Equity Index Fund is managed using mathematical algorithms to determine
which stocks are to be purchased or sold to replicate the S&P 500 Index to the
extent feasible. From time to time, adjustments may be made in the Fund's
portfolio because of changes in the composition of the Index, but such changes
should be infrequent. No attempt is made to manage the portfolio in the
traditional sense using economic, financial and market analysis.
The Sub-Adviser believes that the indexing approach described above is an
effective method of simulating percentage changes in the S&P 500 Index.
TOTAL RETURN FUND
SPECIAL CONSIDERATIONS
Although the Total Return Fund does not intend to seek short-term profits,
securities in its portfolio will be sold whenever the Sub-Adviser believes it is
appropriate to do so without regard to the length of time the particular
security may have been held, subject to certain tax requirements for
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qualification as a regulated investment company under the Code. A high turnover
rate involves greater expenses to the Fund and may increase the possibility of
shareholders realizing taxable capital gains. The Fund engages in portfolio
trading if it believes a transaction, net of costs (including custodian
charges), will help in achieving its investment objective.
CALIFORNIA TAX FREE FUND AND NEW YORK TAX FREE FUND
SPECIAL CONSIDERATIONS
RISK FACTORS AFFECTING CALIFORNIA MUNICIPAL SECURITIES
The following information as to certain California State ("State") risk
factors is given to investors in view of the policy of the MainStay California
Tax Free Fund of concentrating its investments in California municipal issuers.
Such information constitutes only a brief discussion, does not purport to be a
complete description and is based on information from sources believed by the
Trust to be reliable, including official statements relating to securities
offerings of California and municipal issuers, and periodic publications by
national ratings organizations. Such information, however, has not been
independently verified by the Trust.
Certain California constitutional amendments, legislative measures,
executive orders, administrative regulations and voter initiatives, as discussed
below, could adversely affect the market values and marketability of, or result
in default of, existing obligations of the State. Obligations of the State or
local governments may also be affected by budgetary pressures affecting the
State and economic conditions in the State. The following information
constitutes only a brief summary and is not intended as a complete description.
Certain of the California municipal securities in which the Fund may invest
may be obligations of issuers which rely in whole or in part on California State
revenues for payment of these obligations. Property tax revenues and a portion
of the State's General Fund surplus are distributed to counties, cities and
their various taxing entities and the State assumes certain obligations
theretofore paid out of local funds. Whether and to what extent a portion of
the State's General Fund will be
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distributed in the future to counties, cities and their various entities, is
unclear.
Certain of the California municipal securities may be obligations of
issuers who rely in whole or in part on ad valorem real property taxes as a
source of revenue. On June 6, 1978, Proposition 13 added Article XIIIA to the
California Constitu tion. The effect of Article XIIIA is to limit ad valorem
taxes on real property and to restrict the ability of taxing entities to
increase real property tax revenues.
Legislation enacted by the California legislature to implement Article
XIIIA (Statutes of 1978, Chapter 292, as amended) provides that notwithstanding
any other law, local agencies may not levy any ad valorem property tax except to
pay debt service on indebtedness approved by the voters prior to July 1, 1978,
and that each county will levy the maximum tax permitted by Article XIIIA of
$4.00 per $100 assessed valuation. The apportionment of property taxes in
fiscal years after 1978-79 was revised pursuant to Statutes of 1979, Chapter
282, which provides relief funds from State moneys beginning in fiscal year
1979-80 and is designed to provide a permanent system for sharing State taxes
and budget funds with local agencies. Under Chapter 282, cities and counties
receive more of the remaining property tax revenues collected under Proposition
13 instead of direct State aid. School districts receive a correspondingly
reduced amount of property taxes, but receive compensation directly from the
State and are given additional relief.
The application and interpretation of Article XIIIA has been and will
probably continue to be the subject of numerous lawsuits in the California
courts. It is not possible to predict the outcome of litigation or the ultimate
scope and impact of Article XIIIA, its implementing legislation and regulations
issued by the California State Board of Equalization. The outcome of such
litigation, however, could substantially impact local property tax collections
and the ability of State agencies, local governments and districts to make
future payments on outstanding debt obligations.
On November 4, 1986, California voters approved an initiative statute known
as "Proposition 62." This statute (i) requires that any tax for general
governmental purposes imposed by local governments be approved by resolution or
ordinance adopted by a two-thirds vote of the governmental entity's legislative
body and by a majority vote of the
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electorate of the governmental entity; (ii) requires that any special tax
(defined as taxes levied for other than general governmental purposes) imposed
by a local governmental entity be approved by a two-thirds vote of the voters
within that jurisdiction; (iii) restricts the use of revenues from a special tax
to the purposes or for the service for which the special tax was imposed; (iv)
prohibits the imposition of ad valorem taxes on real property by local
governmental entities except as permitted by Article XIIIA of the California
Constitution; (v) prohibits the imposition of transaction taxes and sales taxes
on the sale of real property by local governments; (vi) requires that any tax
imposed by a local government on or after August 1, 1985 be ratified by a
majority of the electorate within two years of the adoption of the initiative or
be terminated by November 15, 1988; (vii) requires that, in the event a local
government fails to comply with the provisions of this measure, a reduction in
the amount of tax revenue allocated to such local government occur in an amount
equal to the revenues received by such entity attributable to the tax levied in
violation of the initiative; and (viii) permits these provisions to be amended
exclusively by the voters of the State of California. In September 1988, the
California Court of Appeals held that it was unconstitutional to require that
local tax measures be submitted to the electorate, as described in (vi) above.
In September 1995, the California Supreme Court upheld the
constitutionality of Proposition 62, creating uncertainty as to the legality of
certain local taxes enacted by non-charter cities in California without voter
approval. It is not possible to predict the impact of the decision.
In November 1996, California voters approved Proposition 218. The
initiative applied the provisions of Proposition 62 to all entities, including
charter cities. It requires that all taxes for general purposes obtain a simple
majority popular vote and that taxes for special purposes obtain a two-thirds
majority vote. Prior to the effectiveness of Proposition 218, charter cities
could levy certain taxes such as transient occupancy taxes and utility user's
taxes without a popular vote. Proposition 218 will also limit the authority of
local governments to impose property-related assessments, fees and charges,
requiring that such assessments be limited to the special benefit conferred and
prohibiting their use for general governmental services. Proposition 218 also
allows voters to use their initiative power to reduce or repeal previously-
authorized taxes, assessments, fees and charges.
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The State is subject to an annual appropriations limit imposed by Article
XIIIB of the State Constitution (the "Appropriations Limit"). The
Appropriations Limit does not restrict appropriations to pay debt service on the
bonds or other voter-authorized bonds. Article XIIIB prohibits the State from
spending "appropriations subject to limitation" in excess of the Appropriations
Limit. "Appropriations subject to limitation," with respect to the State, are
authorizations to spend "proceeds of taxes," which consist of tax revenues, and
certain other funds, including proceeds from regulatory licenses, user charges
or other fees to the extent that such proceeds exceed "the cost reasonably borne
by that entity in providing the regulation, product or service," but "proceeds
of taxes" exclude most State subventions to local governments, tax refunds and
some benefit payments such as unemployment insurance. No limit is imposed on
appropriations of funds which are not "proceeds of taxes," such as reasonable
user charges or fees and certain other non-tax funds.
Not included in the Appropriations Limit are appropriations for the debt
service costs of bonds existing or authorized by January 1, 1979, or
subsequently authorized by the voters, appropriations required to comply with
mandates of courts or the federal government and, pursuant to Proposition 111,
appropriations for qualified capital outlay projects and appropriations of
revenues derived from any increase in gasoline taxes and motor vehicle weight
fees above January 1, 1990 levels, and appropriation of certain special taxes
imposed by initiative (e.g., increased cigarette and tobacco taxes enacted by
Proposition 99 in 1988). The Appropriations Limit may also be exceeded in cases
of emergency.
The State's Appropriations Limit in each year is based on the limit for the
prior year, adjusted annually for changes in State per capita personal income
and changes in population, and adjusted, when applicable, for any transfer of
financial responsibility of providing services to or from another unit of
government. The measurement of change in population is a blended average of
statewide overall population growth, and change in attendance at local school
and community college ("K-14") districts. As amended by Proposition 111, the
Appropriations Limit is tested over consecutive two-year periods. Any excess of
the aggregate "proceeds of taxes" received over such a two-year period above the
combined Appropriations Limits for those two years is divided equally between
transfers to K-14 districts and refunds to taxpayers.
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The legislature enacted legislation to implement Article XIIIB which
defines certain terms used in Article XIIIB and sets forth the methods for
determining the Appropriations Limit. California Government Code Section 7912
requires an estimate of the Appropriations Limit to be included in the
Governor's Budget, and thereafter to be subject to the budget process and
established in the Budget Act.
On November 9, 1988, the State's voters approved Proposition 98, a combined
initiative constitutional amendment and statute called the "Classroom
Instructional Improvement and Accountability Act." Proposition 98 changed State
funding of public education below the university level and the operation of the
State Appropriations Limit, primarily by guaranteeing K-14 schools a minimum
share of General Fund revenues. Under Proposition 98 (as modified by
Proposition 111, enacted on June 5, 1990), K-14 schools are guaranteed the
greater of (a) in general, a fixed percent of General Fund revenues ("Test 1"),
(b) the amount appropriated to K-14 schools in the prior year, adjusted for
changes in the cost of living (measured as in Article XIIIB by reference to
State per capita personal income) and enrollment ("Test 2"), or (c) a third
test, which would replace Test 2 in any year when the percentage growth in per
capita General Fund revenues from the prior year plus one half of one percent is
less than the percentage growth in State per capita personal income ("Test 3").
Under Test 3, schools would receive the amount appropriated in the prior year
adjusted for changes in enrollment and per capita General Fund revenues, plus an
additional small adjustment factor. If Test 3 is used in any year, the
difference between Test 3 and Test 2 would become a "credit" to schools which
would be the basis of payments in future years when per capita General Fund
revenue growth exceeds per capita personal income growth. Legislation adopted
prior to the end of the 1988-89 fiscal year, implementing Proposition 98,
determined the K-14 schools' funding guarantee under Test 1 to be 40.3 percent
of the General Fund tax revenues, based on 1986-87 appropriations. The
percentage has been adjusted to approximately 35 percent to account for a
subsequent redirection of local property taxes, since such redirection directly
affects the share of General Fund revenues to schools.
Proposition 98 permits the legislature by two-thirds vote of both houses,
with the Governor's concurrence, to suspend the K-14 schools' minimum funding
formula for a one-year period. Proposition 98 also contains provisions
transferring certain
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State tax revenues in excess of the Article XIIIB limit to K-14 schools.
During the recent recession, General Fund revenues for several years were
less than originally projected, so that the original Proposition 98
appropriations turned out to be higher than the minimum percentage provided in
the law. The legislature responded to these developments by designating "extra"
Proposition 98 payments in one year as a "loan" from future years' Proposition
98 entitlements, and also intended that the "extra" payments would not be
included in the Proposition 98 "base" for calculating future years'
entitlements. In 1992, a lawsuit was filed, called California Teachers'
--------------------
Association v. Gould, which challenged the validity of these off-budget loans.
- --------------------
As part of the negotiations leading to the 1995-96 Budget Act, an oral agreement
was reached to settle this case. The formal settlement required adoption of
legislation satisfactory to the parties to implement its terms, which has
occurred. The court gave final approval of the settlement in late July, 1996.
The settlement provides, among other things, that both the State and K-14
schools share in the repayment of prior years' emergency loans to schools. Of
the total $1.76 billion in loans, the State will repay $935 million by
forgiveness of the amount owed, while schools will repay $825 million. The
State share of the repayment will be reflected as an appropriation above the
current Proposition 98 base calculation. The schools' share of the repayment
will count as appropriations that count toward satisfying the Proposition 98
guarantee, or from "below" the current base. Repayments are spread over the
eight-year period of 1994-95 through 2001-02 to mitigate any adverse fiscal
impact. The Director of Finance has certified that a settlement has occurred,
allowing approximately $351 million in appropriations from the 1995-96 fiscal
year to be disbursed to schools in August 1996.
Substantially increased General Fund revenues, above initial budget
projections, in the 1994-95 and 1995-96 fiscal years have resulted in
retroactive increases in Proposition 98 appropriations from subsequent fiscal
years' budgets.
Certain California municipal securities in the Fund may be obligations
which are secured in whole or in part by a mortgage or deed of trust on real
property. Upon the default of a mortgage or deed of trust with respect to
California real property, the creditor's nonjudicial foreclosure rights under
the
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power of sale contained in the mortgage or deed of trust are subject to the
constraints imposed by California law upon transfers of title to real property
by private power of sale. During the three-month period beginning with the
filing of a formal notice of default, the debtor is entitled to reinstate the
home mortgage by making any overdue payments. Under standard loan servicing
procedures, the filing of the formal notice of default does not occur unless at
least three full monthly payments have become due and remain unpaid. The power
of sale is exercised by posting and publishing a notice of sale for at least 20
days after expiration of the three-month reinstatement period. Therefore, the
effective minimum period for foreclosing on a mortgage could be in excess of
seven months after the initial default. Such time delays in collections could
disrupt the flow of revenues available to an issuer for the payment of debt
service on the outstanding obligations if such defaults occur with respect to a
substantial number of home mortgages or deeds of trust securing an issuer's
obligations.
Certain California municipal securities in the Fund may be obligations
which finance the acquisition of single family home mortgages for low- and
moderate-income mortgagors. These obligations may be payable solely from
revenues derived from the home mortgages, and are subject to the California
statutory limitations described above applicable to obligations secured by real
property. Under California anti-deficiency legislation, there is no personal
recourse against a mortgagor of a single family residence purchased with the
loan secured by the mortgage.
Under California law, mortgage loans secured by single family owner-
occupied dwellings may be prepaid at any time. Prepayment charges on such
mortgage loans may be imposed only with respect to voluntary prepayments made
during the first five years of the term of the mortgage loan, and cannot in any
event exceed six months' advance interest on the amount prepaid in excess of 20
percent of the original principal amount of the mortgage loan. This limitation
could affect the flow of revenues available to an issuer for debt service on the
outstanding debt obligations which financed such home mortgages.
After suffering through a severe recession, since the start of 1994 the
State's economy has been on a steady recovery. Employment increased by over
500,000 in 1994 and 1995, and the pre-recession employment level is expected to
be matched by early 1996. The strongest growth has been in export-related
industries, business services, electronics, entertainment and
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tourism, all of which have offset the recession-related losses which were
heaviest in aerospace and defense-related industries, finance and insurance.
The recession seriously affected State tax revenues and caused an increase
in expenditures for health and welfare programs. As a result, the State
experienced recurring budget deficits in the late 1980's and early 1990's. The
State Controller reports that expenditures exceeded revenues for four of six
years, and the State accumulated a budget deficit of about $2.8 billion at its
peak at June 30, 1993.
The State's cash condition became so serious from late spring 1992 until
1995 that the State had to rely on the issuance of short-term notes which
matured in a subsequent fiscal year to finance its ongoing deficit and pay
current obligations. With the repayment of the last of these deficit notes in
April, 1996, the State does not plan to rely further on external borrowing
across fiscal years, but will continue its normal cash flow.
On January 17, 1994, a major earthquake measuring an estimated 6.8 on the
Richter Scale struck Los Angeles. Significant property damage to private and
public facilities occurred in a four-county area including northern Los Angeles
County, Ventura County, and parts of Orange and San Bernardino Counties. The
possibility exists that another such earthquake could create a major dislocation
of the State economy.
The State of California entered the 1995-96 budget negotiations with the
smallest nominal "budget gap" to be closed in many years, with strengthening
revenues and reduced caseload growth based on an improving economy.
Nonetheless, serious policy differences between the Governor and the legislature
prevented timely enactment of the budget. The 1995-96 Budget Act was signed by
the Governor on August 3, 1995, 34 days after the start of the fiscal year. The
Budget Act projected General Fund revenues and transfers of $44.1 billion, a 3.5
percent increase from the prior year. Expenditures were budgeted at $43.4
billion, a four percent increase. The Department of Finance projected that,
after repaying the last of the carryover budget deficit, there would be a
positive balance of $28 million in the budget reserve, the Special Fund for
Economic Uncertainties ("SFEU"), at June 30, 1996. The Budget Act also projected
Special Fund revenues of $12.7 billion and appropriated Special Fund
expenditures of $13.0 billion.
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The Governor's proposed budget for 1996-97 projected General Fund revenues
and transfers of about $45.6 billion and proposed total General Fund
appropriations of about $45.2 billion. The Governor's proposed budget renewed a
proposal, which had been rejected by the legislature in 1995, for a 15% cut in
personal and corporate tax rates, phased in over a three-year period. In May
1996, the State Department of Finance updated revenue estimates to $47.1 billion
for 1996-97, assuming enactment of the Governor's proposed tax cut, and
expenditure estimates to $46.5 billion.
The Department of Finance's May Revision to the 1996-97 Governor's Budget,
released on May 21, 1996 (the "May Revision"), updated the projections for the
1995-96 fiscal year, so that revenues and transfers were estimated to be $46.1
billion, some $2 billion over the original fiscal year estimate, which was
attributed to the strong economic recovery. Expenditures also increased, to an
estimated $45.4 billion, as a result of the requirement to expend revenues for
schools under Proposition 98, and, among other things, failure of the federal
government to enact welfare reform and to budget new aid for illegal immigrant
costs.
The 1996-97 Budget Act was signed by the Governor on July 15, 1996, along
with various implementing bills. The Governor vetoed about $82 million of
appropriations (both General Fund and Special Fund). With the signing of the
Budget Act, the State implemented its regular cash flow borrowing program with
the issuance of $3.0 billion of Revenue Anticipation Notes to mature on June 30,
1997. The Budget Act appropriates a modest budget reserve in the SFEU of $305
million, as of June 30, 1997. The Department of Finance projects that, on June
30, 1997, the State's available internal borrowable (cash) resources will be
$2.9 billion, after payment of all obligations due by that date, so that no
cross-fiscal year borrowing will be needed.
The legislature rejected the Governor's proposed 15% cut in personal income
taxes (to be phased over three years), but did approve a 5% cut in bank and
corporation taxes, to be effective for income years starting on January 1, 1997.
As a result, revenues for the fiscal year will be an estimated $550 million
higher than projected in the May Revision, and are now estimated to total
$47.643 billion, a 3.3 percent increase over the final estimated 1995-96
revenues. Special Fund revenues are estimated to be $13.3 billion. The Budget
Act contains General Fund appropriations totaling $47.251 billion, a 4.0 percent
increase
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over the final estimated 1995-96 expenditures. Special Fund expenditures are
budgeted at $12.6 billion.
Other major features of the 1996-1997 Budget Act include an increase of 1.6
billion (General Fund) and $1.65 billion total above revised 1995-96 levels for
Proposition 98 funding, reductions in health and welfare costs, increases in
educational funding, and increased funding for the State's prison inmate
population. The 1996-97 Budget Act contained no tax increases. There was a
reduction in corporate taxes. In addition, the legislature adopted a further
one-year suspension of the Renters Tax Credit, saving $520 million in
expenditures.
Following enactment of the 1996-97 Budget Act, Congress passed and the
President signed (on August 22, 1996) the Personal Responsibility and Work
Opportunity Act of 1996 making a fundamental reform of the current welfare
system. Among many provisions, the Law includes: (i) conversion of Aid to
Families with Dependent Children from an entitlement program to a block grant
titled Temporary Assistance for Needy Families (TANF), with lifetime time limits
on TANF recipients, work requirements and other changes; (ii) provisions denying
certain federal welfare and public benefits to legal noncitizens, allowing
states to elect to deny additional benefits (including TANF) to legal
noncitizens, and generally denying almost all benefits to illegal immigrants;
and (iii) changes in the Food Stamp program, including reducing maximum benefits
and imposing work requirements.
The states are required to implement the new TANF program not later than
July 1, 1997 and provides California approximately $3.7 billion in block grant
funds for fiscal year 1996-97 for the provisions of the law. States are allowed
to implement TANF as soon as possible and will receive a prorated block grant
effective the date of application. The California State Plan was approved
November 27, 1996 to allow grant reductions to be implemented effective January
1, 1997 and to allow the State to capture approximately $267 million in
additional federal block grant funds over the currently budgeted level. None of
the other federal changes needed to achieve the balance of the $660 million cost
savings were enacted. Thus, in lieu of the $669 million savings initially
assumed, it is now projected that savings will total approximately $320 million.
A preliminary analysis of the Law by the State Legislative Analyst's Office
indicates that an overall assessment of how
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these changes will affect the State's General Fund will not be known for some
time, and will depend on how the State implements the Law; the degree to which
the State elects to make cuts in federal aid, provide more aid to counties, or
cut some of its own existing programs to noncitizens; and the State's ability to
avoid certain penalties written into the Law.
With the continued strong economic recovery in the State, the Department of
Finance has estimated, in connection with the release of the Governor's 1997-98
Budget Proposal, that revenues for the 1996-97 Fiscal Year will exceed initial
projections by about $760 million. This increase will be offset by higher
expenditures for K-14 school aid (pursuant to Proposition 98) and for health and
welfare costs, because federal law changes and other federal actions did not
provide as much assistance to the State as was initially planned in the Budget
Act. The Department's updated projections show a balance in the Special Fund
for Economic Uncertainties (the "SFEU") of $197 million, slightly lower than
projected in July, 1996. The Department also projects the State's cash position
will be stronger than originally estimated, with unused internal borrowable
resources at June 30, 1997 of about $4.3 billion.
On January 9, 1997, the Governor released his proposed budget for the 1997-
98 Fiscal Year (the "Governor's Budget"). The Governor's Budget projects General
Fund revenues and transfers in 1997-98 of $50.7 billion, a 4.6% increase from
revised 1996-97 figures. The Governor proposes expenditures of $50.3 billion, a
3.9% increase from 1996-97. The Governor's Budget projects a balance in the
SFEU of $553 million on June 30, 1998. The Governor's Budget also anticipates
about $3 billion of external borrowing for cash flow purposes during the year,
with no requirement for cross-fiscal year borrowing.
Among the major initiatives and features of the Governor's Budget are the
following:
1. A proposed 10% cut in the Bank and Corporation Tax rate, to be phased
in over two years.
2. Proposition 98 funding for K-14 schools will be increased again, as a
result of stronger revenues. Per-pupil funding for K-12 schools will reach
$5,010, compared to $4,220 as recently as the 1993-94 Fiscal Year. Part of the
new funding is proposed to be dedicated to the completion of the current program
to reduce class size to 20 pupils in lower elementary grades, and
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to expand the program by one grade, so that it will cover K-3rd grade.
3. Funding for higher education will be increased consistent with a four-
year "compact" established in 1995-96. There is not projected to be any increase
in student fees at any of the three levels of the State higher education system.
4. The 1997-98 proposed Governor's Budget assumes approximately $500
million in savings contingent upon federal action. The Budget assumes that
federal law will be enacted to remove the maintenance-of-effort requirement for
Supplemental Security Income (SSI) payments, thereby enabling the state to
reduce grant levels pursuant to previously enacted state law ($279 million).
The Budget also assumes the federal government will fund $216 million in costs
of health care for illegal immigrants.
On December 6, 1994, Orange County, California (the "County"), together
with its pooled investment funds (the "Funds") filed for protection under
Chapter 9 of the federal Bankruptcy Code, after reports that the Funds had
suffered significant market losses in their investments, causing a liquidity
crisis for the Funds and the County. More than 200 other public entities, most
of which, but not all, are located in the County, were also depositors in the
Funds. The bankruptcy filing stemmed from approximately $1.7 billion in losses
suffered by the County's investment pool due to investments in high risk
"derivative" securities. On June 12, 1996, it emerged from bankruptcy after the
successful sale of $880 million in municipal bonds allowed the County to pay off
the last of its creditors. On January 7, 1997, the County returned to the
municipal bond market with a $136 million bond issue maturing in 13 years at an
insured yield of 7.23%.
The State is a party to numerous legal proceedings, many of which normally
recur in governmental operations. In addition, the State is involved in certain
other legal proceedings which, if decided against the State, may require the
State to make significant future expenditures or may impair future revenue
sources.
Among the more significant lawsuits pending against the State are the
following: (i) cases relating to the State's method of determining the tax on
gross insurance premiums, in which the State faces losses of approximately $200
million; (ii)
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on appeal, an action seeking reimbursement for alleged state-mandated costs, in
which the State faces losses of approximately $1 billion, if all potentially
eligible school districts pursue timely claims; (iii) lawsuits related to
contamination at the Stringfellow toxic waste site the cost for clean-up of
which ranges from $200 to $800 million; (iv) an action involving damages caused
by the Yuba River flood of February 1986 with potential liability to 3,000
plaintiffs, ranging from $800 million to $1.5 billion; (v) a claim that payment
of wages in registered warrants violated the Fair Labor Standards Act, which
involves maximum damages of approximately $500 million; (vi) a claim involving
the constitutionality of the 1992-93 Budget Act-related legislation which
redirected approximately $1.3 billion in local tax revenues from localities to
schools wherein the parties are currently negotiating a settlement, subject to
court approval; (vii) a lawsuit involving the reduction of the State's Aid to
Families with Dependent Children ("AFDC") payments in 1992, 1993, and 1994;
(viii) a lawsuit involving the 1994-95 Budget Act's 2.3 percent reduction in
AFDC payments; (ix) an appeal by the State of a judgment, in which the State may
be required to pay out approximately $900 million in interest, that legislation
unconstitutionally impaired the vested contract rights of Public Employees'
Retirement System members; (x) two related challenges to appropriations made by
the State under the 1994 and 1995 Budget Acts, which could result in a loss to
the General Fund of a combined amount over $600 million; (xi) a challenge to the
appropriation of approximately $166 million in Proposition 99 Funds for the
years ended June 30, 1990 through June 30, 1995 for programs that were allegedly
not health education or tobacco-related disease research; and (xii) challenges
to the legality of various budget action transfers and appropriations from
particular special funds for years ended June 30, 1995, and June 30, 1996 as
contrary to the substantive law that established the fund.
Due to the State's continuing budget problems, the State's general
obligation bonds were downgraded in July 1994 from A1" to "Aa" by Moody's, from
"A+" to "A" by S&P. The ratings companies expressed uncertainty in the State's
ability to balance its budget by 1996. However, on July 30, 1996, citing the
State's improving economy and budget situation, S&P upgraded the State's general
obligation bonds from "A" to "A+." There can be no assurance that such ratings
will continue for any given period of time or that they will not in the future
be further revised or withdrawn.
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RISK FACTORS AFFECTING NEW YORK MUNICIPAL SECURITIES
The following information as to certain New York State ("State") and New
York City ("City") risk factors is given to investors in view of the policy of
the MainStay New York Tax Free Fund of concentrating its investments in New York
municipal issuers. Such information constitutes only a brief discussion, does
not purport to be a complete description and is based on information from
sources believed by the Trust to be reliable, including official statements
relating to securities offerings of New York and municipal issuers, and periodic
publications by national ratings organizations. Such information, however, has
not been independently verified by the Trust.
There are a number of methods by which the State may incur debt. The State
may issue general obligations bonds. Under the State Constitution, the State
may not, with limited exceptions for emergencies, undertake long-term general
obligation borrowing (i.e., borrowing for more than one year) unless the
borrowing is authorized in a specific amount for a single work or purpose by the
legislature and approved by the voters. There is no limitation on the amount of
long-term general obligation debt that may be so authorized and subsequently
incurred by the State.
The State may undertake short-term borrowings without voter approval (i) in
anticipation of the receipt of taxes and revenues, by issuing tax and revenue
anticipation notes; and (ii) in anticipation of the receipt of proceeds from the
sale of duly authorized but unissued general obligation bonds, by issuing bond
anticipation notes. The State may also, pursuant to specific constitutional
authorization, directly guarantee certain obligations of the State's authorities
("Authorities"). Payments of debt service on State general obligation and
State-guaranteed bonds and notes are legally enforceable obligations of the
State.
The State also employs additional long-term financing mechanisms, lease-
purchase and contractual-obligation financings, which involve obligations of
public authorities or municipalities that are State-supported but not general
obligations of the State. As of March 31, 1997, the total amount of outstanding
general obligation debt was $5.03 billion, including $293.6 billion in bond
anticipation notes.
The fiscal stability of the State is related in part to the fiscal
stability of its public authorities. As of September 30,
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1995, the date of the latest data available, 17 public authorities had
outstanding debt of $100 million or more. The aggregate outstanding debt,
including refunding bonds, of all State public authorities was $73.45 billion.
Public authority operating expenses and debt service costs are generally
paid by revenues generated by the projects financed or operated, such as tolls
charged for the use of highways, bridges or tunnels, rentals charged for housing
units, and charges for occupancy at medical care facilities. In addition, State
legislation authorizes several financing techniques for public authorities.
Also, there are statutory arrangements providing for State local assistance
payments otherwise payable to localities to be made under certain circumstances
to public authorities. Although the State has no obligation to provide
additional assistance to localities whose local assistance payments have been
paid to public authorities under these arrangements, if local assistance
payments are diverted, the affected localities could seek additional State
assistance. Some authorities also receive moneys from State appropriations to
pay for the operating costs of certain of their programs. The Metropolitan
Transit Authority (the "MTA") receives the bulk of this money in order to
provide transit and commuter services.
In 1990, as part of a State fiscal reform program, legislation was enacted
creating the "New York Local Government Assistance Corporation" ("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. Over a period of years, the issuance of those long-
term obligations, which are to be amortized over no more than 30 years, was
expected to eliminate the need for continued short-term seasonal borrowing. The
legislation also dedicated revenues equal to one-quarter of the four cent State
sales and use tax to pay debt service on these bonds. In addition, the
legislation imposed a cap on the annual seasonal borrowing of the State at $4.7
billion, less net proceeds of bonds issued by LGAC and bonds issued to provide
for capitalized interest, except in cases where the Governor and the legislative
leaders have certified both the need for additional borrowing and 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.
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As of June 1995, LGAC had issued bonds and notes to provide net proceeds of
$4.7 billion completing the program. The impact of LGAC's borrowing is that the
State is able to meet its cash flow needs in the first quarter of the fiscal
year without relying on short-term seasonal borrowings. The 1995-96 State
Financial Plan includes no spring borrowing, nor did the 1994-95 State Financial
Plan, which represented the first time in 35 years there was no short-term
seasonal borrowing. This reflects the success of the LGAC program in permitting
the State to accelerate local aid payments from the first quarter of the current
fiscal year to the fourth quarter of the previous fiscal year.
On January 6, 1992, Moody's lowered from "A" to "Baa1" its rating of those
State bonds that are backed by annual legislative appropriations. As of
September 1997, S&P rated the same bonds as "BBB+" On February 11, 1997, Moody's
downgraded its rating of the State's general obligation bonds from "A" to "A2."
On January 13, 1992, S&P lowered its rating of the State's general obligation
bonds from "A" to "A-." As of September 1997, S&P rated general obligation
bonds as an "A".
OVERVIEW
The State's current fiscal year commenced on April 1, 1997, and ends on
March 31, 1998, and is referred to herein as the State's 1997-98 fiscal year.
The State's budget for the 1997-98 fiscal year was adopted by the Legislature on
August 4, 1997, more than four months after the start of the fiscal year. Prior
to adoption of the budget, the Legislature enacted appropriations for
disbursements considered to be necessary for State operations and other
purposes, including necessary appropriations for State-supported debt services.
The State Financial Plan for the 1997-98 fiscal year was formulated on August
11, 1997 and is based on the State's budget as enacted by the Legislature, as
well as actual results for the first quarter of the current fiscal year. The
1997-98 State Financial Plan is expected to be updated in October and January.
The adopted 1997-98 budget projects and increase in General Fund
disbursements of $1.7 billion or 5.2 percent over 1996-97 levels. The average
annual growth rate over the last three fiscal years is approximately 1.2
percent. State Funds disbursements (excluding federal grants) are projected to
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increase by 5.4 percent from the 1996-97 fiscal year. All Governmental Funds
projected disbursements increase by 7.0 percent over the 1996-97 fiscal year.
The 1997-98 State Financial Plan is projected to be balanced on a cash
basis. The Financial Plan projections include a reserve for future needs of
$530 million. As compared to the Governor's Executive Budget as amended in
February 1997, the State's adopted budget for 1997-98 increases General Fund
spending by $1.7 billion, primarily from increases for local assistance ($1.3
billion).
Resources used to fund these additional expenditures include increased
revenues projected for the 1997-98 fiscal year, increased resources produced in
the 1996-97 fiscal year that will be utilized in 1997-98, reestimates of social
service, fringe benefit and other spending, and certain non -recurring
resources. Total non-recurring resources included in the 1997-98 Financial Plan
are projected by DOB to be $270 million, or 0.7 percent of total General Fund
receipts.
The 1997-98 Financial Plan also includes: a projected General Fund reserve
of $530 million; a projected balance of $332 million in the Tax Stabilization
Reserve Fund; and a projected $65 million balance in the Contingency Reserve
Fund.
The projections do not include any subsequent actions that the Governor may
take to exercise his line-item veto (or vetoing any companion legislation)
before signing the 1997-98 budget appropriation bills into law. Under the
Constitution, the Governor may veto any additions to the Executive Budget within
10 days after the submission of appropriation bills for his approval. If the
Governor were to take such action, the resulting impact on the Financial Plan
would be positive.
The General Fund is the principal operating fund of the State and is used
to account for all financial transactions, except those required to be accounted
for in another fund. It is the State's largest fund and receives almost all
State taxes and other resources not dedicated to particular purposes. In the
State's 1997-98 fiscal year, the General Fund is expected to account for
approximately 48 percent of total Governmental Funds disbursements and 71
percent of total State Funds disbursements. General Fund moneys are also
transferred to other funds, primarily to support certain capital projects and
debt service payments in other fund types.
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Total receipts and transfers from other funds are projected to be $35.09
billion, an increase of $2.05 billion from the 1996-97 fiscal year. Total
General Fund disbursements and transfers to other funds are projected to be
$34.60 billion, an increase of $1.70 billion from the 1996-97 fiscal year.
General Fund disbursements and transfers to capital, debt service and other
funds are projected at $34.60 billion, an increase of $1.7 billion (5 percent)
from 1996-97 fiscal year levels. Over the last two years, spending growth for
most State agencies and programs has been negative or flat, producing an overall
decline in General Fund spending during that period. The 1997-98 adopted budget
reflects negotiated increases for State employee salaries, increased transfers
for debt service, and other mandated increases, as well as increased investments
in school aid, higher education, mental health and public protection.
Total General Fund receipts and transfers from other funds in the 1997-98
fiscal year are projected to be $35.09 billion, an increase of over $2 billion
or roughly 6 percent from the $33.04 billion recorded in the 1996-97 fiscal
year. This total includes $31.68 billion in tax receipts, $1.48 billion in
miscellaneous receipts, and $1.94 billion in transfers from other funds.
The projected $2 billion increase in receipts exaggerates the underlying
year-to-year growth in State tax revenues. This increase is largely the result
of actions undertaken by the State to utilize the $1.4 billion 1996-97 budget
surplus reported by DOB to finance costs in the State's 1997-98 fiscal year.
This transaction reduced reported receipts in the 1996-97 fiscal year and
increased projected receipts in the State's 1997-98 fiscal year. Conversely,
the incremental cost of tax reductions newly effective in 1997-98 and the impact
of new earmarking statutes which divert receipts from the General Fund to other
funds work to depress apparent growth below the underlying growth in the
receipts base attributable to expansion of the State's economy. After adjusting
for these actions, tax receipts are projected to grow by approximately 5 percent
in 1997-98.
The State closed projected budget gaps of $5.0 billion, $3.9 billion, and
$2.3 billion for the 1995-96 through 1997-98 fiscal years, respectively. The
1998-99 budget gap was projected at $1.68 billion (before the application of any
assumed efficiencies) in the outyear projections submitted to the Legislature in
February 1997. As a result of changes made in the
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adopted budget, the 1998-99 gap is now expected to be about the same or smaller
than the amount previously projected, after application of the $530 million
reserve for future needs. The expected gap is smaller than the three previous
budget gaps closed by the State. The Governor has indicated that he will propose
to close any potential imbalance primarily through General Fund expenditure
reductions and without increases in taxes or deferrals of scheduled tax
reductions.
The State issued its first update to the GAAP-basis Financial Plan for the
State's 1997-98 fiscal year on August 11, 1997, in conjunction with the release
of the cash-basis 1997-98 Financial Plan. A second GAAP-basis update will be
issued in connection with the Governor's submission of the 1998-99 Executive
Budget.
For 1997-98, total revenues in the General Fund are projected at $33.37
billion, total expenditures are projected at $34.66 billion, and net operating
sources and uses are projected to contribute $331 million. For all governmental
funds, total revenues are projected at $67.48 billion, total expenditures are
projected at $68.24 billion, and financing uses are projected to exceed
financing sources by $220 million. The all governmental funds GAAP-basis
Financial Plan projections show a deficiency of revenues and other financing
sources over expenditures and other financing uses of $979 million, after a
reported 1996-97 all funds surplus of $2.1 billion.
The major factor affecting the General Fund GAAP-basis results for 1996-97
and the projections for 1997-98 is the 1996-97 cash-basis surplus, which helped
produce a GAAP-basis surplus in the 1996-97 fiscal year of $1.93 billion. The
use of this cash-basis surplus to fund liabilities in the 1997-98 fiscal year,
offset by the $494 million change in the projected 1997-98 cash-basis fund
balance, is the primary reason for the projected 1997-98 GAAP-basis deficit of
$959 million. This represents an increase of $191 million from the prior
projection, issued in January 1997 as part of the 1997-98 Executive Budget. The
new projection reflects the impact of legislative changes to the Executive
Budget, and the increase in the 1996-97 cash-basis surplus since that time.
Across the two fiscal years, the General Fund accumulated deficit is projected
to be reduced by $974 million to $1.95 billion.
The Division of the Budget believes that the economic assumptions and
projections of receipts and disbursements
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accompanying the 1997-98 Executive Budget are reasonable. However, the economic
and financial condition of the State may be affected by various financial,
social, economic and political factors. Those factors can be very complex, can
vary from fiscal year to fiscal year, and are frequently the result of actions
taken not only by the State but also by entities, such as the federal
government, that are outside the State's control. Because of the uncertainty and
unpredictability of changes in these factors, their impact cannot be fully
included in the assumptions underlying the State's projections. There can be no
assurance that the State economy will not experience results that are worse than
predicted, with corresponding material and adverse effects on the State's
financial projections.
To make progress toward addressing recurring budgetary imbalances, the
1997-98 Executive Budget includes significant actions to align recurring
receipts and disbursements in future fiscal years. However, there can be no
assurance that the State's actions will be sufficient to preserve budgetary
balance or to align recurring receipts and disbursements in either 1997-98 or in
future fiscal years.
The 1997-98 adopted budget includes multi-year tax reductions, including a
State funded property and local income tax reduction program, estate tax relief,
utility gross receipts tax reductions, permanent reductions in the State sales
tax on clothing, and elimination of assessments on medical providers. These
reductions are intended to reduce the overall level of State and local taxes in
New York and to improve the State's competitive position vis-a-vis other states.
The various elements of the State and local tax and assessment reductions have
little or no impact on the 1997-98 Financial Plan, and do not begin to
materially affect the outyear projections until the State's 1999-2000 fiscal
year. The adopted 1997-98 budget also makes significant investments in
education, and proposes a new $2.4 billion general obligation bond proposal for
school facilities to be submitted to the voters in 1997.
One major uncertainty to the 1997-98 State Financial Plan continues to be
risks related to the economy and tax collections, which could produce either
favorable or unfavorable variances during the balance of the year. It is
possible that recent changes could produce slower economic growth and a
deterioration in State receipts. For example, the securities industry is more
important to the New York economy that the national economy, and a significant
deterioration in stock market performance could
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ultimately produce adverse changes in wage and employment levels, although with
less than six months to go in the current fiscal year, the likelihood of an
adverse impact on the 1997-98 fiscal year is reduced. On the other hand, the
national or State economy may continue to perform better than projected, which
could produce beneficial short-term results in State receipts.
On August 11, 1997 President Clinton exercised his line item veto powers to
cancel a provision in the Federal Balanced Budget Act of 1997 that would have
deemed New York State's health care provider taxes to be approved by the federal
government. New York and several other states have used hospital rate
assessments and other provider tax mechanisms to finance various Medicaid and
health insurance programs since the early 1980s. The State's process of
taxation and redistribution of health care dollars was sanctioned by federal
legislation in 1987 and 1991. However, the federal Health Care Financing
Administration (HCFA) regulations governing the use of provider taxes require
the State to seek waivers from HCFA that would grant explicit approval of the
provider taxing system now in place. The State filed the majority of these
waivers with HCFA in 1995 but has yet to receive final approval.
The Balanced Budget Act of 1997 provision passed by Congress was intended
to rectify the uncertainty created by continued inaction on the State's waiver
requests. A federal disallowance of the State's provider tax system could
jeopardize up to $2.6 billion in Medicaid reimbursement received through
December 31, 1998. The President's veto message valued any potential
disallowance at $200 million. The 1997-98 Financial Plan does not anticipate
any provider tax disallowance.
On October 9, 1997 the President offered a corrective amendment to the HCFA
regulations governing such taxes. The Governor has stated that this proposal
does not appear to address all of the State's concerns, and negotiations are
ongoing between the State and HCFA. In addition, the City of New York and other
affected parties in the health care industry have filed a lawsuit challenging
the constitutionality of the President's line item veto.
On July 31, 1997, the New York State Tax Appeals Tribunal delivered a
decision involving the computation of itemized deductions and personal income
taxes of certain high income taxpayers. By law, the State cannot appeal the
Tribunal's decision. The decision will lower income tax liability
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attributable to such taxpayers for the 1997 and earlier open tax years, as well
as on a prospective basis. The impact of this decision on receipts estimates for
the current and future fiscal years will be reflected in the Financial Plan and
Financial Plan Update that will accompany the 1998-99 Executive Budget.
On August 22, 1996, the President signed into law the Personal
Responsibility and Work Opportunity Reconciliation Act of 1996. This federal
legislation fundamentally changed the programmatic and fiscal responsibilities
for administration of welfare programs at the federal, state and local levels.
The new law abolishes the federal Aid to Families with Dependent Children
program (AFDC), and creates a new Temporary Assistance to Needy Families program
(TANF) funded with a fixed federal block grant to states. The new law also
imposes (with certain exceptions) a five-year durational limit on TANF
recipients, requires that virtually all recipients be engaged in work or
community service activities within two years of receiving benefits, and limits
assistance provided to certain immigrants and other classes of individuals.
States are required to meet work activity participation targets for their TANF
caseload; these requirements are phased in over time. State that fail to meet
these federally mandated job participation rates, or that fail to conform with
certain other federal standards, face potential sanctions in the form of a
reduced federal block grant.
On October 16, 1996, the Governor submitted the State's TANF implementation
plan to the federal government as required under the new federal welfare law.
On December 13, 1996, the State's plan was approved by the federal government.
Legislation will be required to implement the State's TANF plan, and the
Governor has introduced legislation necessary to conform with federal law.
States are required to comply with the new federal welfare reform law no later
than July 1, 1997. There can be no assurances that the State legislature will
enact welfare reform proposals as submitted by the Governor and as required
under federal law.
The State Financial Plan is based upon forecasts of national and State
economic activity developed through both internal analysis and review of State
and national economic forecasts prepared by commercial forecasting services and
other public and private forecasters. Economic forecasts have frequently failed
to predict accurately the timing and magnitude of changes in the national and
the State economies. Many uncertainties exist in forecasts of both the national
and State economies, including consumer attitudes toward spending, the extent of
corporate and
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governmental restructuring, 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 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. In preparing projections of State receipts, economic forecasts
relating to personal income, wages, consumption, profits and employment have
been particularly important. The projection of receipts from most tax or
revenue sources is generally made by estimating the change in yield of such tax
or revenue source caused by economic and other factors, rather than by
estimating the total yield of such tax or revenue source from its estimated tax
base. The forecasting methodology, however, ensures that State fiscal year
estimates for taxes that are based on a computation of annual liability, such as
the business and personal income taxes, are consistent with estimates of total
liability under such taxes.
Projections of total State disbursements are based on assumptions relating
to economic and demographic factors, 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. Factors that may
affect the level of disbursements in the fiscal year include uncertainties
relating to the economy of the nation and the State, the policies of the federal
government, and changes in the demand for and use of State services.
The Division of the Budget believes that its projections of receipts and
disbursements relating to the current State Financial Plan, and the assumptions
on which they are based, are reasonable. Actual results, however, could differ
materially and adversely from any projections. In the past, the State has taken
management actions and made use of internal sources to address potential State
Financial Plan shortfalls, and DOB believes it could take similar actions should
variances occur in its projections for the current fiscal year.
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In recent years, State actions affecting the level of receipts and
disbursements, the relative strength of the State and regional economy, actions
of the federal government and other factors, have created structural budget gaps
for the State. These gaps resulted from a significant disparity between
recurring revenues and the costs of maintaining or increasing the level of
support for State programs. 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 legislature will enact the
Governor's proposals or that the State's actions will be sufficient to preserve
budgetary balance in a given fiscal year or to align recurring receipts and
disbursements in future fiscal years.
Constitutional challenges to State laws have limited the amount of taxes
which political subdivisions can impose on real property. In 1979, the State's
highest court declared unconstitutional a State law allowing localities and
school districts to impose a special increase in real estate property taxes in
order to raise funds for pensions and other uses. Additional court actions have
been brought against the State, certain agencies and municipalities relating to
financing, the amount of real estate tax, the use of tax revenues and other
matters.
An additional risk to the 1997-98 State Financial Plan arises from the
potential impact of certain litigation now pending against the State, which
could produce adverse effects on the State's projections of receipts and
disbursements. Certain litigation pending against the State, its subdivisions
and their officers and employees could have a substantial and long-term adverse
effect on State finances. The State is a party to numerous legal proceedings,
many of which normally recur in governmental operations. Because of the
prospective nature of these proceedings, no estimate of the potential loss can
be made.
Among the more significant of these cases are those that involve: (i) the
validity and fairness of agreements and treaties by which various Indian tribes
transferred title to the State of approximately six million acres of land in
central New York; (ii) certain aspects of the State's Medicaid policies and
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its rates and regulations, including reimbursements to providers of mandatory
and optional Medicaid services; (iii) contamination in the Love Canal area of
Niagara Falls; (iv) alleged responsibility of State officials to assist in
remedying racial segregation in the City of Yonkers; (v) an action, in which the
State is a third party defendant, for injunctive or other appropriate relief,
concerning liability for the maintenance of stone groins constructed along
certain areas of Long Island's shoreline; (vi) a challenge to the practice of
reimbursing certain Office of Mental Health patient care expenses from the
client's Social Security benefits; (vii) an action against New York State and
New York City officials alleging inadequate shelter allowances to maintain
proper housing;(viii) an action challenging the assessment of the petroleum
business tax as unconstitutional; (ix) an action seeking reimbursement from the
State for certain costs arising out of the provision of preschool services and
programs for children with physical disabilities; (x) actions challenging
regulations that establish excess medical malpractice premium rates for the
1986-87 through 1995-96 and 1996-97 fiscal years, respectively; (xi) an action
challenging the enactment of the Clean Water/Clean Air Bond Act of 1996 and its
implementing legislation as against the State Constitution; and (xii) an action
alleging damages for failure to provide accurate and complete data which delayed
completion of a cogeneration facility.
The legal proceedings noted above involve State finances, State programs
and miscellaneous tort, real property and contract claims in which the State is
a defendant and the monetary damages sought are substantial. These proceedings
could affect adversely the financial condition of the State. Adverse
developments in these proceedings or the initiation of new proceedings could
affect the ability of the State to maintain a balanced State Financial Plan. An
adverse decision in any of these proceedings could exceed the amount of the
State Financial Plan reserve for the payment of judgments and, therefore, could
affect the ability of the State to maintain a balanced State Financial Plan.
The fiscal health of the State may also be affected by the fiscal health of
New York City ("the City"), which continues to require significant financial
assistance from the State. The City depends on State aid both to enable the
City to balance its budget and to meet its cash requirements. The State could
also be affected by the ability of the City to market its securities
successfully in the public credit markets. The City has achieved balanced
operating results for each of its fiscal years since
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1981 as reported in accordance with the then-applicable GAAP standards.
Certain localities outside New York 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 any
future requests by localities for additional assistance is not included in the
projections of the State's receipts and disbursements for the State's 1997-1998
fiscal year.
Fiscal difficulties experienced by the City of Yonkers resulted in the re-
establishment of the Financial Control Board for the City of Yonkers by the
State in 1984. That Board is charged with oversight of the fiscal affairs of
Yonkers. Future actions taken by the State to assist Yonkers could result in
increased State expenditures for extraordinary local assistance.
Beginning in 1990, the City of Troy experienced a series of budgetary
deficits that resulted in the establishment of a Supervisory Board for the City
of Troy in 1994. The Supervisory Board's powers were increased in 1995, when
Troy MAC was created to help Troy avoid default on certain obligations. The
legislation creating Troy MAC prohibits the City of Troy from seeking federal
bankruptcy protection while Troy MAC bonds are outstanding.
Seventeen municipalities received extraordinary assistance during the 1996
legislative session through $50 million in special appropriations targeted for
distressed cities, and that was largely continued in 1997.
Municipalities and school districts have engaged in substantial short-term
and long-term borrowings. In 1995, the total indebtedness of all localities in
the State other than New York City was approximately $19.0 billion. A small
portion (approximately $102.3 million) of that indebtedness represented
borrowing to finance budgetary deficits and was issued pursuant to State
enabling legislation. State law requires the Comptroller to review and make
recommendations concerning the budgets of those local government units other
than New York City authorized by State law to issue debt to finance deficits
during the period that such deficit financing is outstanding. Eighteen
localities had outstanding indebtedness for deficit financing at the close of
their fiscal year ending in 1995.
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From time to time, federal expenditure reductions could reduce, or in some
cases eliminate, federal funding of some local programs and accordingly might
impose substantial increased expenditure requirements on affected localities.
If the State, the City or any of the public authorities were to suffer serious
financial difficulties jeopardizing their respective access to the public credit
markets, the marketability of notes and bonds issued by localities within the
State could be adversely affected. Localities also face anticipated and
potential problems resulting from certain pending litigation, judicial decisions
and long-range economic trends. Long-range potential problems of declining
urban population, increasing expenditures and other economic trends could
adversely affect localities and require increasing State assistance in the
future.
NEW YORK CITY
In response to the City's fiscal crisis in 1975, the State took action to
assist the City in returning to fiscal stability. Among those actions, the State
established NYC MAC to provide financing assistance to the City; the New York
State Financial Control Board (the "Control Board") to oversee the City's
financial affairs; and the Office of the State Deputy Comptroller for the City
of New York ("OSDC") to assist the Control Board in exercising its powers and
responsibilities. A "Control Period" existed from 1975 to 1986 during which the
City was subject to certain statutorily-prescribed fiscal controls. Although
the Control Board terminated the Control Period in 1986 when certain statutory
conditions were met and suspended certain Control Board powers, upon the
occurrence or "substantial likelihood and imminence" of the occurrence of
certain events, including (but not limited to) a City operating budget deficit
of more than $100 million or impaired access to the public credit markets, the
Control Board is required by law to reimpose a Control Period.
The City has achieved balanced operating results for each of its fiscal
years since 1981 as reported in accordance with the then-applicable GAAP
standards. The City's financial plans are usually prepared quarterly, and the
annual financial report for its most recent completed fiscal year is prepared at
the end of October of each year.
Currently, the City and its Covered Organizations (i.e., these which
receive or may receive moneys from the City directly, indirectly or
contingently) operate under a four-year financial
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plan (the "Financial Plan") which the City prepares annually and periodically
updates. The City's Financial Plan includes its capital, revenue and expense
projections and outlines proposed gap closing programs for years with projected
budget gaps. The City's projections set forth in the Financial Plan are based on
various assumptions and contingencies, some of which are uncertain and may not
materialize. Unforeseen developments and 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.
Implementation of the Financial Plan is dependent upon the ability of the
City and certain entities issuing debt for the benefit of the City to market
their securities successfully. The City issues securities to finance, refinance
and rehabilitate infrastructure and other capital needs, as well as for seasonal
financing needs. In order to help the City to avoid exceeding its State
Constitutional general debt limit, the State created the New York City
Transitional Finance Authority to finance a portion of the City's capital
program. Despite this additional financing mechanism, the City currently
projects that, if no further action is taken, it will reach its debt limit in
City fiscal year 1999-2000. On June 2, 1997, an action was commenced seeking a
declaratory judgment declaring the legislation establishing the Transitional
Finance Authority to be unconstitutional. If such legislation were voided,
projected contracts for City capital projects would exceed the City's debt limit
during fiscal year 1997-98. Future developments concerning the City or entities
issuing debt for the benefit of the City, and public discussion of such
developments, as well as prevailing market conditions and securities credit
ratings, may affect the ability or cost to sell securities issued by the City or
such entities and may also affect the market for their outstanding securities.
The staffs of the Control Board, OSDC and the City Comptroller issue
periodic reports on the City's Financial Plans which analyze the City's
forecasts of revenues and expenditures, cash flow, and debt service requirements
for, and Financial Plan compliance by, the City and its Covered Organizations.
According to recent staff reports, while economic recovery in New York City has
been slower than in other regions of the country, a surge in Wall Street
profitability resulted in increased tax revenues and generated a substantial
surplus for the City in City fiscal year 1996-97. Although several sectors of
the City's economy have expanded recently, especially tourism and business and
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professional services, City tax revenues remain heavily dependent on the
continued profitability of the securities industries and the course of the
national economy. These reports have also indicated that recent City budgets
have been balanced in part through the use of non-recurring resources; that the
City's Financial Plan tends to rely on actions outside its direct control; that
the City has not yet brought its long-term expenditure growth in line with
recurring revenue growth; and that the City is therefore likely to continue to
face substantial gaps between forecast revenues and expenditures in future years
that must be closed with reduced expenditures and/or increase revenues. In
addition to these monitoring agencies, the Independent Budget Office ("IBO") has
been established pursuant to the City Charter to provide analysis to elected
officials and the public on relevant fiscal and budgetary issues affecting the
City.
The City's financing program for fiscal years 1998 through 2001 contemplate
the issuance of $4.9 billion of general obligation bonds and $7.1 billion of
bonds to be issued by the New York City Transitional Finance Authority (the
"Finance Authority") to finance City capital projects. The Finance Authority
was created as part of the City's effort to assist in keeping the City's
indebtedness within the forecast level of the constitutional restrictions on the
amount of debt the City is authorized to incur. The City is involved in
litigation seeking to have the New York City Transitional Finance Authority Act
(the "Finance Authority Act") declared unconstitutional. In addition, the City
issues revenue and tax anticipation notes to finance its seasonal working
capital requirements. The success of rejected public sales of City bonds and
notes, New York City Municipal Water Finance Authority ("Water Authority") bonds
and Finance Authority 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, and the Water Authority and Finance
Authority bonds. Future developments concerning the City and public discussion
of such developments, as well as prevailing market conditions, may affect the
market for outstanding City general obligation bonds and notes.
The most recent quarterly modification in the City's financial plan for the
1997 fiscal year projects a balanced budget in accordance with GAAP for the 1997
fiscal year, after taking into account an increase in projected tax revenues of
$1.2 billion during the 1997 fiscal year and a discretionary
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prepayment in the 1997 fiscal year of $1.3 billion of debt service due in the
1998 and 1999 fiscal years. The Financial Plan projects revenues and
expenditures for the 1998 fiscal year balanced in accordance with GAAP. The
Financial Plan includes increased tax revenue projections; reduced debt service
costs; the assumed restoration of Federal funding for programs assisting certain
legal aliens; additional expenditure for textbooks, computers, improved
education programs and welfare reform, law enforcement, immigrant
naturalization, initiatives proposed by the City Council and other initiatives;
and a proposed discretionary transfer to the 1998 fiscal year of $300 million of
debt service due in the 1999 fiscal year for budget stabilization purposes. In
addition, the Financial Plan reflects the discretionary transfer to the 1997
fiscal year of $1.3 billion of debt service due in the 1998 and 1999 fiscal
years, and includes actions to eliminate a previously projected budget gap for
the 1998 fiscal year. These gap closing actions include (i) additional agency
actions totaling $621 million; (ii) the proposed sale of various assets; (iii)
additional State aid of $294 million, including a proposal that the State
accelerate a $142 million revenue sharing payment to the City from March 1999;
and (iv) entitlement savings of $128 million which would result from certain of
the reductions in Medicaid spending proposed in the Governor's 1997-1998
Executive Budget and the State making available to the City $77 million of
additional Federal block grant aid, as proposed in the Governor's 1997-1998
Executive Budget. The Financial Plan also sets forth projections for the 1999
through 2001 fiscal years and projects gaps of $1.8 billion, $2.8 billion and
$2.6 billion for the 1999 through 2001 fiscal years, respectively.
The City's projected budget gaps for the 1999 and 2000 fiscal years do not
reflect the savings expected to result from prior years' programs to close the
gaps set forth in the Financial Plan. Thus, for example, recurring savings
anticipated from the actions which the City proposes to take to balance the
fiscal year 1998 budget are not taken into account in projecting the budget gaps
for the 1999 and 2000 fiscal years.
Although the City has maintained balanced budgets in each of its last
sixteen fiscal years and is projected to achieve balanced operating results for
the 1997 fiscal year, there can be no assurance that the gap-closing actions
proposed in the Financial Plan can be successfully implemented or that the City
will maintain a balanced budget in future years without additional State aid,
revenue increases or expenditure
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reductions. Additional tax increases and reductions in essential City services
could adversely affect the City's economic base.
On November 14, 1996, the City submitted to the Control Board the Financial
Plan for the 1997 through 2000 fiscal years, which relates to the City, BOE and
the City University of New York ("CUNY").
The Financial Plan assumes approval by the State Legislature and the
Governor of (i) a tax reduction program proposed by the city totaling $272
million, $435 million, $465 million and $481 million in the 1998 through 2001
fiscal years, respectively, which includes a proposed elimination of the 4% City
sales tax on clothing items under $500 as of December 1, 1997, and (ii) a
proposed State tax relief program, which would reduce the city property tax and
personal income tax, and which the Financial Plan assumes will be offset by
proposed increased State aid totaling $47 million, $254 million, $472 million
and $722 million in the 1998 through 2001 fiscal years, respectively.
The Financial Plan also assumes (i) approval by the Governor and the State
Legislature of the extension of the 14% personal income tax surcharge, which is
scheduled to expire on December 31, 1999, and of the extension of the 12.5%
personal income tax surcharge, which is scheduled to expire on December 31,
1998; (ii) collection of the projected rent payments for the City's airports;
and (iii) State approval of the cost containment initiatives and State aid
proposed by the City for the 1998 fiscal year, and $115 million in State aid
which is assumed in the Financial Plan but was not provided for in the
Governor's 1997-1998 Executive budget. The Financial Plan reflects the
increased costs which the City is prepared to incur as a result of welfare
legislation recently enacted by Congress. 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.
The City's financial plans have been the subject of extensive public
comment. On September 11, 1997, the New York State Comptroller issued a report
which noted that the ability to deal with future budget gaps could become a
significant issue in the State's 2000-2001 fiscal year, when the cost of tax
cuts increases by $1.9 billion. The report contained projections that, based on
current economic conditions and current law for taxes and spending, showed a
gap in the 2000-2001 State fiscal year of $5.6 billion and of $7.4 billion in
the 2001-2002 State
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fiscal year. The report noted that these gaps would be smaller if recurring
spending reductions produce savings in earlier years. The State Comptroller also
stated that if Wall Street earnings moderate and the State experiences a
moderate recession, the gap for the 2001-2002 State fiscal year could grow to
nearly $12 billion.
The projections for the 1988 through 2001 fiscal years reflect the costs of
the settlements with the United Federation of Teachers ("UFT") and a coalition
of unions headed by District Council 37 of the American Federation of State,
County and Municipal Employees, which together represent approximately two-
thirds of the City's workforce, and assume that the City will reach agreement
with its remaining municipal unions under terms which are generally consistent
with such settlements. The settlement provides for a wage freeze in the first
two years, followed by a cumulative effective wage increase of 11% by the end of
the five year period covered by the proposed agreements, ending in fiscal years
2000 and 2001. Additional benefit increases would raise the total cumulative
effective increase to 13% above present costs. Costs associated with similar
settlements for all City-funded employees would total $49 million, $459 million
and $1.2 billion in the 1997, 1998 and 1999 fiscal years, respectively, and
exceed $2 billion in each fiscal year after the 1999 fiscal year. There can be
no assurance that the City will reach an agreement with the unions that have not
reached a settlement with City on the terms contained in the Financial Plan.
In the event of a collective bargaining impasse, the terms of wage
settlements could be determined through statutory impasse procedures, which can
impose a binding settlement except in the case of collective bargaining with the
UFT, which may be subject to a non-binding arbitration.
Estimates of the City's revenues and expenditures is based on numerous
assumptions and are subject to various uncertainties. If expected federal or
State aid is not forthcoming, if unforeseen developments in the economy
significantly reduce revenues derived from economically sensitive taxes or
necessitate increased expenditures for public assistance, if the City should
negotiate wage increases for its employees greater than the amounts provided for
in the City's financial plan or if other uncertainties materialize that reduce
expected revenues or increase projected expenditures, then, to avoid operating
deficits, the City may be required to implement additional
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actions, including increases in taxes and reductions in essential City services.
The City might also seek additional assistance from the State.
On January 20, 1995, Moody's lowered its rating on the City's general
obligations bonds to "Baa1" from "A." In July 1995, S&P revised its rating on
the City's general obligation bonds downward to "BBB+." S&P stated that
"structural budgetary balance remains elusive because of persistent softness in
the City's economy, highlighted by weak job growth and a growing dependence on
the historically volatile financial services sector." Other factors identified
by S&P in lowering its ratings on City general obligation bonds, included a
trend of using one-time measures, including debt refinancings, to close
projected budget gaps, dependence on unratified labor savings to help balance
the City's financial plan, optimistic projections of additional federal and
State aid or mandate relief, a history of cash flow difficulties caused by State
budget delays and continued high debt levels. In July 1997, Moody's changed its
outlook on city bonds to positive from stable.
Both the State and City face potential economic problems which could
seriously affect the ability of both the State and City to meet their financial
obligations. The economic problems of New York City adversely affect the State
in numerous ways. In addition, for decades the State economy has grown more
slowly than that of the nation as a whole, resulting in a decline in the
position of New York as one of the country's wealthier states. The causes of
this decline are varied and complex and some causes reflect international and
national trends beyond the State's and City's control.
SPECIAL CONSIDERATIONS AFFECTING PUERTO RICO
The following highlights some of the more significant financial trends and
problems affecting the Commonwealth of Puerto Rico (the Commonwealth or Puerto
Rico) and is based on information drawn from official statements and
prospectuses relating to the securities offerings of Puerto Rico and its
agencies and instrumentalities. Such information, however, has not been
independently verified by the Trust.
The economy of Puerto Rico is closely integrated with that of the United
States. In fiscal 1995, trade with the United
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States accounted for approximately 89% of Puerto Rico's exports and
approximately 65% of its imports. In this regard, Puerto Rico experienced a $4.6
billion positive adjusted merchandise trade balance in fiscal 1995. Since 1983,
Puerto Rico has experienced a wide ranging economic expansion with growth in
almost every sector of its economy and record levels of employment.
Since fiscal 1985, personal income, both aggregate and per capita, have
increased consistently each fiscal year. In fiscal 1995, aggregate personal
income was $27.0 billion and personal income per capita was $7,296. Gross
domestic product in fiscal year 1991, 1992, 1993, 1994, and 1995 was $22.8
billion, $23.7 billion, $25.2 billion, $26.6 billion, and $28.3 billion,
respectively. For fiscal 1996, Puerto Rico experienced an increase in gross
domestic product of 3.1% over fiscal 1995. An increase of 2.7% over fiscal 1996
is forecasted. Actual growth in the Puerto Rico economy depends on several
factors, including the state of the U.S. economy, the exchange rate for the U.S.
dollar, increases in exports and visitors to the Commonwealth, the price
stability of oil imports, the level of federal transfers, and the cost of
borrowing. Due to uncertainties with respect to these factors, there is no
assurance that the economy of Puerto Rico will continue to grow.
Puerto Rico's economy continued to expand throughout the period from fiscal
1990 through fiscal 1996. While trends in the Puerto Rico economy generally
follow those of the United States, Puerto Rico did not experience a recession in
1991 as the United States did. This was primarily because of low oil prices,
low interest rates, and Puerto Rico's strong manufacturing base, which has a
large component of non-cyclical industries. Other factors contributing to Puerto
Rico's decade-long expansion include commonwealth-sponsored economic development
programs, the relatively stable prices of oil imports, low exchange rates for
the U.S. dollar, the level of federal transfers, and the relatively low cost of
borrowing funds during the period. These factors will continue to affect Puerto
Rico's economic growth rate.
Puerto Rico has made marked improvements in fighting unemployment.
Although unemployment is at relatively low historical levels for the
Commonwealth, it remains above the U.S. average. The unemployment rate declined
from 16.0% to 13.8% from fiscal 1994 to fiscal 1995. As of October 1995, the
unemployment rate stood at 15.0%. At the end of fiscal 1996, the rate stood
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at 13.8%. Despite this relative downturn, there is a possibility that the
unemployment rate will increase if there are changes in factors that directly
impact the economy of Puerto Rico.
Puerto Rico has a diversified economy with the manufacturing and service
sectors comprising the principal sectors. Manufacturing is the largest sector in
terms of gross domestic product. In fiscal 1996, manufacturing generated $18.9
billion (or 41.4%) of gross domestic product. In the last two decades,
industrial development has tended to be more capital intensive and more
dependent on skilled labor. Manufacturing has experienced a basic change over
the years as a result of the influx of higher wage, high technology industries
such as pharmaceuticals, electronics, computers, microprocessors, scientific
instruments, and high technology machinery. The service sector, which includes
wholesale and retail trade, finance and real estate, ranks second in its
contribution to gross domestic product and is the economic sector that employs
the greatest number of people. In fiscal 1996, the service sector generated
$17.1 billion in gross domestic product (or 37.6%) and employed over 527,000
people. Growth in construction and tourism also contributed to increased
economic activity in fiscal 1995. The government sector of the Commonwealth also
plays an important role in the economy of the island. In fiscal 1995, the
government accounted for $4.5 billion of Puerto Rico's gross domestic product
and provided 21.7% of total employment. Tourism also contributed significantly
to the island economy and total visitor expenditures amounted to $1.9 million in
fiscal 1996.
One of the factors that has assisted the development of the manufacturing
sector has been the federal and Commonwealth tax incentives, most notably
section 936 of the Code and the Commonwealth's Industrial Incentives Program.
In 1996, legislation was enacted that will phase out Section 936 tax credits
over a nine-year period, ending January 1, 2006. The effect on Puerto Rico's
economy of the phased elimination of Section 936 tax credit will not be certain
for a number of years. The impact on future investment and employment is more
uncertain.
Section 936 previously granted U.S. corporations that meet certain
criteria and elect its application a credit (the Section 936 credit) against
their U.S. corporate income tax on the portion of the tax attributable to (i)
income derived from the active conduct of a trade or business in Puerto Rico
(active business income) or from the sale or exchange of substantially all of
the assets used in the active conduct of such trade or
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business, and (ii) qualified possession source investment income.
For taxable years commencing after 1993, two alternative limitations were
imposed on the Section 936 credit against active business income and sale of
assets income. The first option limits the credit against such income to 40% of
the credit allowable previous to the amendments of 1993, with a five-year phase-
in period starting at 60% of the current allowable credit (the Percentage
Limitation). The second option limits the allowable credit to the sum of (i)
60% of qualified compensation paid to employees (as defined in the Code), (ii) a
specified percentage of depreciation deductions, and (iii) a portion of the
Puerto Rico income taxes paid by the Section 936 corporation, up to a 9%
effective tax rate (the Economic Activity Limitation).
The Industrial Incentives Program, through the 1987 Industrial Incentives
Act, grants corporations engaged in certain qualified activities a fixed 90%
exemption from Commonwealth income and property taxes and a 60% exemption from
municipal license taxes.
The Constitution of Puerto Rico provides a limitation on the amount of
general obligation debt that can be issued. The Commonwealth's policy has been
and continues to be to maintain the level of such debt within a prudent range
below the constitutional limitation. Historically, the Commonwealth has
maintained a fiscal policy which provides for a prudent relationship between the
growth of public sector debt and the growth of the economic base required to
service that debt. The Commonwealth also has sought opportunities to realize
debt service savings by refunding outstanding debt with obligations bearing
lower interest rates. In certain years, this policy has had the effect of
causing the rate of growth of public sector debt to be higher than the rate of
growth of gross domestic product. Over the fiscal years 1991 to 1995, public
sector debt increased 24.7% while gross product rose 24.4%. Short-term debt
outstanding relative to total debt was 7.5% as of November 30, 1995.
On February 26, 1997, legislation was introduced in the U.S. House of
Representatives proposing a mechanism to settle permanently the political
relationship between Puerto Rico and the United States, either through full self
government (e.g., statehood or independence, including, as an alternative, free
association via a bilateral treaty) or continued commonwealth. Under the
legislation, failure to settle on full self government
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after completion of the referendum process provided therein would result in
retention of commonwealth status. Any change in the current status of Puerto
Rico could have an adverse impact on such matters as the basic characteristics
of future Puerto Rico debt obligations, the markets for these obligations, and
the types, levels and quality of revenue sources pledged for the payment of
existing and future debt obligations.
THE EQUITY INDEX FUND GUARANTEE
NYLIFE Inc. ("NYLIFE") and the Equity Index Fund have entered into a
Guaranty Agreement (the "Guarantee") for the benefit of shareholders. The
Guarantee has been issued for the benefit of all shareholders and has been
issued at no cost to the Equity Index Fund or its shareholders. The Guarantee
Date (as defined in the Prospectus) with respect to a particular Equity Index
Fund share will be 10 years after the purchase date of such share. If, on a
particular Guarantee Date, payments must be made under the terms of the
Guarantee, the terms of the Guarantee will obligate NYLIFE unconditionally and
irrevocably to pay to the Equity Index Fund's transfer and dividend disbursing
agent for the benefit of shareholders with that Guarantee Date an amount equal
to the difference between the Guaranteed Amount and net asset value per each
Guaranteed Share (as defined in the Prospectus) outstanding. The Equity Index
Fund's transfer and dividend disbursing agent will forward the difference
between the Guaranteed Amount and the net asset value directly to each
individual shareholder.
A Guaranteed Share is a unit that will at all times be equal to the net
asset value of one share initially purchased by the investor plus the net asset
value of all dividends and distributions attributable to such share (which
includes cumulative dividends and distributions paid with respect to any
additional shares of the Fund received as dividends and distributions) paid
during the period from the date of purchase to the Guarantee Date. A Guaranteed
Share (the unit to which the Guaranteed Amount will apply) is not the same as a
share of the Fund. Shareholders who redeem shares, or who elect to receive
dividends and distributions in cash, will own fewer units to which the
Guaranteed Amount applies (i.e., they will own fewer Guaranteed Shares) and
----
therefore will lose a portion of the benefit of the Guarantee with respect to
any such redemption or dividends or distributions received in cash.
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NYLIFE will pay any amounts owing under the Guarantee to the Fund's
transfer and dividend disbursing agent on the third business day following a
Guarantee Date. A pro rata portion of any amounts so paid will then be
forwarded to each shareholder holding, as of the close of business on such date,
Guaranteed Shares with that Guarantee Date. If the Guarantee Date should fall
on a weekend or on a holiday, the Guarantee Date shall be the first business day
following the Guarantee Date. The Guarantee is intended to assure each owner of
Guaranteed Shares on a Guarantee Date that he or she will be able to recover, as
of the Guarantee Date, at a minimum, the Guaranteed Amount (with no adjustment
for inflation or the time value of money). The Guarantee will benefit any
holder of such Guaranteed Shares on the relevant Guarantee Date, who need not be
the original purchaser, and who, for example, may own such shares by gift or
inheritance.
Although the Equity Index Fund does not intend to pay dividends and
distributions in cash to shareholders (unless a shareholder elects to receive
payments in cash), such dividends and distributions which are reinvested will be
taxable to shareholders. See "Tax Status." The Guaranteed Amount does not
reflect any adjustment for the payment of taxes by a shareholder on dividends
and distributions received from the Equity Index Fund.
The obligations, if any, of NYLIFE under the Guarantee shall be discharged
when all required payments are made in full to the transfer and dividend
disbursing agent for the benefit of the shareholders or if the Equity Index
Fund's net asset value on a Guarantee Date is such that no amounts are payable
to shareholders under the terms of the Guarantee. Payment obligations under the
Guarantee will be solely the obligations of NYLIFE. Neither the Equity Index
Fund, New York Life Insurance Company, Monitor, NYLIFE Distributors, any of
their affiliates nor any other party is undertaking any obligation to the Equity
Index Fund or its shareholders with respect to the Guarantee.
Although the Guarantee has been arranged for by the Equity Index Fund and
is created under contract between the Equity Index Fund and NYLIFE, the Equity
Index Fund has no interest in, and specifically disclaims any interest in, the
proceeds payable under the Guarantee, which are payable solely to the
shareholders with a particular Guarantee Date. The designation of such
shareholders as the sole beneficiaries of the Guarantee may not be changed by
either the Equity Index Fund or such shareholders.
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The Guarantee is neither transferable nor assignable by the Equity Index Fund or
the shareholders it benefits, nor may the Equity Index Fund or its shareholders
cancel or waive rights under the Guarantee. The Guarantee cannot be surrendered
by either the Fund or its shareholders for cash, except in the event that
payment is made pursuant to its terms. Neither the Equity Index Fund nor its
shareholders may use the Guarantee as a pledge for a loan, nor may the Equity
Index Fund or its shareholders obtain any loan from NYLIFE with respect to
amounts that may be payable pursuant to the Guarantee.
The foregoing is only a summary, and not a complete statement of the
principal terms of the Guarantee. Reference is made to the Guarantee, a
specimen copy of which has been filed as an exhibit to the Registration
Statement. This summary is subject thereto and qualified in its entirety by
such reference.
ADDITIONAL FUNDAMENTAL INVESTMENT RESTRICTIONS
In addition to the fundamental investment restrictions contained in the
Prospectus, the Trustees of the Trust also have adopted the following
fundamental investment restrictions, which may not be changed with respect to
any Fund without the approval of the majority of the outstanding voting
securities of that Fund, as defined under the 1940 Act.
The Trust may not, on behalf of any Fund:
1. Act as an underwriter of securities issued by others, except to the
extent that a Fund may be considered an underwriter within the meaning of the
1933 Act, as amended, in the disposition of portfolio securities.
2. Issue senior securities, except to the extent permitted under the
Investment Company Act of 1940.
The following fundamental investment restriction is applicable to the Tax
Free Bond Fund only. The Tax Free Bond Fund must:
1. Invest at least 80% of the Fund's net assets in securities the
interest on which is exempt from regular federal income tax, except that the
Fund may temporarily invest more than 20% of its net assets in securities the
interest income on which may be subject to regular federal income tax.
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<PAGE>
ADDITIONAL NON-FUNDAMENTAL INVESTMENT RESTRICTIONS
In addition to the Trust's fundamental investment restrictions, the
Trustees of the Trust have voluntarily adopted certain policies and restrictions
which are observed in the conduct of the affairs of the Funds, except the
California Tax Free Fund, New York Tax Free Fund, International Bond Fund,
International Equity Fund, Equity Index Fund and Strategic Income Fund. These
represent intentions of the Trustees based upon current circumstances. They
differ from fundamental investment policies in that the following additional
investment restrictions may be changed or amended by action of the Trustees
without requiring prior notice to or approval of shareholders.
In accordance with such policies and restrictions, a Fund may not:
(a) purchase from or sell portfolio securities of a Fund to any of the
officers or Trustees of the Trust, its investment advisers, its principal
underwriter or the officers, or directors of its Sub-Advisers or principal
underwriter;
(b) invest more than 10% of the net assets of a Fund (taken at market
value at the time of the investment) in "illiquid securities," illiquid
securities being defined to include securities subject to legal or
contractual restrictions on resale (other than restricted securities
eligible for resale pursuant to Rule 144A under the Securities Act of
1933), repurchase agreements maturing in more than seven days, certain
options traded over the counter that a Fund has written, securities for
which market quotations are not available, or other securities which
legally or in the opinion of the Sub-Adviser is deemed illiquid;
(c) invest assets in securities of other open-end investment
companies, but a Fund may invest in shares of the Money Market Fund if
double advisory fees are not assessed, may invest up to 5% total of its
assets in closed-end investment companies (which would cause a Fund to pay
duplicate fees), and may purchase or acquire up to 10% of the outstanding
voting stock of a closed-end investment company (foreign banks or their
agencies or subsidiaries are
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not considered investment companies for the purposes of this limitation);
(d) invest in other companies for the purpose of exercising control or
management;
(e) purchase securities on margin except in connection with arbitrage
transactions or make short sales, unless by virtue of its ownership of
other securities, it has the right to obtain securities equivalent in kind
and amount to the securities sold and, if the right is conditional, the
sale is made upon the same conditions, except that the Trust may obtain
such short-term credits as may be necessary for the clearance of purchases
and sales of securities and in connection with transactions involving
forward foreign currency exchange contracts;
(f) purchase or sell any put or call options or any combination
thereof, except that the Trust may purchase and sell or write (i) options
on any futures contracts into which it may enter, (ii) put and call options
on currencies, securities indexes and covered put and call options on
securities, and (iii) may also engage in closing purchase transactions with
respect to any put and call option position it has entered into; and except
that the Government Fund may not write any covered put options on U.S.
government securities if, as a result, more than 50% of its total assets
(taken at current value) would be subject to put options written by such
Fund; or
(g) purchase, with respect to the Government Fund, any call option,
long futures contract or long option on a futures contract if, at the date
of purchase, realized net losses from such transactions during the fiscal
year to date exceed 5% of such Fund's average net assets during such
period.
The following are non-fundamental restrictions of the California Tax Free
Fund, Equity Index Fund and New York Tax Free Fund:
(a) A Fund may not purchase the securities of other investment
companies except to the extent permitted by the 1940 Act or in connection
with a merger, consolidation or reorganization.
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(b) The Funds may not invest more than 10% of the net assets of a
Fund (taken at market value at the time of the investment) in "illiquid
securities," illiquid securities being defined to include securities
subject to legal or contractual restrictions on resale (other than
restricted securities eligible for resale pursuant to Rule 144A under the
Securities Act of 1933).
(c) A Fund may not invest in other companies for the purpose of
exercising control or management.
(d) A Fund may not purchase securities on margin, except in connection
with arbitrage transactions, or make short sales, unless it owns the
securities sold short or it has the right to obtain securities equivalent
in kind and amount to the securities sold and, if the right is conditional,
the sale is made upon the same conditions, except that the Trust may obtain
such short-term credits as may be necessary for the clearance of purchases
and sales of securities. (This restriction has no application to
transactions in futures, options and foreign currency exchange contracts).
The following investment restrictions are non-fundamental, operating
policies of the International Bond Fund, International Equity Fund and Strategic
Income Fund, and may be amended by the Board of Trustees without shareholder
approval:
(a) As an operating policy, a Fund may not sell securities short,
except for covered short sales or unless it owns or has the right to obtain
securities equivalent in kind and amount to the securities sold short, and
provided that transactions in options, futures and forward contracts are
deemed not to constitute short sales of securities.
(b) As an operating policy, a Fund may not purchase securities on
margin, except that the Fund may obtain such short-term credits as are
necessary for the clearance of transactions, and provided that margin
payments in connection with futures contracts and options on futures
contracts shall not constitute the purchase of securities on margin. This
restriction is not applicable to the Strategic Income Fund.
(c) As an operating policy, a Fund may not invest in securities which
are not readily marketable, or the
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disposition of which is restricted under federal securities laws
(collectively, "illiquid securities"), other than Rule 144A securities
determined to be liquid pursuant to guidelines adopted by the Trust's Board
of Trustees if, as a result, more than 15% of the Fund's net assets would
be invested in illiquid securities. A Fund may not invest more than 15% of
its net assets in repurchase agreements providing for settlement in more
than seven days, or in other instruments which for regulatory purposes or
in the Sub-Adviser's opinion may be deemed to be illiquid, such as a
certain portion of options traded in the over-the-counter market, and
securities being used to cover options a Fund has written.
(d) As an operating policy, a Fund may not acquire or retain the
securities of any other investment company if, as a result, more than 3% of
such investment company's outstanding shares would be held by the Fund,
more than 5% of the value of the Fund's total assets would be invested in
shares of such investment company or more than 10% of the value of the
Fund's assets would be invested in shares of investment companies in the
aggregate, except in connection with a merger, consolidation, acquisition,
or reorganization.
"Value" for the purposes of all investment restrictions shall mean the
value used in determining a Fund's net asset value.
In addition, though not a fundamental policy, the California Tax Free and
New York Tax Free Funds will not sell securities short, except that each Fund
reserves the right to sell securities short "against the box."
In addition, though not a fundamental policy, the Equity Index Fund may not
engage in arbitrage transactions, nor may it purchase warrants (excluding those
acquired by the Equity Index Fund in units or attached to securities), nor will
the Equity Index Fund sell securities short or buy on margin, except that the
Fund reserves the right to sell securities short "against the box."
If a percentage restriction is adhered to at the time of investment, a
later change in percentage resulting from a change in values or assets will not
constitute a violation of such restriction.
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TRUSTEES AND OFFICERS
Information pertaining to the Trustees and officers of the Trust is set
forth below. Trustees deemed to be "interested persons" of the Trust for
purposes of the 1940 Act are indicated by an asterisk.
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<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
Donald K. Ross* Chairman and Trustee Retired Chairman and Chief Executive
953 Cherokee Lane Officer, New York Life Insurance Company;
Franklin Lakes, NJ 07417 Director, New York Life Insurance
Age: 72 Company, 1978 to 1996; President, New
York Life Insurance Company, 1986 to
1990; Chairman of the Board, New York
Life Insurance Company, 1981 to 1990;
Chief Executive Officer, New York Life
Insurance Company, 1981 to 1990; Director,
MacKay-Shields Financial Corporation, 1984
to present; and Trustee, Consolidated Edison
Company of New York, Inc., 1976 to
present.
Stephen C. Roussin* President, Chief Director and Chairperson, MainStay
51 Madison Avenue Executive Officer and Institutional Funds, Inc., 1997 to present;
New York, NY 10010 Trustee Senior Vice President, New York Life
Age: 34 Insurance Company, 1997 to present; Senior
Vice President, Smith Barney, 1994 to 1997;
and Division Sales Manager, Prudential
Securities, 1989 to 1994.
Harry G. Hohn* Trustee Retired Chairman and Chief Executive
51 Madison Avenue Officer, New York Life Insurance Company;
New York, NY 10010 Chairman of the Board and Chief Executive
Age: 65 Officer, New York Life Insurance Company,
1990 to 1997; Vice Chairman of the Board,
New York Life Insurance Company, 1986 to
1990; Director, New York Life Insurance
Company, 1985 to 1986; Director, Million
Dollar Roundtable Foundation, 1996 to 1997;
Director, Insurance Marketplace
Standards Association, 1996 to 1997;
Director, Witco Corporation, 1989 to
present; Member, International Advisory Board
of Credit Commercial de France, 1995 to present;
and a Life Fellow of the American Bar Foundation.
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
Edward J. Hogan Trustee Independent management consultant, 1991 to
Box 2321 1995; President, Westinghouse - Airship
Sun Valley, ID 83353 Industries, Inc. and Managing Director,
Age: 65 Airship Industries U.K., Ltd., 1987 to 1990.
[Richard M. Kernan, Jr. * Trustee Director of MainStay VP Series Fund, Inc.
51 Madison Avenue from January 1987 to present; Chairman of the
New York, NY 10010 Board and Chief Executive Officer of
Age: 57 MainStay VP Series Fund, Inc. from August
1989 to present; Executive Vice President and
Chief Investment Officer of New York Life
Insurance Company from March 1995 to
present; Executive Vice President prior thereto;
Member of the Board of Directors of New
York Life Insurance Company from
November 1996 to present and Chairman of
the Investment Committee from January
1997 to present; and Director, Greystone
Realty Corp. January 1997 to present.]
Nancy Maginnes Trustee Member, Council of Rockefeller University,
Kissinger New York, NY, 1991 to present; Trustee,
Hendersons Road Council of Rockefeller University, 1995 to
Kent, CT 06757 present; Trustee, Animal Medical Center,
Age: 63 1993 to present; and Trustee, The Masters
School, 1994 to present.
Terry L. Lierman Trustee President, Capitol Associates, Inc., 1984 to
426 C Street, N.E. present; President, Employee Health
Washington, D.C. 20002 Programs, 1990 to present; Vice Chairman,
Age: 49 TheraCom Inc., 1994 to present; Member,
UNICEF National Board, 1993 to present;
Director, Harvard University, Pollin
Institute, 1995 to present; Director,
PeacePac, 1994 to present;
Commissioner, State of Maryland, Higher
Education Commission, 1995 to present[;
Vice Chairman, National Organization on
Fetal Alcohol Syndrome, 1993 to present;
Chief Executive Officer, Medical Crisis
Systems, 1993 to present; and Board
Member, Hollings Cancer Center, Medical
University of South Carolina, 1993 to
present.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
John B. McGuckian Trustee Chairman of the Board, Ulster Television
Ardverna plc, 1990 to present; Director, Ulster
Cloughmills Television plc, 1970 to present; Chairman of
Northern Ireland the Board, Tedcastle Holding Ltd. (energy),
BT4 49NL 1995 to present; Director, Cooneen Textiles
Age: 58 Ltd. (clothing manufacturer), 1967 to
present; Director Allied Irish Banks plc,
1977 to present; Director, First Trust Bank,
1991 to present; Director, Unidare plc
(engineering), 1986 to present; Director,
Irish Continental Group plc (ferry
operations), 1988 to present; Director,
Harbour Group Ltd. (management company),
1980 to present; Chairman, Industrial
Development Board, 1990 to present; and
Chairman of Senate and Senior Pro-
Chancellor, Queen's University, 1986 to
present.
Donald E. Nickelson Trustee Vice Chairman, Harbour Group Industries,
1701 Highway A-1-A Inc., 1991 to present; Director, PaineWebber
Suite 101 Group, 1980 to 1993; President,
Vero Beach, FL 32963 PaineWebber Group, 1988 to 1990;
Age: 65 Chairman of the Board, PaineWebber
Properties, 1985 to 1989; Director, Harbour
Group, 1986 to present; Director, CPA 10
Real Estate Inv. Trust, 1990 to present;
Director, CIP 11 Real Estate Inv. Trust,
1991 to present; Chairman of the Board and
Director, Rapid Rock Industries, Inc., 1986
to present; Director and Chairman of the
Board, Del Industries, 1990 to present;
Trustee, Jones Foundation (Los Angeles),
1978 to present; Director, Allied Healthcare
Products, Inc., 1992 to present; Director,
Sugen, Inc., 1992 to present; Director and
Chairman of the Board, Greenfield
Industries, Inc., 1993 to present; Director,
DT Industries, 1992 to present; Chairman of
the Board, Omniquip International, Inc.,
1996 to present; and Advisory Panel,
Sedgwick James of NY, 1996 to present.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
Richard S. Trutanic Trustee Managing Director, The Somerset Group
1155 Connecticut Ave. N.W., (financial advisory firm), 1990 to present;
Suite 400 Senior Vice President, Washington National
Washington, DC 20036 Investment Corporation (financial advisory
Age: 45 firm), 1985 to 1990; Director, Allin
Communications Corporation, 1996 to
present; and Director and Member of
Executive Committee, Southern Net, Inc.,
1986 to 1990.
Walter W. Ubl* Trustee Senior Vice President, New York Life
85 East End Avenue Insurance Company, 1995 to 1997; Vice
Apt. 2N President, 1984 to 1995; Vice President in
New York, NY 10028 charge of Mutual Funds Department, 1989 to
Age: 56 1997 ; Director and Vice President,
NYLIFE Distributors Inc., 1993 to
1997; and Director and Senior
Vice President NYLIFE Securities
Inc., 1996 to 1997.
<CAPTION>
- ---------------------------------------------------------------------------------------------------------
OFFICERS (OTHER THAN TRUSTEES)
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C>
Jefferson C. Boyce Senior Vice President Chairman, Monitor Capital Advisors, Inc.,
51 Madison Avenue 1997 to present; Senior Vice President,
New York, NY 10010 MainStay Institutional Funds Inc., 1995 to
Age: 40 present; Senior Vice President, New York
Life Insurance Company, 1994 to present;
Director, NYLIFE Distributors Inc., 1993 to
present; and Chief Administrative Officer,
Pension, Mutual Funds, Structured Finance,
Corporate Quality, Human Resources and
Employees' Health Departments, New York
Life Insurance Company, 1992 to 1994.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
Anthony W. Polis Vice President and Vice President, New York Life Insurance
51 Madison Avenue Chief Financial Officer Company, 1988 to present; Director, Vice
New York, NY 10010 President and Chief Financial Officer,
Age: 54 NYLIFE Securities Inc., 1988 to present;
Vice President and Chief Financial Officer,
NYLIFE Distributors Inc., 1993 to present;
Treasurer, MainStay Institutional Funds Inc.,
1990 to present; Treasurer, MainStay VP
Series Fund, Inc., 1993 to present; Assistant
Treasurer, MainStay VP Series Fund, Inc.,
1992 to 1993; Vice President and Treasurer,
Eclipse Financial Asset Trust, 1992 to
present; Vice President and Chief Financial
Officer, Eagle Strategies Corp. (registered
investment adviser), 1993 to present.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
Richard Zuccaro Tax Vice President Vice President, New York Life Insurance
51 Madison Avenue Company, 1995 to present; Vice President --
New York, NY 10010 Tax, New York Life Insurance Company,
Age: 48 1986 to 1995; Tax Vice President, NYLIFE
Securities Inc., 1987 to present; Tax Vice
President, NAFCO, Inc., 1990 to present;
Tax Vice President, NYLIFE Depositary
Inc., 1990 to present; Tax Vice President,
NYLIFE Inc., 1990 to present; Tax Vice
President, NYLIFE Insurance Company of
Arizona, 1990 to present; Tax Vice
President, NYLIFE Realty Inc., 1991 to
present; Tax Vice President, NYLICO Inc.,
1991 to present; Tax Vice President, New
York Life Fund Inc., 1991 to present; Tax
Vice President, New York Life International
Investment, Inc., 1991 to present; Tax Vice
President, NYLIFE Equity Inc., 1991 to
present; Tax Vice President, NYLIFE
Funding Inc., 1991 to present; Tax Vice
President, NYLCO Inc., 1991 to present;
Tax Vice President, MainStay VP Series
Fund, Inc., 1991 to present; Tax Vice
President, CNP Realty, 1991 to present; Tax
Vice President, New York Life Worldwide
Holding Inc., 1992 to present; Tax Vice
President, NYLIFE Structured Asset
Management Co. Ltd., 1992 to present; Tax
Vice President, MainStay Institutional Funds
Inc., 1992 to present; Tax Vice President,
NYLIFE Distributors Inc., 1993 to present;
Vice President & Assistant Controller, New
York Life Insurance and Annuity Corp.,
1995 to present, and Assistant Controller,
1991 to present; Vice President, NYLCARE
Health Plans, Inc., 1995 to present; Vice
President - Tax, New York Life and Health
Insurance Co., 1996 to present; and Tax
Vice President, NYL Trust Company, 1996
to present.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- ---------------------------- ---------------------- ----------------------------------------------
<S> <C> <C>
A. Thomas Smith III Secretary Vice President and Associate General
51 Madison Avenue Counsel, New York Life Insurance
New York, NY 10010 Company, 1997 to present; Associate
Age: 41 General Counsel, New York Life Insurance
Company, 1996 to 1997; Assistant General
Counsel, New York Life Insurance
Company, 1994 to 1996; Secretary, Eclipse
Financial Asset Trust, 1994 to present;
Secretary, MainStay Institutional Funds Inc.,
MainStay VP Series Fund, Inc., New York
Life Fund Inc., 1994 to 1997; Assistant
Secretary, Eagle Strategies Corp. (registered
investment adviser), 1997 to present;
Secretary, Eagle Strategies Corp. (registered
investment adviser), 1996 to present; and
Assistant General Counsel, Dreyfus
Corporation, 1991 to 1993.
</TABLE>
*Messrs. Ross, Roussin, Hohn, Kernan and Ubl are deemed
to be "interested persons" of the Trust under the 1940 Act.
As indicated in the above table, certain Trustees and officers also hold
positions with MacKay-Shields, Monitor, New York Life Insurance Company, NYLIFE
Securities Inc. and/or NYLIFE Distributors Inc.
The Independent Trustees of the Trust receive from the Trust an annual
retainer of $40,000 and a fee of $1,000 for each Board of Trustees meeting and
for each Board committee meeting attended and are reimbursed for all out-of-
pocket expenses related to attendance at such meetings. Trustees who are
affiliated with New York Life Insurance Company do not receive compensation from
the Trust.
For the fiscal year ended December 31, 1996, the Trustees received the
following compensation from the Trust and from certain other investment
companies (as indicated) that have the same investment advisers as the Trust or
an investment adviser that is an affiliated person of one of the Trust's
investment advisers:
<PAGE>
Total Compensation
Aggregate From Registrant
Name of Compensation and Fund Complex
Trustee from the Trust Paid to Trustees
- ---------------------- -------------- ----------------
Edward J. Hogan* $ 0 $ 0
Nancy M. Kissinger $46,000 $46,000
Terry L. Lierman $45,000 $45,000
Donald E. Nickelson $45,000 $45,000
Richard S. Trutanic $44,000 $44,000
Ralph A. Pfeiffer** $33,000 $33,000
John B. McGuckian*** $ 0 $ 0
* Mr. Hogan was elected to his position as Trustee of the Trust on October
28, 1996, effective January 27, 1997.
** Mr. Pfeiffer passed away on September 13, 1996.
*** Mr. McGuckian was elected to his position as Trustee of the Trust on July
28, 1997.
As of December 8, 1997, the Trustees and officers of the Trust as a group
owned less than 1% of the outstanding shares of any class of beneficial interest
of each of the Funds.
THE MANAGER, THE SUB-ADVISERS AND THE DISTRIBUTOR
MANAGEMENT AGREEMENT
Pursuant to the Management Agreement for the Funds, MainStay Management,
Inc. (the "Manager"), subject to the supervision of the Trustees of the Trust
and in conformity with the stated policies of the Funds, administers the Funds'
business affairs and has investment advisory responsibilities.
The Trustees, including the Independent Trustees, approved the Management
Agreement at an in-person meeting held July 28, 1997. On October 24, 1997, the
shareholders of each of the Funds approved the Management Agreement. The
Management Agreement will remain in effect for two years following its effective
date, and will continue in effect thereafter only if such continuance is
specifically approved at least annually by the Trustees or by vote of a majority
of the outstanding voting securities of each of the Funds (as defined in the
1940 Act and in a rule under the 1940 Act) and, in either case, by a majority of
the Trustees who are not "interested persons" of the Trust or the Manager (as
the term is defined in the 1940 Act).
<PAGE>
The Manager has authorized any of its directors, officers and employees who
have been elected or appointed as Trustees or officers of the Trust to serve in
the capacities in which they have been elected or appointed.
The Management Agreement provides that the Manager shall not be liable to a
Fund for any error or judgment by the Manager or for any loss sustained by a
Fund except in the case of the Manager's willful misfeasance, bad faith, gross
negligence or reckless disregard of duty. The Management Agreement also
provides that it shall terminate automatically if assigned and that it may be
terminated without penalty by either party upon no more than 60 days' nor less
than 30 days' written notice.
In connection with its administration of the business affairs of each of
the Funds, and except as indicated in the Prospectus under the heading "Manager,
Sub-Advisers and Distributor," the Manager bears the following expenses:
(a) the salaries and expenses of all personnel of the Trust and the
Manager, except the fees and expenses of Trustees not affiliated with the
Manager or the Sub-Adviser;
(b) the fees to be paid to the Sub-Advisers pursuant to the Sub-Advisory
Agreements; and
(c) all expenses incurred by the Manager in connection with administering
the ordinary course of the Funds' business, other than those assumed by the
Trust.
SUB-ADVISORY AGREEMENTS
Pursuant to Sub-Advisory Agreements between the Manager and MacKay-Shields
and between the Manager and Monitor on behalf of each Fund (each a "Sub-Adviser"
and collectively the "Sub-Advisers"), MacKay-Shields and Monitor, subject to the
supervision of the Trustees of the Trust and the Manager and in conformity with
the stated policies of each of the Funds and the Trust, manage the Funds'
portfolios, including the purchase, retention, disposition and loan of
securities.
The Trustees, including the Independent Trustees, approved the Sub-Advisory
Agreements at an in-person meeting held July 28, 1997. On October 24, 1997, the
shareholders of each of the Funds approved the Sub-Advisory Agreements with
MacKay-Shields and Monitor. The Sub-Advisory Agreements will remain in effect
for two years following their effective date, and will continue in effect
thereafter only if such continuance is specifically
<PAGE>
approved at least annually by the Trustees or by vote of a majority of the
outstanding voting securities of each of the Funds (as defined in the 1940 Act
and in a rule under the 1940 Act) and, in either case, by a majority of the
Trustees who are not "interested persons" of the Trust, the Manager, MacKay-
Shields or Monitor (as the term is defined in the 1940 Act).
The Sub-Advisers have authorized any of their directors, officers and
employees who have been elected or appointed as Trustees or officers of the
Trust to serve in the capacities in which they have been elected or appointed.
In connection with the services they render, the Sub-Advisers bear the salaries
and expenses of all of their personnel.
The Sub-Advisory Agreements provide that MacKay-Shields and Monitor shall
not be liable for any error of judgment by MacKay-Shields or Monitor or for any
loss suffered by any of the Funds except in the case of MacKay-Shields' or
Monitor's willful misfeasance, bad faith, gross negligence or reckless disregard
of duty. The Agreements also provide that they shall terminate automatically if
assigned and that they may be terminated without penalty by either party upon no
more than 60 days' nor less than 30 days' written notice.
In previous years, prior to a change in management structure, the Funds
paid an advisory fee directly to MacKay-Shields or Monitor. For the fiscal
years ended December 31, 1996 and December 31, 1995, and the period September 1,
1994 through December 31, 1994, the amount of the advisory fee paid by each Fund
to MacKay-Shields or Monitor was as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
<S> <C> <C> <C>
California Tax Free Fund.... $ 45,307++ $ 29,964++ $ 8,612++
Capital Appreciation Fund... 3,429,258 2,155,386 543,137
Convertible Fund............ 2,444,000 1,027,604 206,175
Equity Index Fund........... 163,785 81,072 20,578
Government Fund............. 2,643,801 3,056,716 1,062,816
High Yield Corporate Bond
Fund.................... 5,816,110 3,930,939 1,068,277
International Bond Fund+.... 68,489++ 52,534++ 10,037++
International Equity Fund+.. 342,100 166,703 27,355
Money Market Fund........... 397,071++ 391,304++ 93,386++
New York Tax Free Fund...... 29,457++ 31,482++ 9,230++
Strategic Income Fund....... N/A+++
Tax Free Bond Fund.......... 1,579,820 1,610,982 525,805
</TABLE>
<PAGE>
Total Return Fund........... 3,087,111 2,396,247 674,170
Value Fund.................. 2,682,642 1,932,406 518,495
- -------------------------
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ After expense reimbursement.
+++ The strategic income fund commenced operations on february 28, 1997.
In previous years, prior to a change in management structure, the Funds
paid an administrative fee directly to NYLIFE Distributors Inc. as
administrator. For the fiscal year ended December 31, 1996, the fiscal year
ended December 31, 1995 and the fiscal period September 1, 1994 through December
31, 1994, the amount of the administration fee paid by each Fund was as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
<S> <C> <C> <C>
California Tax Free Fund.... $ 45,307++ $ 29,964++ $ 8,612++
Capital Appreciation Fund... 3,429,258 2,155,386 543,137
Convertible Fund............ 2,444,000 1,027,604 206,175
Equity Index Fund........... 365,118++ 324,287 20,578
Government Fund............. 2,643,801 3,056,716 1,062,816
High Yield Corporate Bond
Fund.................... 5,816,110 3,930,939 1,068,277
International Bond Fund+.... 41,100++ 31,522++ 10,037++
International Equity Fund+.. 228,066 111,135 27,355
Money Market Fund........... 397,071++ 391,304++ 93,386++
New York Tax Free Fund...... 29,457++ 31,481++ 9,230++
Strategic Income Fund....... N/A+++
Tax Free Bond Fund.......... 1,579,820 1,610,982 525,805
Total Return Fund........... 3,087,111 2,396,247 674,170
Value Fund.................. 2,682,642 1,932,406 518,495
- ----------
</TABLE>
<PAGE>
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ After expense reimbursement.
+++ The Strategic Income Fund commenced operations on February 28, 1997.
The Manager and the Sub-Adviser have voluntarily agreed to assume the
expenses of the Money Market Fund described above to the extent that such
expenses for a month would exceed on an annualized basis .70% of the average
daily net assets of that Fund. For the fiscal year ended December 31, 1996, the
fiscal year ended December 31, 1995, and the period September 1, 1994 through
December 31, 1994, $3,420,347, $2,455,139, and $648,381 in expenses would have
been incurred by the Money Market Fund, respectively, had such expenses not been
limited pursuant to a similar arrangement under the previous management
structure.
The Sub-Adviser and the Manager have voluntarily agreed to reimburse
expenses for the California Tax Free Fund and the New York Tax Free Fund to the
extent that operating expenses exceed on an annualized basis 1.24% and 1.49% for
the Class A and Class B shares, respectively, of the daily average net assets.
For the period September 1, 1994 to December 31, 1994, pursuant to the expense
limitation arrangement under the previous management structure, the expense
reimbursements to the California Tax Free Fund and the New York Tax Free Fund
were $10,836 and $10,334, respectively. For the fiscal year ended December 31,
1995, the expense reimbursements to the California Tax Free Fund and New York
Tax Free Fund were $33,690 and $28,483, respectively. And, for the fiscal year
ended December 31, 1996, the expense reimbursements to the California Tax Free
Fund and the New York Tax Free Fund were $22,456 and $39,823, respectively.
Effective January 1, 1996, in the event the total expenses of the Equity
Index Fund for any fiscal year exceed 0.80% of the value of the Fund's average
annual net assets, the Manager will reduce its fee payable by the Fund by the
difference between the Fund's total expenses and 0.80%. Under the previous
management structure this reduction amounted to $290,022 for the year ended
December 31, 1996. This fee waiver is voluntary and may be terminated at any
time. Effective April 1, 1998, the expense limitation in place with respect to
the MainStay Equity Index Fund will be terminated.
The Sub-Adviser and the Manager have jointly agreed to waive a portion of
their fees payable by the International Bond Fund
<PAGE>
until such time as the Fund reaches $50 million in net assets. Pursuant to a
similar arrangement under the previous management structure, the advisory fee
paid by the International Bond Fund for the period September 13, 1994 to
December 31, 1994 equalled an annual rate of 0.25% and for the fiscal years
ended December 31, 1995 and 1996 equalled an annual rate of 0.25% and 0.25%,
respectively. Under that arrangement, the administration fee paid by the
International Bond Fund for the period September 13, 1994 to December 31, 1994
equalled an annual rate of 0.15% and for the fiscal years ended December 31,
1995 and 1996 equalled an annual rate of 0.15% and 0.15%, respectively.
DISTRIBUTION AGREEMENT
NYLIFE Distributors acts as the Principal Underwriter and Distributor of
the Funds' shares pursuant to the Distribution Agreement with the Trust dated
January 1, 1994. NYLIFE Securities Inc., an affiliated company, sells shares of
the Funds pursuant to a dealer agreement with the Distributor. The Distributor
and other broker-dealers will pay commissions to salesmen as well as the cost of
printing and mailing prospectuses to potential investors and of any advertising
incurred by them in connection with their distribution of Trust shares. In
addition, the Distributor will pay for a variety of account maintenance and
personal services to shareholders after the sale.
The Distribution Agreement for the Funds was approved by the Trustees,
including a majority of the Trustees who are not "interested persons" (as the
term is defined in the 1940 Act) of the Trust nor have any direct or indirect
financial interest in the operation of the distribution plan or in any related
agreement (the "Independent Trustees") at a meeting held on October 25, 1993.
The Distribution Agreement for the International Bond Fund and the International
Equity Fund was approved by the Trustees, including a majority of the
Independent Trustees at a meeting held on July 25, 1994. The Distribution
Agreement for the Strategic Income Fund was approved by the Trustees, including
a majority of the Independent Trustees at a meeting held on January 27, 1997.
The Distribution Agreements were reapproved (initial approval, with respect to
the Strategic Value Fund) by the Trustees, including a majority of the
Independent Trustees, at a meeting held on April 28, 1997.
As disclosed in the Prospectus, each of the Funds (except the Money Market
Fund and the Equity Index Fund, which does not offer Class B shares) has adopted
separate plans of distribution pursuant to Rule 12b-1 under the 1940 Act for
each class of shares of each Fund (the "Class A Plans", the "Class B Plans"
<PAGE>
and, collectively, the "Plans"). Under the Class A Plans, Class A shares of each
Fund pay the Distributor a monthly fee at the annual rate of 0.25% of the
average daily net assets of each Fund's Class A shares for distribution or
service activities, as designated by the Distributor. The Class A Plans for each
of the Funds other than the California Tax Free Fund, New York Tax Free Fund,
Equity Index Fund and Strategic Income Fund were approved by the sole initial
shareholder of the Class A of shares of each Fund on December 31, 1994. The
Class A Plans were approved by the shareholders of the California Tax Free Fund,
New York Tax Free Fund and the Equity Index Fund at a Special Meeting of
Shareholders held on December 28, 1994 and the Class A Plan was approved by the
sole initial shareholder of the Strategic Income Fund on February 3, 1997.
Regarding the California Tax Free Fund, the New York Tax Free Fund and the
Equity Index Fund, the Trustees of the Trust, including a majority of the
Independent Trustees, by vote cast in person at a meeting called for the purpose
of voting on such Plans, initially approved the Plan now designated as the Class
A Plans on July 25, 1994. Regarding the Strategic Income Fund, the Trustees of
the Trust, including a majority of the Independent Trustees, by vote cast in
person at a meeting called for the purpose of voting on such Plan, initially
approved the Class A Plan on January 27, 1997.
As noted above, the Class B shares of each Fund (except the Money Market
Fund and the Equity Index Fund, which does not offer Class B shares) also have
adopted Rule 12b-1 distribution plans. Originally, Rule 12b-1 plans of
distribution were adopted by each of the Funds (except the California Tax Free
Fund, New York Tax Free Fund and Money Market Fund) for the then sole existing
class of shares of the Funds. More specifically, Rule 12b-1 distribution plans
were approved on February 3, 1997 by the sole initial shareholder of the
Strategic Income Fund, on September 8, 1994 by the sole initial shareholder of
each of the International Bond Fund and International Equity Fund, on April 25,
1988 by the shareholders of the Total Return Fund, on May 29, 1987 by the sole
initial shareholder of the Tax Free Bond Fund and on April 27, 1987 by the
shareholders of the Capital Appreciation Fund, Convertible Fund, Government
Fund, High Yield Corporate Bond Fund and Value Fund. The Trustees of the Trust,
including a majority of the Independent Trustees, by vote cast in person at
meetings called for the purpose of voting on such Plans, initially approved the
Plans of the Total Return Fund on October 26, 1987, initially approved the Plans
of the Tax Free Bond Fund on April 27, 1987, and initially approved the Plans of
the Capital Appreciation Fund, Convertible Fund, Government Fund, High Yield
Corporate Bond Fund and Value Fund on April 28, 1986. In addition, on October
31, 1988, the Trustees of the Trust,
<PAGE>
including a majority of the Independent Trustees, amended the Tax Free Bond
Fund's Plan to permanently reduce the amount of the distribution fee to be
imposed subsequent to that date. On October 26, 1992, the Trustees of the Trust,
including a majority of the Independent Trustees, amended each of the plans of
distribution to provide that a portion of total amount of the distribution fee
as a service fee, to pay for a variety of account maintenance and personal
services to shareholders after the sale. On October 25, 1993, the Trustees of
the Trust, including a majority of the Independent Trustees, amended each of the
plans of distribution to reflect that NYLIFE Distributors would serve as
principal underwriter of the Funds' shares, effective January 1, 1994. Prior to
the implementation of the multi-class distribution system the distribution plans
in effect for the Funds were amended and redesignated and, now, are applicable
only to the Class B shares of each Fund. On October 30, 1995, the Trustees of
the Trust, including a majority of the Independent Trustees, amended the Class A
Plans and the Class B Plans to clarify that the Plans contemplate payment for
expenses that may generally be characterized as administrative.
Regarding the California Tax Free Fund and New York Tax Free Fund, the
Class B Plans were approved by the sole initial shareholder of the Class B
shares of each Fund on December 31, 1994. The Trustees of the Trust, including
a majority of the Independent Trustees, by vote cast in person at meetings
called for the purpose of voting on such Plans, initially approved such Plans
now designated as the Class B Plans on October 24, 1994.
Regarding the International Bond Fund and International Equity Fund, the
Trustees of the Trust, including a majority of the Independent Trustees, by vote
cast in person at meetings called for the purpose of voting on such Plans,
initially approved the distribution plans now designated as the Class B Plans on
July 25, 1994, and the Class A Plans on October 24, 1994. Regarding the
Strategic Income Fund, the Class B Plan for the Fund was approved on February 3,
1997 by the sole initial shareholder of the Fund. The Trustees of the Trust,
including a majority of the Independent Trustees, by vote cast in person at a
meeting called for the purpose of voting on such Plan, initially approved the
Class B Plan of the Fund on January 27, 1997.
On October 24, 1997, Class B shareholders for each of the Funds, other than
the Equity Index Fund, Money Market Fund and Strategic Income Fund, approved a
revision to the Class B Plans of each Fund to revise the method of calculation
of the distribution fee. The Trustees, including a majority of the
<PAGE>
Independent Trustees, approved the revision at an in-person meeting held July
28, 1997.
Under the amended Class B plans, each Fund's Class B shares pay a monthly
distribution fee to the Distributor at the annual rate of 0.75% (0.25% in the
case of the California Tax Free Fund, New York Tax Free Fund and the Tax Free
Bond Fund) of the average daily net assets attributable to the Fund's Class B
shares. Pursuant to the Class B Plan, the Class B shares also pay a service fee
to the Distributor at the annual rate of 0.25% of the average daily net assets
of the Funds' Class B shares.
Once approved by a vote of a majority of the outstanding voting securities
of a class of shares of a Fund, each Plan shall continue in effect thereafter,
provided such continuance is approved annually by a vote of the Trustees in the
manner described above. No Plan may be amended to increase materially the
amount to be spent for the services described therein without approval of the
shareholders of the affected class of shares of a Fund, and all material
amendments of each Plan must also be approved by the Trustees in the manner
described above. Each Plan may be terminated at any time, without payment of
any penalty, by vote of a majority of the Independent Trustees, or by a vote of
a majority of the outstanding voting securities of the affected Fund (as defined
in the 1940 Act) on not more than 30 days' written notice to any other party to
the Plan. So long as any Plan is in effect, the selection and nomination of
Trustees who are not such interested persons has been committed to those
Trustees who are not such interested persons. The Trustees have determined
that, in their judgment, there is a reasonable likelihood that each Plan will
benefit the respective Fund and its shareholders. Pursuant to both the Class A
and Class B Plans, the Distributor shall provide the Trust for review by the
Trustees, and the Trustees shall review at least quarterly, a written report of
the amounts expended under each Plan and the purpose for which such expenditures
were made. In the Trustees' quarterly review of each Plan, they will consider
its continued appropriateness and the level of compensation provided therein.
Pursuant to a rule of the National Association of Securities Dealers, Inc.,
the amount which a Fund may pay for distribution expenses, excluding service
fees, is limited to 6.25% of the gross sales of the Fund's shares since
inception of the Fund's Plan, plus interest at the prime rate plus 1% per annum
(less any contingent deferred sales charges paid by shareholders to the
Distributor or distribution fee (other than service fees) paid by the Funds to
the Distributor).
<PAGE>
For the fiscal year ended December 31, 1996, the Funds paid distribution
and service fees pursuant to the Class A and Class B Plans as follows:
Amount of Fee Amount of Fee
Pursuant to Pursuant to
Class A Plan Class B Plan
------------- -------------
California Tax Free Fund+........ $ 46,788 $ 19,206
Capital Appreciation Fund+....... 212,203 8,346,723
Convertible Fund+................ 109,177 5,623,832
Equity Index Fund................ 409,463 N/A
Government Fund+................. 38,937 7,206,791
High Yield Corporate Bond Fund+.. 190,154 16,701,333
International Bond Fund+......... 29,310 141,984
International Equity Fund+....... 39,917 395,760
Money Market Fund................ N/A N/A
New York Tax Free Fund+.......... 42,333 14,072
Strategic Income Fund*........... N/A N/A
Tax Free Bond Fund+.............. 33,245 2,367,663
Total Return Fund+............... 122,644 7,048,842
Value Fund+...................... 114,102 6,604,450
__________
* The Strategic Income Fund commenced operations on February 28, 1997.
+ Based on previous method of calculation under Class B Plans prior to
amendment in October 1977
For the fiscal year ended December 31, 1996, the fiscal year ended December
31, 1995, and the period September 1, 1994 through December 31, 1994, NYLIFE
Distributors retained the following amounts in sales charges for sales of Class
A shares of the Funds:
<PAGE>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
California Tax Free Fund....... $ 35,009 $ 57,181 $ 25,670
Capital Appreciation Fund(1). 1,430,417 718,806 --
Convertible Fund(1)............ 903,782 529,361 --
Equity Index Fund.............. 1,968,993 308,486 133,857
Government Fund(1)............. 96,545 95,975 --
High Yield Corporate Bond
Fund(1).................... 1,413,313 782,534 --
International Bond Fund+(1).... 54,586 10,984 --
International Equity Fund+(1) 91,571 63,684 --
Money Market Fund(1)........... N/A N/A N/A
New York Tax Free Fund......... 22,774 35,722 21,343
Strategic Income Fund++........ N/A N/A N/A
Tax Free Bond Fund(1).......... 51,345 62,656 --
Total Return Fund(1)........... 334,470 233,202 --
Value Fund(1).................. 574,807 413,692 --
- ----------
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ The Strategic Income Fund commenced operations on February 28, 1997.
(1) The Fund began offering Class A shares on January 3, 1995.
For the fiscal year ended December 31, 1996, contingent deferred sales
charges were paid by investors on the redemption of Class B shares of each Fund,
as follows:
<PAGE>
Year Ended
December 31,
1996
------------
California Tax Free Fund(2)..... $ 2,008
Capital Appreciation Fund....... 966,555
Convertible Fund................ 852,359
Equity Index Fund............... N/A
Government Fund................. 952,234
High Yield Corporate Bond Fund.. 1,482,294
International Bond Fund......... 27,332
International Equity Fund....... 48,979
Money Market Fund(1)............ 640,623
New York Tax Free Fund.......... 2,810
Strategic Income Fund (2)....... N/A
Tax Free Bond Fund.............. 605,386
Total Return Fund............... 745,382
Value Fund...................... 712,915
__________
(1) The amount shown represents proceeds from contingent deferred sales charges
which were assessed on redemptions of shares which had previously been
exchanged from other Funds into the Money Market Fund.
(2) The Strategic Income Fund commenced operations on February 28, 1997.
For the fiscal year ended December 31, 1996, it is estimated that the
following amounts were spent with respect to the Class A shares of each Fund:
California Tax Free Fund spent $89,152 on compensation to dealers; Capital
Appreciation Fund spent $1,501,787 on compensation to dealers; Convertible Fund
spent $920,619 on compensation to dealers; Equity Index Fund spent $1,909,644 on
compensation to dealers; Government Fund spent $173,229 on compensation to
dealers; High Yield Corporate Bond Fund spent $1,466,889 on compensation to
dealers; International Bond Fund spent $186,704 on compensation to dealers;
International Equity Fund spent $105,124 on compensation to dealers; New York
Tax Free Bond Fund spent $19,981 on compensation to dealers; Tax Free Bond Fund
spent $128,691 on compensation to dealers; Total Return Fund spent $381,683 on
compensation to dealers; and Value Fund spent $645,363 on compensation to
dealers.
<PAGE>
For the fiscal year ended December 31, 1996, it is estimated that the
following amounts were spent for distribution-related activities with respect to
the Class B shares of each Fund:
<TABLE>
<CAPTION>
Printing And Approximate
Mailing Total Amount
Prospectuses Spent By
Sales to other Compensation Compensation NYLIFE
Material than to to Sales Distributors
and Current Distribution Sales Distribution With Respect
Advertising Shareholders Personnel Personnel Other Costs to Each Fund
----------- ------------ ------------ ------------ ---------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
California Tax Free
Fund................... $ 73,801 $ 1,535 $ 189,852 $ 30,604 $ 44,742 $ 747,673 $ 1,088,207
Capital Appreciation
Fund................... 758,717 421,361 3,141,106 650,035 1,450,098 15,825,633 22,246,951
Convertible Fund........ 249,150 242,683 1,013,084 210,885 469,303 14,788,597 16,973,703
Government Fund......... 128,893 329,715 544,630 115,854 253,004 2,672,887 4,044,982
High Yield Corporate
Bond Fund.............. 933,969 756,839 3,917,489 810,212 1,813,951 29,791,670 38,024,130
International Bond
Fund................... 9,150 5,966 38,118 7,981 17,983 263,481 342,679
International Equity
Fund................... 34,089 15,940 152,765 33,208 75,613 896,403 1,208,020
New York Tax Free Fund.. 17,892 1,102 52,265 8,571 16,894 191,834 288,558
Strategic Income Fund*.. 0 0 0 0 0 0 0
Tax Free Bond Fund...... 57,743 196,491 273,828 58,731 130,519 1,314,695 2,032,007
Total Return Fund....... 304,008 360,068 1,360,199 290,227 658,192 6,647,325 9,620,019
Value Fund.............. 371,691 320,958 1,540,187 320,666 714,276 8,899,927 12,167,704
---------- ---------- ----------- ---------- ---------- ----------- ------------
Total 2,939,103 2,652,658 12,223,523 2,536,974 5,644,575 82,040,125 108,036,960
</TABLE>
__________
* The Strategic Income Fund commenced operations on February 28, 1997.
OTHER SERVICES
Pursuant to an Accounting Agreement with the Trust, dated October 24, 1997,
the Manager performs certain bookkeeping and pricing services for the Funds.
Each Fund will bear an allocable portion of the cost of providing these services
to the Trust.
For fiscal years ended December 31, 1996 and 1995, the period September 1,
1994 through December 31, 1994, the amount of
<PAGE>
recordkeeping fee to NYLIFE Distributors, the previous Accounting Agent, paid by
each Fund was as follows:
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
California Tax Free Fund.... $ N/A $ N/A $ N/A
Capital Appreciation Fund... 145,721 95,042 24,684
Convertible Fund............ 81,568 57,184 13,603
Equity Index Fund........... N/A N/A N/A
Government Fund............. 114,622 128,798 42,333
High Yield Corporate Bond
Fund.................... 233,333 164,329 45,331
International Bond Fund+.... 12,511 12,000 3,600
International Equity Fund+.. 22,075 12,668 3,600
Money Market Fund........... 62,593 53,064 16,047
New York Tax Free Fund...... N/A N/A N/A
Strategic Income Fund++..... N/A N/A N/A
Tax Free Bond Fund.......... 80,430 79,801 24,274
Total Return Fund........... 126,154 103,032 29,600
Value Fund.................. 116,985 85,935 23,809
__________
* The Funds changed their fiscal year end from August 31 to December 31.
+The International Bond Fund and International Equity Fund commenced operations
on September 13, 1994.
++The Strategic Income Fund commenced operations on February 28, 1997.
In addition, each Fund may reimburse NYLIFE Securities, NYLIFE Distributors
and MainStay Shareholder Services for the cost of certain correspondence to
shareholders and the establishment of shareholder accounts.
<PAGE>
EXPENSES BORNE BY THE TRUST
Except for the expenses to be paid by the Manager as described in the
Prospectus, the Trust, on behalf of each Fund, is responsible under its
Management Agreement for the payment of expenses related to each Fund's
operations, including (i) the fees payable to the Manager, (ii) the fees and
expenses of Trust ees who are not affiliated with the Manager or Sub-Advisers,
(iii) certain fees and expenses of the Trust's Custodian and Transfer Agent,
including the cost of pricing a Fund's shares, (iv) the charges and expenses of
the Trust's legal counsel and independent accountants, (v) brokers' commissions
and any issue or transfer taxes chargeable to the Trust, on behalf of a Fund, in
connection with its securities transactions, (vi) the fees of any trade
association of which a Fund or the Trust is a member, (vii) the cost of share
certificates representing shares of a Fund, (viii) reimbursement of a portion of
the organization expenses of a Fund and the fees and expenses involved in
registering and maintaining registration of the Trust and of its shares with the
SEC and registering the Trust as a broker or dealer and qualifying its shares
under state securities laws, including the preparation and printing of the
Trust's registration statements and prospectuses for such purposes, (ix)
allocable communications expenses with respect to investor services and all
expenses of shareholders' and Trustees' meetings and preparing, printing and
mailing prospectuses and reports to shareholders, (x) litigation and
indemnification expenses and other extraordinary expenses not incurred in the
ordinary course of a Fund's business, (xi) any expenses assumed by the Fund
pursuant to its plan of distribution, and (xii) all taxes and business fees
payable by a Fund to federal, state or other governmental agencies. Fees and
expenses of legal counsel, registering shares, holding meetings and
communicating with shareholders include an allocable portion of the cost of
maintaining an internal legal and compliance department.
Certain of the Funds have entered into a committed line of credit with The
Bank of New York as agent, and various other lenders from whom a Fund may borrow
up to 5% of its net assets in order to honor redemptions. The credit facility
is expected to be utilized in periods when the Funds experience unusually large
redemption requests.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Purchases and sales of securities on a securities exchange are effected by
brokers, and the Funds pay a brokerage commission for this service. In
transactions on stock exchanges in the
<PAGE>
United States, these commissions are negotiated, whereas on many foreign stock
exchanges these commissions are fixed. In the over-the-counter markets,
securities (i.e., Municipal Bonds and other debt securities) are generally
traded on a "net" basis with dealers acting as principal for their own accounts
without a stated commission, although the price of the security usually includes
a profit to the dealer. Transactions in certain over-the-counter securities also
may be effected on an agency basis, when the total price paid (including
commission) is equal to or better than the best total prices available from
other sources. In underwritten offerings, securities are purchased at a fixed
price which includes an amount of compensation to the underwriter, generally
referred to as the underwriter's concession or discount. On occasion, certain
money market instruments may be purchased directly from an issuer, in which case
no commissions or discounts are paid.
Regarding the California Tax Free Fund and New York Tax Free Fund, newly
issued securities normally are purchased directly from the issuer or from an
underwriter acting as principal. Other purchases and sales usually are placed
with those dealers from which it appears that the best price or execution will
be obtained; those dealers may be acting as either agents or principals. The
purchase price paid by a Fund to underwriters of newly issued securities usually
includes a concession paid by the issuer to the underwriter, and purchases of
after-market securities from dealers normally are executed at a price between
the bid and asked prices.
The primary consideration in placing portfolio security transactions with
broker-dealers for execution is to obtain and maintain the availability of
execution at the most favorable prices and in the most effective manner
possible. The Sub-Advisers attempt to achieve this result by selecting broker-
dealers to execute portfolio transactions on behalf of each Fund and their
other clients on the basis of the broker-dealers' professional capability, the
value and quality of their brokerage services and the level of their brokerage
commissions. Consistent with the foregoing primary considerations, the Conduct
Rules of the NASD and such other policies as the Trustees may determine, the
Sub-Advisers may consider sales of shares of the Funds as a factor in the
selection of broker-dealers to execute the Funds' portfolio transactions.
NYLIFE Securities (the "Affiliated Broker") may act as broker for the
Trust. In order for the Affiliated Broker to effect any portfolio transactions
for the Trust, the commissions,
<PAGE>
fees or other remuneration received by the Affiliated Broker must be reasonable
and fair compared to the commissions, fees or other remuneration paid to other
brokers in connection with comparable transactions involving similar securities
being purchased or sold on an exchange during a comparable period of time. This
standard would allow the Affiliated Broker to receive no more than the
remuneration which would be expected to be received by an unaffiliated broker in
a commensurate arms-length transaction. The Trust will not deal with the
Affiliated Broker in any portfolio transaction in which the Affiliated Broker
acts as principal.
Under each Sub-Advisory Agreement and as permitted by Section 28(e) of the
Securities Exchange Act of 1934 (the "1934 Act"), a Sub-Adviser may cause a Fund
to pay a broker-dealer (except the Affiliated Broker) which provides brokerage
and research services to the Sub-Adviser an amount of commission for effecting a
securities transaction for a Fund in excess of the amount other broker-dealers
would have charged for the transaction if the Sub-Adviser determines in good
faith that the greater commission is reasonable in relation to the value of the
brokerage and research services provided by the executing broker-dealer viewed
in terms of either a particular transaction or the Sub-Adviser's overall
responsibilities to the Trust or to its other clients. The term "brokerage and
research services" includes advice as to the value of securities, the
advisability of investing in, purchasing, or selling securities, and the
availability of securities or of 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 and settlement.
Although commissions paid on every transaction will, in the judgment of the
Sub-Advisers, be reasonable in relation to the value of the brokerage services
provided, commissions exceeding those which another broker might charge may be
paid to broker-dealers (except the Affiliated Broker) who were selected to
execute transactions on behalf of the Trust and the Sub-Advisers' other clients
in part for providing advice as to the availability of securities or of
purchasers or sellers of securities and services in effecting securities
transactions and performing functions incidental thereto such as clearance and
settlement.
Broker-dealers may be willing to furnish statistical, research and other
factual information or services ("Research")
<PAGE>
to the Sub-Advisers for no consideration other than brokerage or underwriting
commissions. Securities may be bought or sold through such broker-dealers, but
at present, unless otherwise directed by the Trust, a commission higher than one
charged elsewhere will not be paid to such a firm solely because it provided
Research to an Sub-Adviser. Research provided by brokers is used for the benefit
of all of the Sub-Advisers' clients and not solely or necessarily for the
benefit of the Trust. The Sub-Advisers' investment management personnel attempt
to evaluate the quality of Research provided by brokers. Results of this effort
are sometimes used by the Sub-Advisers as a consideration in the selection of
brokers to execute portfolio transactions.
In certain instances there may be securities which are suitable for a
Fund's portfolio as well as for that of another Fund or one or more of the other
clients of the Sub-Advisers. Investment decisions for a Fund and for the Sub-
Advisers' other clients are made with a view to achieving their respective
investment objectives. It may develop that a particular security is bought or
sold for only one client even though it might be held by, or bought or sold for,
other clients. Likewise, a particular security may be bought for one or more
clients when one or more other clients are selling that same security. Some
simultaneous transactions are inevitable when several clients receive investment
advice from the same investment adviser, particularly when the same security is
suitable for the investment objectives of more than one client. When two or
more clients are simultaneously engaged in the purchase or sale of the same
security, the securities are allocated among clients in a manner believed to be
equitable to each. It is recognized that in some cases this system could have a
detrimental effect on the price or volume of the security in a particular
transaction as far as a Fund is concerned. The Trust believes that over time
its ability to participate in volume transactions will produce better executions
for the Funds.
The Sub-Advisory fee that the Manager pays on behalf of each Fund to the
Sub-Advisers will not be reduced as a consequence of the Sub-Advisers' receipt
of brokerage and research services. To the extent a Fund's portfolio
transactions are used to obtain such services, the brokerage commissions paid by
the Fund will exceed those that might otherwise be paid, by an amount which
cannot be presently determined. Such services would be useful and of value to
the Sub-Advisers in serving both the Funds and other clients and, conversely,
such services obtained by the placement of brokerage business of other clients
would be useful
<PAGE>
to the Sub-Advisers in carrying out their obligations to the Funds.
For the fiscal years ended December 31, 1996 and 1995 and the period
September 1, 1994 through December 31, 1994,* each of the following Funds paid
brokerage commissions as follows:
<PAGE>
<TABLE>
<CAPTION>
Total Brokerage Total Brokerage Commissions
Commissions Paid Paid to Affiliated Persons
---------------------------- ---------------------------
Sept. 1, 1994 Sept. 1, 1994
Year Ended Year ended through Year ended Year ended through
Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31,
1996 1995 1994* 1996 1995 1994
---------- ---------- ---------- ----------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Capital Appreciation Fund.. $ 882,877 $ 681,250 $126,845 $ --- $ --- $ ---
Convertible Fund........... 1,952,991 674,139 151,524 --- --- ---
Equity Index Fund.......... 63,111 7,018 2,364 --- --- ---
Government Fund............ 20,809 71,818 27,123 --- --- ---
High Yield Corporate Bond
Fund..................... 1,187,150 1,207,587 333,548 --- 1,970(0%)(1) ---
International Equity Fund+. 215,696 135,267 54,215 --- --- ---
Strategic Income Fund++.... N/A N/A N/A N/A N/A N/A
Total Return Fund.......... 399,858 436,507 102,550 --- --- ---
Value Fund................. 1,354,707 1,055,169 246,712 --- 5,074(0%)(1) 1,540(1%)(1)
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Total Brokerage
Commissions Paid
Total Amount of Transactions to Brokers that
Where Commissions Paid Provided Research
-------------------------------------------------------------------------- -----------------
September 1, 1994
Year Ended Year Ended through Year ended
December 31, 1996 December 31, 1995 December 31, 1994* December 31, 1996
----------------- ----------------- ------------------ -----------------
<S> <C> <C> <C> <C>
Capital Appreciation Fund.. $ 571,478,397(0.0%)(2) $391,017,677(0.0%)(2) $ 71,345,660(0.0%)(2) $ 880,764
Convertible Fund........... 1,296,465,108(0.0%)(2) 395,570,645(0.0%)(2) 81,374,040(0.0%)(2) 1,942,771
Equity Index Fund.......... 64,348,135(0.0%)(2) 5,863,505(0.0%)(2) 1,660,008(0.0%)(2) 63,111
Government Fund............ 275,083,720(0.0%)(2) 712,117,650(0.0%)(2) 291,468,420(0.0%)(2) 20,809
High Yield Corporate Bond
Fund..................... 2,471,387,854(0.0%)(2) 1,414,045,455(0.0%)(2) 375,961,540(0.0%)(2) 1,084,021
International Equity Fund+. 49,098,906(0.0%)(2) 33,559,758(0.0%)(2) 12,781,223 215,696
Strategic Income Fund++.... N/A N/A N/A N/A
Total Return Fund.......... 271,187,968(0.0%)(2) 604,631,476(0.0%)(2) 153,671,710(0.0%)(2) 398,594
Value Fund................. 848,170,710(0.0%)(2) 544,224,812(0.0%)(2) 141,666,160(0.1%)(2) 1,347,479
</TABLE>
__________
* The Funds changed their fiscal year end from August 31 to December 31.
(1) Percent of total commissions paid.
(2) Percent of total transactions involving the payment of commissions effected
through affiliated persons.
+ The International Equity Fund commenced operations on September 13, 1994.
++ The Strategic Income Fund commenced operations on February 28, 1997.
The California Tax Free Fund, International Bond Fund, Money Market Fund,
New York Tax Free Fund and Tax Free Bond Fund paid no brokerage commissions
during the year ended December 31, 1996, the year ended December 31, 1995, and
the period from September 1, 1994 through December 31, 1994.
Capital Appreciation Fund held common stock in Schwab (Charles) valued at
$14,480,000 and commercial paper of American Express Credit Corp. valued at
$22,585,000; Convertible Fund held commercial paper of American Express Credit
Corp. valued at $38,000,000; Total Return Fund held long-term bonds of Lehman
Brothers Holdings Inc., 7.375%, due 5/15/07, valued at $2,623,462, long-term
bonds of Merrill Lynch & Co., Inc., 6.65%, due 1/15/99, valued at $4,016,442,
long-term bonds of PaineWebber Group Inc., 7.75%, due 9/1/02, valued at
$1,032,540, long-term bonds of Salomon Inc., 6.70%, due 12/1/98, valued at
$2,182,152, common stock in Schwab (Charles) valued at $7,472,000 and
<PAGE>
commercial paper of American Express Credit Corp. valued at $15,285,000; Value
Fund held commercial paper of American Express Credit Corp. valued at
$21,922,000.
Investors may, subject to the approval of the Trust, the Manager and the
Sub-Adviser, purchase shares of a Fund with liquid securities that are eligible
for purchase by that Fund and that have a value that is readily ascertainable.
These transactions will be effected only if the Sub-Adviser intends to retain
the security in the Fund as an investment. The Trust reserves the right to
amend or terminate this practice at any time.
NET ASSET VALUE
The net asset value per share of each Fund (other than the Money Market
Fund) is determined by the Trust daily as of the close of regular trading on the
New York Stock Exchange (currently 4:00 p.m., Eastern time) on each day when the
New York Stock Exchange is open for trading. The net asset value per share of
the Money Market Fund is also determined at noon on such days.
Portfolio securities of the Money Market Fund are valued at their amortized
cost, which does not take into account unrealized securities gains or losses.
While this method provides certainty in valuation, it may result in periods
during which value, as determined by amortized cost, is higher or lower than the
price the Money Market Fund would receive if it sold the instrument. During
periods of declining interest rates, the quoted yield on shares of the Money
Market Fund may tend to be higher than a like computation made by a fund with
identical investments utilizing a method of valuation based upon market prices
and estimates of market prices for all of its portfolio instruments. Thus, if
the use of amortized cost by the Money Market Fund resulted in a lower aggregate
portfolio value on a particular day, a prospective investor in the Money Market
Fund would be able to obtain a somewhat higher yield if he or she purchased
shares of the Money Market Fund on that day, than would result from investment
in a fund utilizing solely market values, and existing investors in the Money
Market Fund would receive less investment income. The converse would apply in a
period of rising interest rates.
Portfolio securities of each other Fund are valued (a) by appraising common
and preferred stocks which are traded on the New York Stock Exchange at the last
sale price on that Exchange on the day as of which assets are valued or, if no
sale occurs, at the mean between the closing bid price and asked price, (b) by
<PAGE>
appraising other common and preferred stocks as nearly as possible in the manner
described in clause (a) if traded on any other exchange, including the National
Association of Securities Dealers National Market System and foreign securities
exchanges, (c) by appraising over-the-counter common and preferred stocks quoted
on the National Association of Securities Dealers NASDAQ system (but not listed
on the National Market System) at the closing bid price supplied through such
system, (d) by appraising over-the-counter common and preferred stocks not
quoted on the NASDAQ system and securities listed or traded on certain foreign
exchanges whose operations are similar to the U.S over-the-counter market at
prices supplied by a pricing agent selected by the Sub-Adviser if those prices
are deemed by the Sub-Adviser to be representative of market values at the first
close of business of the New York Stock Exchange, (e) by appraising debt
securities at prices supplied by a pricing agent selected by the Sub-Adviser,
which prices reflect broker-dealer-supplied valuations and electronic data
processing techniques if those prices are deemed by the Sub-Adviser to be
representative of market values at the first close of business of the New York
Stock Exchange, (f) by appraising exchange-traded options and futures contracts
at the last posted settlement price on the market where any such option or
futures contract is principally traded and (g) by appraising all other
securities and other assets, including over-the-counter common and preferred
stocks not quoted on the NASDAQ system, securities listed or traded on certain
foreign exchanges whose operations are similar to the U.S. over-the-counter
market and debt securities for which prices are supplied by a pricing agent but
are not deemed by the Sub-Adviser to be representative of market values, but
excluding money market instruments with a remaining maturity of 60 days or less
and including restricted securities and securities for which no market quotation
is available, at fair value in accordance with procedures approved by and
determined in good faith by the Trustees, although the actual calculation may be
done by others. Money market instruments held by the Funds with a remaining
maturity of 60 days or less will be valued by the amortized cost method unless
such method does not represent fair value. Forward foreign cur rency exchange
contracts held by the Funds are valued at their respective fair market values
determined on the basis of the mean between the last current bid and asked
prices based on dealer or exchange quotations.
Portfolio securities traded on more than one U.S. national securities
exchange or foreign securities exchange are valued at the last sale price on the
business day as of which such value is being determined at the close of the
exchange representing the principal market for such securities. The value of
all assets
<PAGE>
and liabilities expressed in foreign currencies will be converted into U.S.
dollar values at the mean between the buying and selling rates of such
currencies against U.S. dollars last quoted by any major bank or broker-dealer.
If such quotations are not available, the rate of exchange will be determined in
accordance with policies established by the Trustees. The Trust recognizes
dividend income and other distributions on the ex-dividend date, except that
certain dividends from foreign securities are recog nized as soon as the Trust
is informed after the ex-dividend date.
Trading in securities on European and Far Eastern securities exchanges and
over-the-counter markets is normally completed well before the close of business
on each business day in New York (i.e., a day on which the New York Stock
---
Exchange is open for trading). In addition, European or Far Eastern securities
trading generally in a particular country or countries may not take place on all
business days in New York. Furthermore, trading takes place in Japanese markets
on certain Saturdays and in various foreign markets on days which are not
business days in New York and on which the Funds' net asset values are not
calculated. Such calculation of net asset value does not take place
contemporaneously with the determination of the prices of the majority of the
portfolio securities used in such calculation.
Events affecting the values of portfolio securities that oc cur between
the time their prices are determined and the close of the New York Stock
Exchange will not be reflected in the Funds' calculation of net asset values
unless the Sub-Adviser deems that the particular event would materially affect
net asset value, in which case an adjustment will be made.
Because the Guarantee regarding the Equity Index Fund is payable to
shareholders directly (and not payable to the Equity Index Fund), and because it
represents only a contingent liability rather than an agreement to pay a
definite amount on the Guarantee Date, the Trustees believe that the Guarantee
should have no impact in determining the Equity Index Fund's net asset value.
The proceeds received by each Fund for each issue or sale of its shares,
and all net investment income, realized and unrealized gain and proceeds
thereof, subject only to the rights of creditors, will be specifically allocated
to such Fund and constitute the underlying assets of that Fund. The underlying
assets of each Fund will be segregated on the books of account, and will be
charged with the liabilities in respect to such Fund
<PAGE>
and with a share of the general liabilities of the Trust. Expenses with respect
to any two or more Funds will be allocated in proportion to the net asset values
of the respective Funds except where allocations of direct expenses can
otherwise be fairly made.
To the extent that any newly organized fund or class of shares receives, on
or before December 31, any seed capital, the net asset value of such fund(s) or
class(es) will be calculated as of December 31.
SHAREHOLDER INVESTMENT ACCOUNT
A Shareholder Investment Account is established for each investor in the
Funds, under which a record of the shares of each Fund held is maintained by the
Transfer Agent. If a share certificate is desired, it must be requested in
writing for each transaction. There is no charge to the investor for issuance
of a certificate. Whenever a transaction takes place in a Fund (other than the
Money Market Fund), the shareholder will be mailed a confirmation showing the
transaction. Shareholders will be sent a quarterly statement showing the status
of the Account. In addition, shareholders will be sent a monthly statement for
each month in which a transaction occurs.
SHAREHOLDER SERVICING AGENT
The Glass-Steagall Act prohibits national banks from engaging in the
business of underwriting, selling or distributing securities. There is
currently no precedent prohibiting banks from performing shareholder servicing
and recordkeeping functions. Changes in federal or state statutes and
regulations pertaining to the permissible activities of banks and their
affiliates or subsidiaries, as well as further judicial or administrative
decisions or interpretations of those provisions, could prevent a bank from
continuing to perform all or a part of such services. If a bank were prohibited
from so acting, the Trustees would consider what actions, if any, would be
necessary to continue to provide efficient and effective shareholder services.
It is not expected that shareholders would suffer any adverse financial
consequences as a result of any of these occurrences.
PURCHASES, REDEMPTION AND REPURCHASE
LETTER OF INTENT ("LOI")
<PAGE>
The LOI is a non-binding obligation on the Qualified Purchaser to purchase
the full amount indicated; however, on the initial purchase, if required (or, on
subsequent purchases if necessary), 5% of the dollar amount specified in the LOI
will be held in escrow by the Transfer Agent in shares registered in the
shareholder's name in order to assure payment of the proper sales charge. If
total purchases pursuant to the LOI (less any dispositions and exclusive of any
distribution on such shares automatically reinvested) are less than the amount
specified, the investor will be requested to remit to the Distributor an amount
equal to the difference between the sales charge paid and the sales charge
applicable to the aggregate purchases actually made. If not remitted within 20
days after written request, an appropriate number of escrowed shares will be
redeemed in order to realize the difference.
SUSPENSION OF REDEMPTIONS
The Trust may suspend the right of redemption of shares of any Fund and may
postpone payment for any period: (i) during which the New York Stock Exchange
is closed other than customary weekend and holiday closings or during which
trading on the New York Stock Exchange is restricted; (ii) when the SEC
determines that a state of emergency exists which may make payment or transfer
not reasonably practicable; (iii) as the SEC may by order permit for the
protection of the security holders of the Trust; or (iv) at any other time when
the Trust may, under applicable laws and regulations, suspend payment on the
redemption or repurchase of its shares.
CDSC WAIVERS
The Prospectus identifies certain categories of Class B share redemptions
on which the contingent deferred sales charge ("CDSC") will be waived. See
"Tell Me the Details - Alternative Sales Arrangements - Deferred Sales Charge
Class B Shares." In addition to those categories, the CDSC will be waived in
connection with the following redemptions of Class B shares by accounts
established before January 1, 1998: (i) withdrawals from IRS qualified and
nonqualified retirement plans, individual retirement accounts, tax sheltered
accounts, and deferred compensation plans, where such withdrawals are permitted
under the terms of the plan or account (e.g., attainment of age 59 1/2,
separation from service, death, disability, loans, hardships, withdrawals of
excess contributions pursuant to applicable IRS rules, withdrawals based on life
expectancy under applicable IRS rules); (ii) preretirement
<PAGE>
transfers or rollovers within a retirement plan where the proceeds of the
redemption are invested in proprietary products offered or distributed by New
York Life or its affiliates; (iii) living revocable trusts on the death of the
beneficiary; (iv) redemptions made within one year following the death or
disability or a shareholder; (v) redemptions by directors, Trustees, officers
and employees (and immediate family members) of the Trust and of New York Life
and its affiliates where no commissions have been paid; (vi) redemptions by
employees of any dealer which has a soliciting dealer agreement with the
Distributor, and by any trust, pension, profit-sharing or benefit plan for the
benefit of such persons where no commissions have been paid; (vii) redemptions
by tax-exempt employee benefit plans resulting from the adoption or promulgation
of any law or regulation; (viii) redemptions by any state, country or city, or
any instrumentality, department, authority or agency thereof and by trust
companies and bank trust departments; and (ix) transfers to (a) other funding
vehicles sponsored or distributed by New York Life or an affiliated company, or
(b) guaranteed investment contracts, regardless of the sponsor, within a
retirement plan.
TAX-DEFERRED RETIREMENT PLANS
CASH OR DEFERRED PROFIT SHARING PLANS UNDER SECTION 401(K) FOR CORPORATIONS
AND SELF-EMPLOYED INDIVIDUALS
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be purchased as an investment under a
specimen cash or deferred profit sharing plan intended to qualify under Section
401(k) of the Code (a "401(k) Plan") adopted by a corporation, a self-employed
individual (including sole proprietors and partnerships), or other organization.
All Funds, except the California Tax Free Fund, New York Tax Free Fund and Tax
Free Bond Fund, may be used as funding vehicles for qualified retirement plans
including 401(k) plans, which may be administered by third-party administrator
organizations. NYLIFE Distributors does not sponsor or administer such
qualified plans at this time.
INDIVIDUAL RETIREMENT ACCOUNT ("IRA")
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be purchased as an underlying investment
for an IRA made available by NYLIFE Distributors. For tax years beginning in
1997, only a traditional IRA is available. For tax years beginning after 1997,
two additional types of IRAs will be available -- the "Roth" IRA and the
"Education" IRA.
<PAGE>
An individual may contribute as much as $2,000 of his or her earned income
to a traditional IRA. A married individual filing a joint return may also
contribute to a traditional IRA for a nonworking spouse. The maximum deduction
allowed for a contribution to a spousal IRA is the lesser of (i) $2,000 or (ii)
the sum of (a) the compensation includible in the working spouse's gross income
plus (b) any compensation includible in the gross income of the nonworking
spouse, reduced by the amount of the deduction taken by the working spouse. The
maximum deduction for a IRA contribution by a married couple is $4,000.
An individual who has not attained age 70-1/2 may make a contribution to a
traditional IRA which is deductible for federal income tax purposes. For tax
years beginning before 1998, a contribution is deductible only if (i) neither
the individual nor his or her spouse (unless filing separate returns and living
apart at all times during the taxable year) is an active participant in an
employer's retirement plan, or (ii) the individual (and his or her spouse, if
applicable) has an adjusted gross income below a certain level ($40,000 for
married individuals filing a joint return, with a phase-out of the deduction for
adjusted gross income between $40,000 and $50,000; $25,000 for a single
individual, with a phase-out for adjusted gross income between $25,000 and
$35,000). These phase-out limits will gradually increase starting with tax years
beginning in 1998, eventually reaching $50,000 - $60,000 for single filers in
2005 and thereafter (and reaching $80,000 -$100,000 if married filing jointly in
2007 and thereafter). In addition, for tax years beginning after 1997, a
married individual may make a deductible IRA contribution even though the
individual's spouse is an active participant in a qualified employer's
retirement plan, subject to a phase-out for adjusted gross income between
$150,000 - $160,000. However, an individual not permitted to make a deductible
contribution to an IRA may nonetheless make nondeductible contributions up to
the maximum contribution limit for that year. The deductibility of IRA
contributions under state law varies from state to state.
Distributions from IRAs (to the extent they are not treated as a tax-free
return of nondeductible contributions) are taxable under federal income tax laws
as ordinary income. There are special rules for determining how withdrawals are
to be taxed if an IRA contains both deductible and nondeductible amounts. In
general, all traditional IRAs are aggregated and treated as one IRA, all
withdrawals are treated as one withdrawal, and then a proportionate amount of
the withdrawal will be deemed to be made from nondeductible contributions;
amounts treated as a return of nondeductible contributions will not be taxable.
Certain early withdrawals are subject to an additional excise tax. For
<PAGE>
distributions made after 1997, the excise tax does not apply to withdrawals up
to a total of $10,000 for first-time homebuyer expenses or to withdrawals used
to pay "qualified higher education expenses" of the taxpayer or his or her
spouse, child or grandchild. There are also special rules governing when IRA
distributions must begin and the minimum amount of such distributions; failure
to comply with these rules can result in the imposition of an excise tax.
Roth IRAs. Roth IRAs are a form of individual retirement account
---------
applicable for tax years beginning after 1997. Contributions to a Roth IRA are
not deductible but may be made even after the individual attains the age of 70-
1/2. In certain cases, distributions from a Roth IRA may be tax free. The Roth
IRA, like the traditional IRA, is subject to a $2,000 ($4,000 for a married
couple) contribution limit (taking into account both Roth IRA and traditional
IRA contributions). The maximum contribution that can be made is phased-out for
taxpayers with adjusted gross income between $95,000 and $110,000 ($150,000 -
$160,000 if married filing jointly). If the Roth IRA has been in effect for
five years, and distributions are (1) made on or after the individual attains
the age of 59-1/2; (2) made after the individual's death; (3) attributable to
disability; or (4) used for "qualified first-time home buyer expenses," they are
not taxable. If these requirements are not met, distributions are treated first
as a return of contributions and then as taxable earnings. Taxable
distributions may be subject to the same excise tax described above with respect
to traditional IRAs. All Roth IRAs, like traditional IRAs, are treated as one
IRA for this purpose. Unlike the traditional IRA, Roth IRAs are not subject to
minimum distribution requirements during the account owner's lifetime. However,
the amount in a Roth IRA is subject to required distribution rules after the
death of the account owner.
Education IRAs. After 1997, a taxpayer may make non-deductible
--------------
contributions of up to $500 per year per beneficiary to an Education IRA.
Contributions cannot be made after the beneficiary becomes 18 year old. The
maximum contribution is phased out for taxpayers with adjusted gross income
between $95,000 and $110,000 ($150,000 - $160,000 if married filing jointly).
Earnings are tax-deferred until a distribution is made. If a distribution does
not exceed the beneficiary's "qualified higher education expenses" for the year,
no part of the distribution is taxable. If part of a distribution is taxable,
an excise tax will generally apply as well. Any balance remaining in an
Education IRA when the beneficiary becomes 30 years old must be distributed and
any earnings will be taxable and subject to an excise tax upon distribution.
<PAGE>
All income and capital gains deriving from IRA investments in the Fund are
reinvested and compounded tax-deferred until distributed from the IRA. The
combination of annual contributions to a traditional IRA, which may be
deductible, and tax-deferred compounding can lead to substantial retirement
savings. Similarly, the combination of tax free distributions from a Roth IRA
or Education IRA combined with tax-deferred compounded earnings on IRA
investments can lead to substantial retirement and/or education savings.
403(B)(7) TAX SHELTERED ACCOUNT
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be purchased as the underlying investment
for tax sheltered custodial accounts (403(b) plans) made available by NYLIFE
Distributors. In general, employees of tax-exempt organizations described in
Section 501(c)(3) of the Code (such as hospitals, churches, religious,
scientific, or literary organizations and educational institutions) or a public
school system are eligible to participate in a 403(b) plan.
GENERAL INFORMATION
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be a permitted investment under profit
sharing, pension, and other retirement plans, IRAs, and tax-deferred annuities
other than those offered by the Fund depending on the provisions of the relevant
plan. Third-party administrative services, available for some corporate plans,
may limit or delay the processing of transactions.
The custodial agreements and forms provided by the Funds' Custodian and
Transfer Agent designate New York Life Trust Company as custodian for IRAs and
403(b) plans (unless another trustee or custodian is designated by the
individual or group establishing the plan) and contain specific information
about the plans. Each plan provides that dividends and distributions will be
reinvested automatically. For further details with respect to any plan,
including fees charged by New York Life Trust Company, tax consequences and
redemption information, see the specific documents for that plan.
The federal tax laws applicable to retirement plans, IRAs and 403(b) plans
are extremely complex and change from time to time. Therefore, an investor
should consult with his or her own professional tax adviser before establishing
any of the tax-deferred retirement plans described above.
<PAGE>
CALCULATION OF PERFORMANCE QUOTATIONS
From time to time, quotations of the Money Market Fund's "yield" and
"effective yield" may be included in advertisements or communications to
shareholders. These performance figures are calculated in the following manner:
A. Yield -- the net annualized yield based on a specified seven-
-----
calendar day period calculated at simple interest rates. Yield is
calculated by determining the net change, exclusive of capital changes, in
the value of a hypothetical preexisting account having a balance of one
share at the beginning of the period, subtracting a hypothetical charge
reflecting deductions from shareholder accounts, and dividing the
difference by the value of the account at the beginning of the base period
to obtain the base period return. The yield is annualized by multiplying
the base period return by 365/7. The yield figure is stated to the nearest
hundredth of one percent. The yield of the Class A and Class B shares of
the Money Market Fund for the seven-day period ended June 30, 1997 was
5.04% and 5.04%, respectively.
B. Effective Yield -- the net annualized yield for a specified seven-
---------------
calendar day period assuming a reinvestment of dividends (compounding).
Effective yield is calculated by the same method as yield except the yield
figure is compounded by adding one, raising the sum to a power equal to 365
divided by 7, and subtracting one from the result, according to the
following formula: Effective Yield = [(Base Period Return + 1) /365/7/] -
1. The effective yield of the Class A and Class B shares of the Money
Market Fund for the seven-day period ended June 30, 1997 was 5.17% and
5.17%, respectively.
The yield and effective yield of the Money Market Fund reflect the
reduction of certain fees otherwise payable and voluntary expense
limitations. Had there been no reduction of fees or expense limitations,
the yield and effective yield of the Money Market Fund would have been
4.86% and 4.97%, respectively, for Class A shares and 4.86% and 4.97%,
respectively, for Class B shares for the seven-day period ended June 30,
1997.
As described above, yield and effective yield are based on historical
earnings and are not intended to indicate future performance. The "effective
yield" will be slightly higher than the "yield" because of the compounding
effect of the assumed reinvestment of dividends. Yield and effective yield will
vary based on changes in market conditions and the level of expenses.
<PAGE>
From time to time a Fund, other than the Money Market Fund, may publish its
yield and/or average annual total return in advertisements and communications to
shareholders. Total return and yield are computed separately for Class A and
Class B shares. The average annual total return of each Fund is determined for a
particular period by calculating the actual dollar amount of the investment
return on a $1,000 investment in the Fund made at the maximum public offering
price at the beginning of the period, and then calculating the annual compounded
rate of return which would produce that amount. Total return for a period of
one year is equal to the actual return of the Fund during that period. This
calculation assumes a complete redemption of the investment and the deduction of
the maximum contingent deferred sales charge at the end of the period in the
case of Class B shares. In the case of Class A shares, the calculation assumes
the maximum sales charge is deducted from the initial $1,000 purchase order. It
also assumes that all dividends and distributions are reinvested at net asset
value on the reinvestment dates during the period. The performance information
shown below for the period ended December 31, 1996 provides performance figures
for both Class A and Class B shares of the Funds, except in the case of the
Equity Index Fund which offers only one class of shares, Class A shares.
In considering any average annual total return quotation, investors should
remember that the maximum initial sales charge reflected in each quotation for
Class A shares is a one-time fee which will have its greatest impact during the
early stages of an investor's investment in the Fund. The actual performance of
your investment will be affected less by this charge the longer you retain your
investment in the Fund.
Quotations of each Fund's average annual total return will be calculated
according to the following SEC formula:
P(1+T) to the power of n = ERV
where:
P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment made at the
beginning of the 1, 5 or 10-year periods at the end of the 1, 5, or
10-year periods (or fractional portion thereof)
<PAGE>
Each Fund may quote total rates of return in addition to its average annual
total return. Such quotations are computed in the same manner as the average
annual compounded rate, except that such quotations will be based on a Fund's
actual return for a specified period as opposed to its average return over 1, 5,
and 10-year periods. In considering any total rate of return quotation,
investors should remember that the maximum initial sales charge reflected in
each quotation for Class A shares is a one-time fee which will have its greatest
impact during the early stages of an investor's investment in the Fund. The
actual performance of your investment will be affected less by this charge the
longer you retain your investment in the Fund.
The average annual total returns of the Class A shares of the following
Funds for the one-year and, as applicable, five-year and ten-year periods ended
June 30, 1997 and the period from inception to June 30, 1997 were as follows:*
<TABLE>
<CAPTION>
Five Ten Average
Year Years Years Annual
Ended Ended Ended Total Inception
Fund 6/30/97 6/30/97 6/30/97 Return(a) Date
- ------------------------------ ------- ------- ------- ------- ---------
<S> <C> <C> <C> <C> <C>
California Tax Free Fund...... 2.30% 5.34% 5.67% 10/01/91
Capital Appreciation Fund(b).. 15.95% 19.52% 14.19% 14.64% 5/01/86
Convertible Fund(b)........... 6.19% 13.99% 10.65% 10.01% 5/01/86
Equity Index Fund............. 29.70% 17.91% 17.59% 12/20/90
Government Fund(b)............ 1.98% 4.18% 6.24% 6.24% 5/01/86
High Yield Corporate
Bond Fund(b)................. 10.61% 13.33% 10.95% 10.48% 5/01/86
International Bond Fund(b).... 3.78% 9.69% 9/13/94
International Equity Fund(b).. 8.21% 6.31% 9/13/94
New York Tax Free Fund........ 2.52% 5.48% 5.95% 10/01/91
Strategic Income Fund......... -1.66% -1.66% 2/28/97
Tax Free Bond Fund(b)......... 3.15% 4.79% 6.19% 5.93% 5/01/86
Total Return Fund(b).......... 11.31% 12.67% 12.30% 12/29/87
Value Fund(b)................. 18.97% 15.86% 12.99% 12.33% 5/01/86
</TABLE>
- ----------
* Assumes the deduction of the maximum applicable initial sales charge.
(a) From inception to 6/30/97.
(b) Performance figures for the Fund's Class A shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class B shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The average annual total returns of the Class B shares of the following
Funds for the one-year and, as applicable, five-year and ten-year periods ended
June 30, 1997, were as follows:
<PAGE>
<TABLE>
<CAPTION>
Five Ten Average
Year Years Years Annual
Ended Ended Ended Total Inception
Fund 6/30/97 6/30/97 6/30/97 Return(a) Date
- ----------------------------- ------- ------- ------- ------ ---------
<S> <C> <C> <C> <C> <C>
California Tax Free Fund(b).. 2.00% 5.88% 6.29% 10/01/91
Capital Appreciation Fund.... 17.08% 20.39% 14.69% 15.10% 5/01/86
Convertible Fund............. 6.77% 14.72% 11.12% 10.43% 5/01/86
Government Fund.............. 1.17% 4.48% 6.57% 6.53% 5/01/86
High Yield Corporate
Bond Fund................... 9.95% 13.79% 11.30% 10.78% 5/01/86
International Bond Fund...... 3.06% 9.98% 9/13/94
International Equity Fund.... 8.63% 6.79% 9/13/94
New York Tax Free Fund(b).... 2.08% 6.03% 6.57% 10/01/91
Strategic Income Fund........ -2.32% -2.32% 2/28/97
Tax Free Bond Fund........... 2.81% 5.34% 6.64% 6.33% 5/01/86
Total Return Fund............ 12.25% 13.42% 12.82% 12/29/87
Value Fund................... 20.25% 16.64% 13.47% 12.76% 5/01/86
</TABLE>
- ----------
* Assumes a complete redemption at the end of each year and the deduction of
the maximum applicable contingent deferred sales charge.
(a) From inception to 6/30/97.
(b) Performance figures for the Fund's Class B shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class A shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The average annual total returns of the Class A shares of the following
Funds without deducting the applicable initial sales charge is as follows:
<PAGE>
<TABLE>
<CAPTION>
Five Ten Average
Year Years Years Annual
Ended Ended Ended Total Inception
Fund 6/30/97 6/30/97 6/30/97 Return(a) Date
- ------------------------------ ------- ------- ------- ------- ---------
<S> <C> <C> <C> <C> <C>
California Tax Free Fund...... 7.12% 6.32% 6.52% 10/01/91
Capital Appreciation Fund(b).. 22.69% 20.88% 14.83% 15.22% 5/01/86
Convertible Fund(b)........... 12.37% 15.29% 11.28% 10.57% 5/01/86
Equity Index Fund............. 33.71% 18.63% 18.14% 12/20/90
Government Fund(b)............ 6.78% 5.14% 6.74% 6.67% 5/01/86
High Yield Corporate
Bond Fund(b)................. 15.82% 14.38% 11.47% 10.93% 5/01/86
International Bond Fund(b).... 8.67% 11.51% 9/13/94
International Equity Fund(b).. 14 51% 8.48% 9/13/94
New York Tax Free Fund........ 7.35% 6.46% 6.80% 10/01/91
Strategic Income Fund......... 2.97% 2.97% 2/28/97
Tax Free Bond Fund(b)......... 8.01% 5.75% 6.68% 6.37% 5/01/86
Total Return Fund(b).......... 17.79% 13.95% 12.97% 12/29/87
Value Fund(b)................. 25.90% 17.18% 13.63% 12.90% 5/01/86
</TABLE>
- ----------
(a) From inception to 6/30/97.
(b) Performance figures for the Fund's Class A shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class B shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The average annual total returns of the Class B shares of the following
Funds without deducting the applicable contingent deferred sales charge is as
follows:
<PAGE>
<TABLE>
<CAPTION>
Five Ten Average
Year Years Years Annual
Ended Ended Ended Total Inception
Fund 6/30/97 6/30/97 6/30/97 Return(a) Date
- ----------------------------- ------- ------- ------- ------ --------
<S> <C> <C> <C> <C> <C>
California Tax Free Fund(b).. 7.00% 6.20% 6.42% 10/01/91
Capital Appreciation Fund.... 22.08% 20.58% 14.69% 15.10% 5/01/86
Convertible Fund............. 11.77% 14.95% 11.12% 10.43% 5/01/86
Government Fund.............. 6.17% 4.82% 6.57% 6.53% 5/01/86
High Yield Corporate
Bond Fund................... 14.95% 14.03% 11.30% 10.78% 5/01/86
International Bond Fund...... 8.06% 10.88% 9/13/94
International Equity Fund.... 13.63% 7.73% 9/13/94
New York Tax Free Fund(b).... 7.08% 6.34% 6.70% 10/01/91
Strategic Income Fund........ 2.68% 2.68% 2/28/97
Tax Free Bond Fund........... 7.81% 5.66% 6.64% 6.33% 5/01/86
Total Return Fund............ 17.25% 13.66% 12.82% 12/29/87
Value Fund................... 25.25% 16.85% 13.47% 12.76% 5/01/86
</TABLE>
- ----------
(a) From inception to 6/30/97.
(b) Performance figures for the Fund's Class B shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class A shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The performance data quoted represents historical performance and the
investment return and principal value of an investment will fluctuate so that an
investor's shares, when redeemed, may be worth more or less than their original
cost.
The yield of each Fund, except the Money Market Fund, is computed by
dividing its net investment income (determined in accordance with the following
SEC formula) earned during a recent 30-day period by the product of the average
daily number of shares outstanding and entitled to receive dividends during the
period and the maximum offering price per share on the last day of the period.
The results are compounded on a bond equivalent (semiannual) basis and then they
are annualized. Yield will be calculated using the following SEC formula:
<PAGE>
Yield = 2[(a-b +1) to the power of 6 -1]
---
cd
where:
a = interest earned during the period
b = expenses accrued for the period (net of reimbursements)
c = the average daily number of shares outstanding during the period that
were entitled to receive dividends
d = the maximum offering price per share on the last day of the period
This yield figure does not reflect the deduction of any contingent deferred
sales charges which are imposed upon certain redemptions at the rates set forth
under "Redemptions and Repurchases" in the Prospectus.
For the 30-day period ended June 30, 1997, the yield of each of the
following Funds was:
30-Day
Period Ended
June 30,
1997
-----------------
Fund Class A Class B
- -------------------------------- ------- -------
California Tax Free Fund........ 4.88% 4.85%
Government Fund................. 5.47% 5.22%
High Yield Corporate Bond Fund.. 6.83% 6.65%
International Bond Fund......... 4.57% 4.13%
New York Tax Free Fund.......... 4.88% 4.85%
Tax Free Bond Fund.............. 5.13% 5.18%
Strategic Income Fund........... 6.16% 5.67%
The California Tax Free Fund, New York Tax Free Fund and Tax Free Bond Fund
may publish its tax equivalent yield in advertisements and communications to
shareholders. The tax equivalent yield is calculated by determining the rate of
return that would have to be achieved on a fully taxable investment to
<PAGE>
produce the after-tax equivalent of the Fund's yield, assuming certain tax
brackets for a Fund shareholder.
The table below illustrates the taxable yield equivalent to a tax-free
yield of 5.50%.*+
To Equal a 5.50% Tax
If Free Return, a Taxable
Your Federal Investment Would Have to
Marginal Tax Earn Without Fee Reduction
Rate is: or Expense Limit
------------- ---------------------------
15.00% 6.47%
28.00% 7.64%
31.00% 7.99%
36.00% 8.59%
39.60% 9.11%
__________
* This table reflects application of the regular Federal income tax only;
other taxes may be applicable with respect to a particular shareholder.
Such taxes could change the information shown. Tax rates are subject to
change. Investors in the California and New York Tax Free Funds should in
particular note that the chart does not reflect any state and local taxes
that may be deductible in computing Federal income tax liability.
+ This table is for illustrative purposes only; investors should consult
their tax advisers with respect to the tax implications of an investment in
a Fund that invests primarily in securities, the interest on which is
exempt from regular Federal income tax.
A Fund may also include its current dividend rate in its prospectus, in
supplemental sales literature, or in communications to shareholders. The
current dividend rate of each Fund for a particular period is calculated by
annualizing total distributions per share from net investment income (including
equalization credits, excluding realized short-term capital gains and premiums
from writing options) during this period and dividing this amount by the maximum
offering price per share on the last day of the period. The current dividend
rate does not reflect all components
<PAGE>
of a Fund's performance including (i) realized and unrealized capital gains and
losses, which are reflected in calculations of a Fund's total return, or (ii)
the amortized discount and premium on debt obligations in income using the
current market value of the obligations, as is currently required for yield
calculations. In addition, the current dividend rate does not take into account
the imposition of any contingent deferred sales charge on the redemption of Fund
shares. Any performance figure which does not take into account the contingent
deferred sales charge would be reduced to the extent such charge is imposed upon
a redemption.
Investors should note that the investment results of a Fund will fluctuate
over time, and any presentation of a Fund's yield, current dividend rate, total
return or tax-equivalent yield of any prior period should not be considered as a
representation of what an investment may earn or what an investor's yield,
current dividend rate, total return or tax-equivalent yield may be in any future
period.
In addition, advertising for a Fund may indicate that investors may
consider diversifying their investment portfolios in order to seek protection of
the value of their assets against inflation. From time to time, advertising
materials for a Fund may refer to or discuss current or past business,
political, economic or financial conditions, including events as they relate to
those conditions, such as any U.S. monetary or fiscal policies and the current
rate of inflation. In addition, from time to time, advertising materials for a
Fund may include information concerning retirement and investing for retirement
and may refer to the approximate number of then-current Fund shareholders,
shareholder accounts and Fund assets.
From time to time, advertising and sales literature for a Fund may discuss
the investment philosophy, personnel and assets under management of the Fund's
Manager and Sub-Adviser, and other pertinent facts relating to the management of
the Fund by the adviser.
From time to time any of the Funds may publish an indication of its past
performance as measured by independent sources such as Lipper Analytical
Services, Incorporated, Weisenberger Investment Companies Service, Donoghue's
Money Fund Report, Spot Market Prices, Barron's, BusinessWeek, Kiplinger's
-------- ------------ -----------
Personal Finance, Financial World, Forbes, Money, Morningstar, Personal
- ---------------- --------------- ------ ----- ----------- --------
Investor, Sylvia Porter's Personal Finance, and The Wall Street Journal.
-------------------------------- -----------------------
In addition, performance information for a Fund may be compared, in
advertisements, sales literature, and reports to
<PAGE>
shareholders, to: (i) unmanaged indexes, such as the Standard & Poor's 500
Composite Stock Price Index, the Salomon Brothers Broad Investment Grade Bond
Index, the Morgan Stanley Capital International indexes; the Dow Jones
Industrial Average, Donoghue Money Market Institutional Averages, the Merrill
Lynch 1 to 3 Year Treasury Index, the Salomon Brothers World Government
Benchmark Bond Index, the Salomon Brothers non-U.S. Dollar World Government Bond
Index, the Lehman Brothers Municipal Bond Index and the Lehman Brothers
Government Corporate Index; (ii) other groups of mutual funds tracked by
Morningstar Inc. or Lipper Analytical Services, widely used independent research
firms which rank mutual funds by overall performance, investment objectives and
assets, or tracked by other services, companies, publications or persons who
rank mutual funds on overall performance or other criteria; and (iii) the
Consumer Price Index (measure for inflation) and other measures of the
performance of the economy to assess the real rate of return from an investment
in the Funds. Unmanaged indexes may assume the reinvestment of dividends but
generally do not reflect deductions for administrative and management costs and
expenses.
From time to time, advertisements for the Funds may include general
information about the services and products offered by the Funds, MainStay
Institutional Funds Inc. and New York Life Insurance Company and its
subsidiaries. For example, such advertisements may include statistical
information about those entities including, but not limited to, the number of
current shareholder accounts, the amount of assets under management, sales
information, the distribution channels through which the entities' products are
available, marketing efforts and statements about this information by the
entities' officers, directors and employees.
TAX STATUS
TAXATION OF THE FUNDS
The following summarizes certain federal income tax considerations
generally affecting the Funds and their stockholders. No attempt is made to
present a detailed explanation of the tax treatment of the Funds or their
stockholders, and the discussion here is not intended as a substitute for
careful tax planning. The discussion is based upon present provisions of the
Internal Revenue Code of 1986, as amended (the "Code"), the regulations
promulgated thereunder, and judicial and administrative ruling authorities, all
of which are subject to change, which change may be the retroactive.
Prospective investors should consult their own tax advisors with regard to the
federal tax consequences of the purchase ownership, and disposition of Fund
<PAGE>
shares, as well as the tax consequences arising under the laws of any state,
foreign country, or other taxing jurisdiction.
Each Fund intends to be treated as a regulated investment company ("RIC")
under Subchapter M of the Code.
To qualify as a regulated investment company, each Fund must, among other
things: (i) derive in each taxable year at least 90% of its gross income from
dividends, interest, payments with respect to certain securities loans, and
gains from the sale or other disposition of stock, securities or foreign
currencies, or other income derived with respect to its business of investing in
such stock, securities, or currencies ("Qualifying Income Test"); (ii) diversify
its holdings so that, at the end of each quarter of the taxable year, (a) at
least 50% of the market value of the Fund's assets is represented by cash, cash
items, U.S. Government securities, the securities of other regulated investment
companies, and other securities, with such other securities of any one issuer
limited for the purposes of this calculation to an amount not greater than 5% of
the value of the Fund's total assets and 10% of the outstanding voting
securities of such issuer, and (b) not more than 25% of the value of its total
assets is invested in the securities on any one issuer (other than U.S.
Government securities or the securities of other regulated investment
companies), or of two or more issuers which the Fund controls (as that term is
defined in the relevant provisions of the Code) and which are determined to be
engaged in the same or similar trades or businesses or related trades or
businesses; and (iii) distribute at least 90% of the sum of its investment
company taxable income (which includes, among other items, dividends, interest
and net short-term capital gains in excess of any net long-term capital losses)
and its net tax-exempt interest each taxable year. The Treasury Department is
authorized to promulgate regulations under which foreign currency gains would
constitute qualifying income for purposes of the Qualifying Income Test only if
such gains are directly related to investing in securities (or options and
futures with respect to securities). To date, no such regulations have been
issued.
Certain requirements relating to the qualification of a Fund as regulated
investment company may limit the extent to which a Fund will be able to engage
in certain investment practices, including transactions in futures contracts and
other types of derivative securities transactions. In addition, if a Fund were
unable to dispose of portfolio securities due to settlement problems relating to
foreign investments or due to the holding of illiquid securities, the Fund's
ability to qualify as a regulated investment company might be affected.
<PAGE>
A Fund qualifying as a regulated investment company generally will not be
subject to U.S. federal income tax on its investment company taxable income and
net capital gains (any net long-term capital gains in excess of the net short-
term capital losses), if any, that it distributes to shareholders. Each Fund
intends to distribute to its shareholders, at least annually, substantially all
of its investment company taxable income and any net capital gains.
Generally, regulated investment companies, like the Fund, must distribute
amounts on a timely basis in accordance with a calendar year distribution
requirement in order to avoid a nondeductible 4% excise tax. Generally, to
avoid the tax, a regulated investment company must distribute during each
calendar year, (i) at least 98% of its ordinary income (not taking into account
any capital gains or losses) for the calendar year, (ii) at least 98% of its
capital gains in excess of its capital losses (adjusted for certain ordinary
losses) for the 12-month period ending on October 31 of the calendar year, and
(iii) all ordinary income and capital gains for previous years that were not
distributed during such years. To avoid application of the excise tax, each
Fund intends to make its distributions in accordance with the calendar year
distribution requirement. A distribution is treated as paid on December 31 of
the calendar year if it is declared by a Fund in October, November or December
of that year to shareholders of record on a date in such a month and paid by the
Fund during January of the following calendar year. Such distributions are
taxable to shareholders in the calendar year in which the distributions are
declared, rather than the calendar year in which the distributions are received.
Provided that a Fund qualifies as a regulated investment company for purposes of
Massachusetts law, it generally will not be subject to any excise or income
taxes in Massachusetts. A Fund's investments, if any, in REMIC residual
interests (as explained previously in this SAI) or in Passive Foreign Investment
Companies, as explained below, may cause the Fund to become liable for certain
taxes. Investors that are tax-exempt organizations should carefully consider
whether distributions of a Fund's earnings will be subject to tax in their
hands.
Each Fund, other than the Equity Index Fund (which offers only one class of
shares) and the Strategic Income Fund and Strategic Value Fund, has received a
ruling from the IRS to the effect that differing distributions between the
classes of its shares will not result in a Fund's dividends and other
distributions being regarded as "preferential dividends" under the Code.
Generally, a preferential dividend is a dividend which a Fund cannot treat as
having been distributed for purposes of (i) determining whether the
<PAGE>
Fund qualifies as a regulated investment company for federal tax purposes, and
(ii) determining the Fund's tax liability.
CHARACTER OF DISTRIBUTIONS TO SHAREHOLDERS -- GENERAL
Assuming a Fund qualifies as a RIC, distributions of taxable net investment
income and net short-term capital gains in excess of net long-term capital
losses will be treated as ordinary income in the hands of shareholders. If a
Fund's investment income is derived exclusively from sources (such as interest)
other than dividends, no portion of such distributions will be eligible for the
dividends-received deduction available to corporations.
If a portion of a Fund's net investment income is derived from dividends
from domestic corporations, then a portion of such distributions may be eligible
for the corporate dividends-received deduction. The dividends-received
deduction is reduced to the extent shares of a Fund are treated as debt-financed
under the Code and is generally eliminated unless such shares are deemed to have
been held for more than 45 days. For dividends received or accrued after
September 4, 1997, the holding period must occur during the 90-day period
beginning 45 days before the date on which the shares become x-dividend. In
addition, the entire dividend (including the deducted portion) is includable in
the corporate shareholder's alternative minimum taxable income. Finally, if
such dividends are large enough to constitute "extraordinary dividends" under
Section 1059 of the Code and the applicable holding period requirements are not
met, the shareholder's basis in its shares could be reduced by all or a portion
of the amount of the dividends that qualifies for the dividends-received
deduction.
Distributions of net capital gain, whether received in cash or reinvested
in Fund shares, will generally be taxable to shareholders as either "20% Gain"
or "28% Gain," depending upon the Fund's holding period for the assets sold.
"20% Gains" arise from sales of assets held by a Fund for more than 18 months
and are subject to a maximum tax rate of 20%; "28% Gains" arise from sales of
assets held by a Fund for more than one year but no more than 18 months and are
subject to a maximum tax rate of 28%. Net capital gains from assets held for
one year or less will be taxed as ordinary income. Distributions will be
subject to these capital gains rates regardless of how long a shareholder has
held Fund shares.
Any loss realized upon the redemption of shares within six months from the
date of their purchase will be treated as a long-term capital loss to the extent
of any capital gain dividends received with respect to such shares during that
six-month period.
<PAGE>
A loss realized upon a redemption of shares of a Fund within 30 days before or
after a purchase of shares of the same Fund (whether by reinvestment of
distributions or otherwise) may be disallowed in whole or in part.
If any net long-term capital gains in excess of net short-term capital
losses are retained by a Fund for reinvestment, requiring federal income taxes
to be paid thereon by that Fund, the Fund intends to elect to treat such capital
gains as having been distributed to shareholders. As a result, capital gains
will be taxable to the shareholders. Shareholders will be able to claim their
proportionate share of the federal income taxes paid by the Fund on such gains
as a credit against their own federal income tax liabilities and will be
entitled to increase the adjusted tax basis of the relevant Fund shares by the
difference between their pro-rata share of such gains and their tax credit.
Except for distributions by the Money Market Fund, distributions by a Fund
result in a reduction in the net asset value of a Fund's shares. Should a
distribution reduce the net asset value below a shareholder's cost basis, such
distribution nevertheless would generally be taxable to the shareholder (except
to the extent the distribution is an exempt interest dividend as described
below) as ordinary income or capital gain as described above, even though, from
an investment standpoint, it may constitute a partial return of investment. In
particular, investors should be careful to consider the tax implications of
buying shares just prior to a distribution. The price of shares purchased at
that time includes the amount of the forthcoming distribution. Those investors
purchasing shares just prior to a distribution will then receive a partial
return of their investment upon such distribution, which may nevertheless be
taxable to them.
Distributions of taxable net investment income and net realized capital
gains will be taxable as described above, whether received in shares or in cash.
Any distributions that are not from a Fund's net investment income or net
capital gain may be characterized as a return of capital to shareholders or, in
some cases, as capital gain. Shareholders electing to receive distributions in
the form of additional shares will have a cost basis for federal income tax
purposes in each share so received equal to the net asset value of such share on
the reinvestment date.
CHARACTER OF DISTRIBUTIONS TO SHAREHOLDERS -- THE TAX-FREE FUNDS
The Code permits the character of tax-exempt interest distributed by a
regulated investment company to "flow through" as
<PAGE>
tax-exempt interest to its shareholders, provided that 50% or more of the value
of its assets at the end of each quarter of its taxable year is invested in
state, municipal or other obligations the interest on which is exempt under
Section 103(a) of the Code. Each of the California Tax Free Fund, New York Tax
Free Fund and Tax Free Bond Fund (collectively, the "Tax Free Funds") intend to
satisfy the 50% requirement to permit their distributions of tax-exempt interest
to be treated as such for regular Federal income tax purposes in the hands of
their shareholders. Exempt-interest dividends must be taken into account by
individual shareholders in determining whether their total incomes are large
enough to result in taxation of up to 85% of their social security benefits and
certain railroad retirement benefits. None of the income distributions of the
Tax Free Funds will be eligible for the deduction for dividends received by
corporations.
Although a significant portion of the distributions by the Tax Free Funds
generally is expected to be exempt from federal taxes, each of these Funds may
under certain circumstances invest in obligations the interest from which is
fully taxable, or, although exempt from the regular federal income tax, is
subject to the alternative minimum tax. Similarly, gains from the sale or
exchange of obligations the interest on which is exempt from regular Federal
income tax will constitute taxable income to those Funds. In addition, a sale
of shares in such Fund (including a redemption of such shares and an exchange of
shares between two mutual funds) will be a taxable event, and may result in a
taxable gain or loss to a shareholder. Accordingly, it is possible that a
significant portion of the distributions of these Funds will constitute taxable
rather than tax-exempt income in the hands of a shareholder. Furthermore,
investors should be aware that tax laws may change, and issuers may fail to
follow applicable laws, causing a tax-exempt item to become taxable.
Exempt-interest dividends from the Tax Free Funds; ordinary dividends from
the Tax Free Funds, if any; capital gains distributions from the Tax Free Funds
and any capital gains or losses realized from the sale or exchange of shares may
be subject to state and local taxes. However, the portion of a distribution of
the Funds' tax-exempt income that is attributable to state and municipal
securities issued within the shareholder's own state may not be subject, at
least in some states, to state or local taxes.
Distributions derived from interest on certain private activity bonds which
is exempt from regular federal income tax are treated as a tax preference item
and may subject individual or corporate shareholders to liability (or increased
liability) for the alternative minimum tax. In addition, because a portion of
the
<PAGE>
difference between adjusted current earnings, as defined in the Code, and
alternative minimum taxable income is an addition to the alternative minimum tax
base, all distributions derived from interest which is exempt from regular
federal income tax are included in adjusted current earnings and may subject
corporate shareholders to or increase their liability for the alternative
minimum tax. In addition, a deductible "environmental tax" of 0.12% is imposed
on a corporation's modified alternative minimum taxable income in excess of $2
million. The environmental tax will be imposed even if the corporation is not
required to pay an alternative minimum tax because the corporation's regular
income tax liability exceeds its minimum tax liability. The inclusion of exempt-
interest dividends paid by a Fund in alternative minimum taxable income may
increase the likelihood that, corporate shareholders will be subject to the
environmental tax.
DISCOUNT
Certain of the bonds purchased by the Funds, such as zero coupon bonds, may
be treated as bonds that were originally issued at a discount. Original issue
discount represents interest for federal income tax purposes and can generally
be defined as the difference between the price at which a security was issued
(or the price at which it was deemed issued for federal income tax purposes) and
its stated redemption price at maturity. Original issue discount is treated for
federal income tax purposes as income earned by a Fund over the term of the
bond, and therefore is subject to the distribution requirements of the Code.
The annual amount of income earned on such a bond by a Fund generally is
determined on the basis of a constant yield to maturity which takes into account
the semiannual compounding of accrued interest.
In addition, some of the bonds may be purchased by a Fund at a discount
which exceeds the original issue discount on such bonds, if any. This
additional discount represents market discount for federal income tax purposes.
The gain realized on the disposition of any bond having market discount
generally will be treated as taxable ordinary income to the extent it does not
exceed the accrued market discount on such bond (unless a Fund elects to include
market discount in income in tax years to which it is attributable). Realized
accrued market discount on obligations that pay tax-exempt interest is
nonetheless taxable. Generally, market discount accrues on a daily basis for
each day the bond is held by a Fund at a constant rate over the time remaining
to the bond's maturity. In the case of any debt security having a fixed
maturity date of not more than one year from date of issue, the gain realized on
disposition will be treated as short-term capital gain.
<PAGE>
USERS OF BOND-FINANCED FACILITIES
Section 147(a) of the Code prohibits exemption from taxation of interest on
certain governmental obligations to persons who are "substantial users" (or
persons related thereto) of facilities financed thereby. No investigation as to
the users of the facilities financed by bonds in the portfolios of the Tax Free
Funds has been made by these Funds. Persons who may be "substantial users" (or
"related persons" of substantial users) of facilities financed by private
activity bonds should consult their tax advisers before purchasing shares of a
Fund since the acquisition of shares of the Tax Free Bond Fund, California Tax
Free Fund or New York Tax Free Fund may result in adverse tax consequences to
them.
TAXATION OF OPTIONS, FUTURES AND SIMILAR INSTRUMENTS
Many of the options, futures contracts and forward contracts entered into
by a Fund will be classified as "Section 1256 contracts." Generally, gains or
losses on Section 1256 contracts are considered 60% long-term and 40% short-term
capital gains or losses ("60/40"). Also, certain Section 1256 contracts held by
a Fund are "marked-to-market" at the times required pursuant to the Code with
the result that unrealized gains or losses are treated as though they were
realized. The resulting gain or loss generally is treated as 60/40 gain or
loss, except for foreign currency gain or loss on such contracts, which
generally is ordinary in character.
Distribution of fund gains from hedging transactions will be taxable to
shareholders. Generally, hedging transactions and certain other transactions in
options, futures and forward contracts undertaken by a Fund may result in
"straddles" for federal income tax purposes. The straddle rules may affect the
character of gains (or losses) realized by a Fund. In addition, losses realized
by a Fund on positions that are part of a straddle may be deferred under the
straddle rules rather than being taken into account in the taxable year in which
such losses are realized. Furthermore, certain transactions (including options,
futures contracts, notional principal contracts, short sales and including short
sales against the box) with respect to an "appreciated position" in certain
financial instruments may be deemed a constructive sale of the appreciated
position, requiring the immediate recognition of gain as if the appreciated
position were sold. Because only a few regulations implementing the straddle
rules have been promulgated, and regulations relating to constructive sales of
appreciated positions have yet to be promulgated, the tax consequences of
transactions in options, futures and forward contracts to a Fund are not
entirely clear.
<PAGE>
The hedging transactions in which a Fund engages may increase the amount of
short-term capital gain realized by a Fund which is taxed as ordinary income
when distributed to shareholders.
A Fund may make one or more of the elections available under the Code which
are applicable to straddles. If a Fund makes any of the elections, the amount,
character and timing of the recognition of gains or losses from the affected
straddle positions will be determined under rules that vary according to the
election(s) made. The rules applicable under certain of the elections may
accelerate the recognition of gains or losses from the affected straddle
positions.
Because application of the straddle rules may affect the character of gains
or losses, defer losses and/or accelerate the recognition of gains or losses
from the affected straddle positions, the amount which must be distributed to
shareholders and which will be taxed to shareholders as ordinary income or long-
term capital gain, may be increased or decreased substantially as compared to a
Fund that did not engage in such hedging transactions.
The diversification requirements applicable to a Fund's status as a
regulated investment company may limit the extent to which a Fund will be able
to engage in transactions in options, futures contracts or forward contracts.
Regarding the Tax Free Bond Fund, the California Tax Free Fund and New York
Tax Free Fund, gains from certain transactions, including, for example,
transactions in options, futures, and other instruments, and from obligations
the interest on which is not exempt from Federal income tax, will be taxable
income to those Funds.
The International Bond Fund, International Equity Fund and Strategic Income
Fund may engage in swap transactions. The tax treatment of swap agreements is
not entirely clear in certain respects. Accordingly, while the Funds intend to
account for such transactions in a manner they deem to be appropriate, the IRS
might challenge such treatment. If such a challenge were successful, status of
a Fund as a regulated investment company might be affected. The Funds intend to
monitor developments in this area. Certain requirements that must be met under
the Code in order for a Fund to qualify as a regulated investment company may
limit the extent to which a Fund will be able to engage in swap agreements.
<PAGE>
PASSIVE FOREIGN INVESTMENT COMPANIES
Certain of the Funds may invest in shares of foreign corporations which may
be classified under the Code as passive foreign investment companies ("PFICs").
In general, a foreign corporation is classified as a PFIC if at least one-half
of its assets constitute investment-type assets or 75% or more of its gross
income is investment-type income. If a Fund receives a so-called "excess
distribution" with respect to PFIC stock, the Fund itself may be subject to a
tax on a portion of the excess distribution, whether or not the corresponding
income is distributed by the Fund to Shareholders. In general, under the PFIC
rules, an excess distribution is treated as having been realized ratably over
the period during which the Fund held the PFIC shares. The Fund itself will be
subject to tax on the portion, if any, of an excess distribution that is so
allocated to prior Fund taxable years and an interest factor will be added to
the tax, as if the tax had been payable in such prior taxable years. Certain
distributions from a PFIC as well as gain from the sale of PFIC shares are
treated as excess distributions. Excess distributions are characterized as
ordinary income even though, absent application of the PFIC rules, certain
excess distributions might have been classified as capital gain.
A Fund may be eligible to elect alternative tax treatment with respect to
PFIC shares. Under an election that currently is available in some
circumstances, a Fund generally would be required to include in its gross income
its share of the earnings of a PFIC on a current basis, regardless of whether
distributions are received from the PFIC in a given year. If this election were
made, the special rules, discussed above, relating to the taxation of excess
distributions, would not apply. In addition, another election may be available
that would involve marking-to-market a Fund's PFIC shares at the end of each
taxable year (and on certain other dates prescribed in the Code), with the
result that unrealized gains are treated as though they were realized. If this
election were made, tax at the fund level under the PFIC rules would generally
be eliminated, but a Fund could, in limited circumstances, incur nondeductible
interest charges. Other elections may become available that would affect the
tax treatment of PFIC shares held by the Fund. The Fund's intention to qualify
annually as a regulated investment company may limit its elections with respect
to PFIC shares.
Because the application of the PFIC rules may affect, among other things,
the character of gains, the amount of gain or loss and the timing of the
recognition of income with respect to PFIC shares, as well as subject the Fund
itself to tax on certain
<PAGE>
income from PFIC shares, the amount that must be distributed to shareholders,
and which will be taxed to shareholders as ordinary income or long-term capital
gain, may be increased or decreased substantially as compared to a Fund that did
not invest in PFIC shares.
FOREIGN CURRENCY GAINS AND LOSSES
Under the Code, gains or losses attributable to fluctuations in exchange
rates which occur between the time a Fund accrues income or other receivables or
accrues expenses or other liabilities denominated in a foreign currency and the
time a Fund actually collects such receivables or pays such liabilities
generally are treated as ordinary income or ordinary loss. Similarly, on the
disposition of debt securities denominated in a foreign currency and on the
disposition of certain options, futures, forward and other contracts, gain or
loss attributable to fluctuations in the value of foreign currency between the
date of acquisition of the security or contract and the date of disposition also
are treated as ordinary gain or loss. These gains or losses, referred to under
the Code as "Section 988" gains or losses, may increase or decrease the amount
of a Fund's net investment income to be distributed to its shareholders. If
Section 988 losses exceed other investment company taxable income (which
includes, among other items, dividends, interest and the excess, if any, of net
short-term capital gains over net long-term capital losses) during the taxable
year, a Fund would not be able to make any ordinary dividend distributions, and
distributions made before the losses were realized would be recharacterized as a
return of capital to shareholders or, in some cases, as capital gain, rather
than as an ordinary dividend.
COMMODITY INVESTMENTS
A regulated investment company is required under the Code to derive at
least 90% of its gross income from certain qualifying sources. Qualifying income
includes, inter alia, interest, dividends, and gain from the sale of stock or
----------
securities, but it does not include gain from the sale of commodities such as
gold and other precious metals.
DISPOSITIONS OF FUND SHARES
Upon redemption, sale or exchange of shares of a Fund, a shareholder will
realize a taxable gain or loss, depending on whether the gross proceeds are more
or less than the shareholder's tax basis for the shares. Such gain or loss
generally will be a capital gain or loss if the shares of a Fund were capital
assets in
<PAGE>
the hands of the shareholder, and generally will be taxable to stockholders as
"20% Gain" if the shares had been held for more than 18 months or as "28% Gain"
if the shares had been held for more than one year but no more than 18 months. A
loss realized by a shareholder on the redemption, sale or exchange of shares of
a Fund with respect to which capital gain dividends have been paid will, to the
extent of such capital gain dividends, be treated as long-term capital loss if
such shares have been held by the shareholder for six months or less at the time
of their disposition. Furthermore, a loss realized by a shareholder on the
redemption, sale or exchange of shares of a Fund with respect to which exempt-
interest dividends have been paid will, to the extent of such exempt-interest
dividends, be disallowed if such shares have been held by the shareholder for
six months or less at the time of their disposition. A loss realized on a
redemption, sale or exchange also will be disallowed to the extent the shares
disposed of are replaced (whether through reinvestment of distributions, or
otherwise) within a period of 61 days beginning 30 days before and ending 30
days after the shares are disposed of. In such a case, the basis of the shares
acquired will be adjusted to reflect the disallowed loss.
Shareholders should be aware that redeeming shares of a Fund after tax-
exempt interest has been accrued by the Fund but before that income has been
declared as a dividend may be disadvantageous. This is because the gain, if any,
on the redemption will be taxable, even though such gains may be attributable in
part to the accrued tax-exempt interest which, if distributed to the shareholder
as a dividend rather than as redemption proceeds, might have qualified as an
exempt-interest dividend.
Under certain circumstances, the sales charge incurred in acquiring shares
of either Fund may not be taken into account in determining the gain or loss on
the disposition of those shares. This rule applies where shares of a Fund are
exchanged within 90 days after the date they were purchased and new shares are
acquired without a sales charge or at a reduced sales charge. Pursuant to a
right acquired upon the initial purchase of Shares. In that case, the gain or
loss recognized on the exchange will be determined by excluding from the tax
basis of the shares exchanged all or a portion of the sales charge incurred in
acquiring those shares. The portion of the sales charge affected by this rule
will be treated as a sales charge paid for the new shares and will be re-elected
in their basis, accordingly.
If reverse stock splits are done, a share may have a split holding period
reflecting the fact that part of the share represents a reinvested dividend or
distribution.
<PAGE>
TAX REPORTING REQUIREMENTS
All distributions, whether received in shares or cash, must be reported by
each shareholder on his or her federal income tax return. Shareholders are also
required to report tax-exempt interest. Dividends declared and payable to
shareholders of record on a specified date in October, November or December, if
any, will be deemed to have been received by shareholders on December 31 if paid
during January of the following year. Redemptions of shares, including
exchanges for shares of another Fund, may result in tax consequences (gain or
loss) to the shareholder and generally are also subject to these reporting
requirements. Each shareholder should consult his or her own tax adviser to
determine the tax status of a Fund distribution in his or her own state and
locality (or foreign country).
Under the federal income tax law, a Fund will be required to report to the
IRS all distributions of income (other than exempt-interest dividends) and
capital gains as well as gross proceeds from the redemption or exchange of Fund
shares (other than shares of the Money Market Fund), except in the case of
certain exempt shareholders. Under the backup withholding provisions of Section
3406 of the Code, all such taxable distributions and proceeds from the
redemption or exchange of a Fund's shares may be subject to withholding of
federal income tax at the rate of 31% in the case of nonexempt shareholders who
fail to furnish a Fund with their taxpayer identification number and with
required certifications regarding their status under the federal income tax law
or if the IRS or a broker notifies a Fund that the number furnished by the
shareholder is incorrect. In addition, both the Fund and the shareholder are
potentially subject to a $50 penalty imposed by the IRS if a correct, certified
taxpayer identification number is not furnished and used on required information
returns. If the withholding provisions are applicable, any such distributions
and proceeds, whether taken in cash or reinvested in shares, will be reduced by
the amounts required to be withheld. Backup withholding is not an additional tax
and any amounts withheld are creditable against the shareholder's U.S. Federal
tax liability. Investors may wish to consult their tax advisers about the
applicability of the backup withholding provisions.
FOREIGN TAXES
Investment income and gains received by a Fund from sources outside the
United States may be subject to foreign taxes which were paid or withheld at the
source. The payment of such taxes will reduce the amount of dividends and
distributions paid to the Funds' stockholders. Since the percentage of each
Fund's total
<PAGE>
assets (with the exception of the International Bond Fund and International
Equity Fund) which will be invested in foreign stocks and securities will not be
more than 50%, any foreign tax credits or deductions associated with such
foreign taxes will not be available for use by its shareholders. The effective
rate of foreign taxes to which a Fund will be subject depends on the specific
countries in which each Fund's assets will be invested and the extent of the
assets invested in each such country and, therefore, cannot be determined in
advance.
The International Bond Fund and the International Equity Fund may qualify
for and make the election permitted under Section 853 of the Code so that
shareholders will be able to claim a credit or deduction on their federal income
tax returns for, and will be required to treat as part of the amounts
distributed to them, their pro rata portion of qualified taxes paid by the Fund
to foreign countries (which taxes relate primarily to investment income). The
U.S. shareholders of a Fund may claim a foreign tax credit or deduction by
reason of the Fund's election under Section 853 of the Code, provided that more
than 50% of the value of the total assets of the Fund at the close of the
taxable year consists of securities of foreign corporations. The foreign tax
credit and deduction available to shareholders is subject to certain limitations
imposed by the Code. Also, under Section 63 of the Code, no deduction for
foreign taxes may be claimed by shareholders who do not itemize deductions on
their federal income tax returns, although any such shareholder may claim a
credit for foreign taxes and in any event will be treated as having taxable
income in respect to the shareholder's pro rata share of foreign taxes paid by
the Fund. It should also be noted that a tax-exempt shareholder, like other
shareholders, will be required to treat as part of the amounts distributed its
pro rata portion of the income taxes paid by the Fund to foreign countries.
However, that income will generally be exempt from taxation by virtue of such
shareholder's tax-exempt status, and such a shareholder will not be entitled to
either a tax credit or a deduction with respect to such income. The foreign tax
credit generally may offset only up to 90% of the alternative minimum tax in any
given year. Foreign taxes generally are not deductible in computing alternative
minimum taxable income.
STATE AND LOCAL TAXES - GENERAL
The state and local tax treatment of distributions received from a Fund and
any special tax considerations associated with foreign investments of a Fund
should be examined by shareholders with regard to their own tax situations.
<PAGE>
Shareholders of the Tax Free Bond Fund, the California Tax Free Fund and
New York Tax Free Fund may be subject to state and local taxes on distributions
from the Fund, including distributions which are exempt from federal income
taxes. Some states exempt from the state personal income tax distributions from
a Fund derived from interest on obligations issued by the U.S. government or by
such state or its municipalities or political subdivisions. Each investor should
consult his or her own tax adviser to determine the tax status of distributions
from the Funds in his or her own state and locality.
Opinions relating to the validity of municipal securities and the exemption
of interest thereon from federal income tax are rendered by bond counsel to the
issuers. The Tax Free Bond Fund, California Tax Free Fund and New York Tax Free
Fund, the Sub-Adviser and its affiliates, and the Funds' counsel make no review
of proceedings relating to the issuance of state or municipal securities or the
bases of such opinions.
Due to the lack of adequate supply of certain types of tax-exempt
obligations, and other reasons, various instruments are being marketed which are
not "pure" state and local obligations, but which are thought to generate
interest excludable from taxable income under Code section 103. While a Fund
may invest in such instruments, it does not guarantee the tax-exempt status of
the income earned thereon or from any other investment. Thus, for example, were
a Fund to invest in an instrument thought to give rise to tax-exempt interest
but such interest ultimately were determined to be taxable, the Fund might have
invested more than 20% of its assets in taxable instruments. In addition, it is
possible in such circumstances that a Fund will not have met the 50% investment
threshold, described above, necessary for it to pay exempt-interest dividends.
EXPLANATION OF FUND DISTRIBUTIONS
Each distribution is accompanied by a brief explanation of the form and
character of the distribution. In January of each year, each Fund will issue to
each shareholder a statement of the federal income tax status of all
distributions, including, in the case of the Tax Free Bond Fund, the California
Tax Free Fund and New York Tax Free Fund, a statement of the percentage of the
prior calendar year's distributions which the Fund has designated as tax-exempt,
the percentage of such tax-exempt distributions treated as a tax-preference
item for purposes of the alternative minimum tax, and in, the case of the Tax
Free Bond Fund, the source on a state-by-state basis of all distributions.
<PAGE>
ADDITIONAL INFORMATION REGARDING THE EQUITY INDEX FUND
If Shareholders receive distributions of amounts paid pursuant to such
distributions from the Fund may not be eligible for the dividends-received
deduction available to corporations.
In addition, although not considered likely, it is possible that
shareholders could be regarded for tax purposes as receiving a constructive
distribution(s) (which could be taxable) from the Fund to the extent that the
Guarantee is deemed to have value.
It is anticipated that capital gain or loss from the disposition of shares
will be eligible for treatment as long-term, mid-term or short-term capital gain
or loss depending upon the shareholder's actual holding period for the shares.
Investors should be aware that, under IRS regulations, as a result of the
Guarantee, a shareholder's holding period for Fund shares might be deemed not to
commence until the Guarantee is paid or expires. In that event, the capital
gain or loss on the disposition of Fund shares would be short-term capital gain
or loss until such time as the shares have been held continuously by the
shareholder for the requisite long-term holding period (currently more than one
year for Federal income tax purposes) after the expiration or payment of the
Guarantee. The holding period for shares received from reinvestment of
dividends and distributions will commence no earlier than the reinvestment date
but could be delayed as described previously in this paragraph as a result of
the Guarantee.
ADDITIONAL INFORMATION REGARDING THE CALIFORNIA TAX FREE FUND AND NEW YORK TAX
FREE FUND
Under California law, a mutual fund which qualifies as a regulated
investment company must have at least 50% of its total assets in obligations
exempt from California personal income tax at the end of each quarter of its
taxable year in order to be eligible to pay dividends which will be exempt from
California personal income tax. Generally, shareholders who are California
residents will not incur California personal income tax on the amount of exempt-
interest dividends received by them from the California Tax Free Fund and
derived from California state and local issues, whether taken in cash or
reinvested in additional shares. However, other taxes, such as the franchise
tax may apply. Shareholders will normally be subject to California personal
income tax on dividends paid from interest income derived from taxable
securities and from securities issued by states other than California and its
subsidiaries and on distributions of capital gains.
<PAGE>
Deductions for interest on indebtedness incurred or continued by a
shareholder to purchase or carry shares of the Fund may be disallowed in whole
or in part for California personal income tax purposes.
Exempt-interest dividends paid by the New York Tax Free Fund from interest
on qualifying New York bonds generally are exempt from New York State and New
York City personal income taxes, but not corporate franchise taxes. Dividends
and distributions of the Fund derived from taxable income and capital gains are
not exempt from New York State and New York City taxes. Deductions for interest
on indebtedness incurred or continued by a shareholder to purchase or carry
shares of the Fund may be disallowed in whole or in part for New York State or
New York City personal income tax purposes.
Dividends from the California Tax Free Fund or New York Tax Free Fund
(including exempt-interest dividends), capital gains distributions from a Fund,
and any capital gains or losses realized from the sale or exchange of shares may
be subject to state and local taxes (as well as Federal taxes). However, the
portion of a distribution of a Fund's tax-exempt income that is attributable to
state and municipal securities issued within the shareholder's own state
generally will not be subject to state or local taxes. Individuals are often
exempt from state and local personal income taxes on distributions of tax-exempt
interest income derived from obligations of issuers located in the state in
which they reside when these distributions are received directly from these
issuers, but are usually subject to such taxes on income derived from
obligations of issuers located in other jurisdictions. Shareholders are urged to
consult their tax advisers with specific reference to their own federal, state
and local tax situations.
ANNUAL STATEMENTS
Each shareholder of the California Tax Free Fund will be sent after the
close of the calendar year an annual statement as to the federal income tax and
California state personal income tax status of his or her dividends and
distributions from the Fund for the prior calendar year. Any dividends
attributable to interest on municipal obligations that are not California
municipal securities will be taxable as ordinary dividends for California state
personal income tax purposes even if such dividends are excluded from gross
income for federal income tax purposes. These statements will also designate
the amount of exempt-interest dividends that is a specific preference item for
purposes of the federal individual and corporate alternative minimum taxes.
Each shareholder also will receive, if appropriate, various written notices
after the close of
<PAGE>
the Fund's prior taxable year as to the federal income tax status of his or her
dividends and distributions which were received from the Fund during the Fund's
prior taxable year. Shareholders should consult their tax advisers as to any
other state and local taxes that may apply to these dividends and distributions.
The dollar amount of dividends excluded or exempt from federal income taxation
or California state personal income taxation, if any, will vary for each
shareholder depending upon the size and duration of each shareholder's
investment in the Fund.
Each shareholder of the New York Tax Free Fund will be sent after the close
of the calendar year an annual statement as to the federal income tax and New
York State and New York City personal income tax status of his or her dividends
and distributions from the Fund for the prior calendar year. These statements
will also designate the amount of exempt-interest dividends that is a specified
preference item for purposes of the federal individual and corporate alternative
minimum taxes. Each shareholder also will receive, if appropriate, various
written notices after the close of the Fund's prior taxable year as to the
federal income tax status of his or her dividends and distributions which were
received from the Fund during the Fund's prior taxable year. Shareholders should
consult their tax advisers as to any other state and local taxes that may apply
to these dividends and distributions. The dollar amounts of dividends excluded
or exempt from federal income taxation or New York State and City personal
income taxation and the dollar amount subject to federal income taxation or New
York State and City personal income taxation, if any, will vary for each
shareholder depending upon the size and duration of each shareholder's
investment in the Fund.
GENERAL INFORMATION
The foregoing discussion generally relates to U.S. federal income tax law
as applicable to U.S. persons (i.e., U.S. citizens and residents and U.S.
domestic corporations, partnerships, trusts and estates). Each shareholder who
is not a U.S. person should consult his or her tax adviser regarding the U.S.
and non-U.S. tax consequences of ownership of shares of a Fund, including the
possibility that such a shareholder may be subject to a U.S. withholding tax at
a rate of 30% (or at a lower rate under an applicable U.S. income tax treaty) on
amounts constituting ordinary income to him or her.
<PAGE>
ORGANIZATION AND CAPITALIZATION
GENERAL
The Funds are separate series of an open-end investment company, The
MainStay Funds ("Trust"), established under the laws of The Commonwealth of
Massachusetts by a Declaration of Trust dated January 9, 1986, as amended. The
Tax Free Bond Fund was originally formed as the MacKay-Shields MainStay Tax Free
Bond Fund pursuant to a Declaration of Trust on January 9, 1986 and became a
series of the Trust pursuant to a reorganization which occurred on May 29, 1987.
The Total Return Fund commenced operations on December 29, 1987. The Equity
Index Fund commenced operations on December 20, 1990. The California Tax Free
Fund and New York Tax Free Fund commenced operations on October 1, 1991. The
International Bond Fund and International Equity Fund commenced operations on
September 13, 1994. The Strategic Income Fund and Strategic Value Fund
commenced operations on February 28 and October 22, 1997, respectively. The
organizational expenses of each Fund will be amortized and deferred over a
period not to exceed 60 months. The Declaration of Trust and By-laws authorize
the Trustees to establish additional series or "Funds" as well as additional
classes of shares.
VOTING RIGHTS
Shares entitle their holders to one vote per share; however, separate votes
will be taken by each Fund or class on matters affecting an individual Fund or a
particular class of shares issued by a Fund. Shares have noncumulative voting
rights, which means that holders of more than 50% of the shares voting for the
election of Trustees can elect all Trustees and, in such event, the holders of
the remaining shares voting for the election of Trustees will not be able to
elect any person or persons as Trustees. Shares have no preemptive or
subscription rights and are transferable.
SHAREHOLDER AND TRUSTEE LIABILITY
Under Massachusetts law, shareholders of such a trust may, under certain
circumstances, be held personally liable as partners for the obligations of the
trust. The Declaration of Trust contains an express disclaimer of shareholder
liability for acts or obligations of the Trust. Notice of such disclaimer will
normally be given in each agreement, obligation or instrument entered into or
executed by the Trust or the Trustees. The Declaration of Trust provides for
indemnification by the relevant Fund for any loss suffered by a shareholder as a
result of an obligation of the Fund. The Declaration of Trust also provides that
the Trust shall, upon
<PAGE>
request, assume the defense of any claim made against any shareholder for any
act or obligation of the Trust and satisfy any judgment thereon. Thus, the risk
of a shareholder incurring financial loss on account of shareholder liability is
limited to circumstances in which a Fund would be unable to meet its
obligations. The Trustees believe that, in view of the above, the risk of
personal liability of shareholders is remote.
The Declaration of Trust further provides that the Trustees will not be
liable for errors of judgment or mistakes of fact or law, but nothing in the
Declaration of Trust protects a Trustee against any liability to which he or she
would otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence or reckless disregard of the duties involved in the conduct of his or
her office.
OTHER INFORMATION
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP, 1177 Avenue of the Americas, New York, New York,
10036, has been selected as independent public accountants of the Trust. The
Funds' Annual Reports, which are incorporated by reference in this SAI have been
so incorporated or included in reliance on the reports of Price Waterhouse,
independent public accountants, given on the authority of said firm as experts
in auditing and accounting.
LEGAL COUNSEL
Dechert Price & Rhoads, 1500 K Street, N.W., Washington, D.C. 20005, passes
upon certain legal matters in connection with the shares offered by the Trust,
and also acts as counsel to the Trust.
SHARE OWNERSHIP OF THE FUNDS
The following table sets forth information concerning beneficial and record
ownership, as of December 8, 1997, of the Funds' shares by each person who
beneficially or of record owns more than five percent of the voting securities
of any Fund:
<PAGE>
<TABLE>
<CAPTION>
Shares Percentage
Name and Address Beneficially Outstanding
Name of Fund of Shareholder Owned (1) Shares Owned
- ------------ ---------------- --------- ------------
<S> <C> <C> <C> <C> <C>
California NYLIFE Distributors Inc.(2) 271,121 (Class A) 14.97% (Class A)
Tax Free Fund 260 Cherry Hill Road
Parsippany, NJ 07054
California Otto V. & Yvonne Louise-Ericksen 101,010 (Class A) 5.58% (Class A)
Tax Free Fund Tschudi Revoc. Living Trust
1805 St. Andrews Dr.
Morasa, CA 94668
California William J. & Elinor Potikian 82,372 (Class B) 11.59% (Class B)
Tax Free Fund Family Revocable Trust
4475 N. College
Fresno, CA 93704
Capital- New York Life Trust Company 1,189,954 (Class A) 21.23% (Class A)
Appreciation Client Accounts
51 Madison Avenue, Rm 117A
New York, NY 10010-1603
Convertible New York Life Trust Company 505,836 (Class A) 11.43% (Class A)
Fund Client Accounts
51 Madison Avenue, Rm 117A
New York, NY 10010-1603
New York Tax NYLIFE Distributors Inc.(2) 499,488 (Class A) 36.82% (Class A)
Free Fund 260 Cherry Hill Road
Parsippany, NJ 07054
New York Tax Felice Brand 53,120 (Class B) 10.30% (Class B)
Free Fund 158 Wright Avenue
Deer Park, NY 11729-2224
New York Tax Henry Sheimann Irrevocable Trust 31,421 (Class B) 5.93% (Class B)
Free Fund 11-31 Jackson Avenue
Scardsdale, NY 10583
International NYLIFE Distributors Inc.(2) 750,150 (Class A) 64.61% (Class A)
Bond Fund 260 Cherry Hill Road
Parsippany, NJ 07054
Defined Benefit Pension Trust of FMCNA 74,304 (Class A) 6.40% (Class A)
C/O the Free Methodist Foundation
8050 Spring Arbor Road
Spring Arbor, MI 49283
</TABLE>
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C>
International NYLIFE Distributors Inc.(2) 625,089 (Class A) 37.77% (Class A)
Equity Fund 260 Cherry Hill Road
Parsippany, NJ 07054
International New York Life Trust Company 107,257 (Class A) 6.48% (Class A)
Equity Fund Clients Accounts
51 Madison Avenue, Room 117A
New York, NY 10010
Strategic Income NYLIFE Distributors Inc.(2) 520,912 (Class B) 12.69% (Class B)
Fund 260 Cherry Hill Road
Parsippany, NJ 07054
Strategic Income New York Life Insurance 1,115, 285 (Class A) 49.15% (Class A)
Fund Company General Account
51 Madison Avenue
New York, NY 10010
Value Fund New York Life Trust Company 1,065,019 (Class A) 21.73% (Class A)
Client Accounts
51 Madison Avenue, Rm 117A
New York, NY 10010-1603
Government New York Life Trust Company 221,680 (Class A) 11.19% (Class A)
Fund Client Accounts
51 Madison Avenue, Rm 117A
New York, NY 10010-1603
Richland County Treasurer 176,959 (Class A) 8.93% (Class A)
50 Park Avenue East
Mansfield, OH 44902
Jane D. Keeling 103,115 (Class A) 5.21% (Class A)
Dec. of Rev. Trust
3209 Old Mallard Road
Enid, OK 73703
Tax Free
Bond Fund Schmitt Family Trust 201,524 (Class A) 15.77% (Class A)
P.O. box 1566
Savannah, GA 31402
BHC Securities Inc. 74,708 (Class A) 5.84% (Class A)
2005 Market Street
Philadelphia, PA 19103
</TABLE>
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C>
Money Market New York Life Trust Company 5,970,580 (Class A) 7.54% (Class A)
Fund Client Accounts
51 Madison Avenue, Room 117A
New York, NY 10010
Calvin Fayard 4,904,078 (Class A) 6.19% (Class A)
APLC Clearing Account
519 Florida Boulevard
Denham Springs, LA 70726
Total Return New York Life Trust Company 2,319,911 (Class A) 51.83 (Class A)
Fund Client Accounts
51 Madison Avenue, Room 117A
New York, NY 10010
</TABLE>
- ----------
(1) This information, not being within the knowledge of the Trust, has been
furnished by each of the above persons. Beneficial ownership is as defined
under Section 13(d) of the Securities Exchange Act of 1934. Fractional
Shares have been omitted.
(2) Mr. George Daoust, in connection with his position with NYLIFE Distributors,
has the power to vote all of the shares shown in the above table owned by
NYLIFE Distributors. Mr. Daoust disclaims beneficial ownership of such
shares.
NYLIFE Distributors Inc. is a corporation organized under the laws of
Delaware. NYLIFE Distributors Inc. is a wholly owned subsidiary of NYLIFE Inc.,
and an indirect wholly owned subsidiary of New York Life Insurance Company.
CODE OF ETHICS
The Trust has adopted a Code of Ethics governing personal trading
activities of all Trustees, officers of the Trust and persons who, in connection
with their regular functions, play a role in the recommendation of any purchase
or sale of a security by the Trust or obtain information pertaining to such
purchase or sale or who have the power to influence the management or policies
of the Trust or an Investment Sub-Adviser unless such power is the result of
their position with the Trust or Investment Sub-Adviser. Such persons are
generally required to preclear all security transactions with the Trust's
Compliance Officer or his designee and to report all transactions on a regular
basis. The Trust has developed procedures for administration of the Code.
<PAGE>
FINANCIAL STATEMENTS
The financial statements of the Capital Appreciation Fund, California Tax
Free Fund, New York Tax Free Fund, Value Fund, Convertible Fund, Total Return
Fund, High Yield Corporate Bond Fund, Government Fund (formerly the Government
Plus Fund), Tax Free Bond Fund (formerly the MacKay-Shields MainStay Tax Free
Bond Fund), International Bond Fund, International Equity Fund, Equity Index
Fund and the Money Market Fund, including the Portfolio of Investments as of
December 31, 1996, the Statement of Assets and Liabilities as of December 31,
1996, the Statement of Operations for the year ended December 31, 1996, the
Statement of Changes in Net Assets for the years ended December 31, 1996 and
1995, the Notes to the Financial Statements and the Reports of Independent
Accountants, all of which are included in the 1996 Annual Reports to the
Shareholders are hereby incorporated by reference into this Statement of
Additional Information. In addition, unaudited financial statements of each of
the Funds including the Portfolio of Investments as of June 30, 1997, the
Statement of Assets and Liabilities as of June 30, 1997, the Statement of
Operations for the six months ended June 30, 1997, the Statement of Changes in
Net Assets for the six months ended June 30, 1997 and the Notes to the Financial
Statements are hereby incorporated by reference into the Statement of Additional
Information.
An audited financial statement for NYLIFE Inc. as of December 31, 1996, is
included in this Statement of Additional Information.
<PAGE>
[LOGO]
NYLIFE INC. AND SUBSIDIARIES
(affiliates of
New York Life Insurance Company)
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996 AND 1995
<PAGE>
1177 Avenue of the Americas Telephone 212 596 7000
New York, NY 10036 Facsimile 212 596 8910
[LOGO]
PRICE WATERHOUSE LLP
April 15, 1997
To the Board of Directors and
Stockholder of NYLIFE Inc.
REPORT OF INDEPENDENT ACCOUNTANTS
- ---------------------------------
We have audited the accompanying statutory basis consolidated statement of
financial position of NYLIFE Inc. and its subsidiaries (affiliates of New York
Life Insurance Company) as of December 31, 1996 and 1995, and the related
statutory basis consolidated statements of operations, of changes in
stockholder's equity and of cash flows for each of the three years in the period
ended December 31, 1996. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As described in Note 2, these financial statements were prepared in conformity
with accounting practices prescribed or permitted by the New York State
Insurance Department for valuing companies owned by an insurer, which is a
comprehensive basis of accounting other than generally accepted accounting
principles. The effects on the financial statements of the variances between
such practices and generally accepted accounting principles are described in
Note 2.
In our opinion, except for the effects of the matters described in the preceding
paragraph, the financial statements referred to above present fairly, in all
material respects, the financial position of NYLIFE Inc. and its subsidiaries at
December 31, 1996 and 1995, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1996, in
conformity with generally accepted accounting principles.
<PAGE>
To the Board of Directors and
Stockholder of NYLIFE Inc.
Page 2
April 15, 1997
Also, in our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of NYLIFE Inc. and its
subsidiaries at December 31, 1996 and 1995, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1996, on the basis of the accounting described in Note 2.
As described in Note 1, on January 1, 1996, New York Life Insurance Company
combined certain of its group life and health indemnity insurance operations
with a subsidiary of the Company. The combination has been treated as a
transaction between entities under common control and, accordingly, the
consolidated financial statements presented herein for periods prior to January
1, 1996 have been restated to reflect the combination as if it had occurred on
January 1, 1994.
/s/ Price Waterhouse LLP
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
--------------------------------------------
<TABLE>
<CAPTION>
December 31,
-----------------------------
(Restated)
1996 1995
---- ----
(in thousands)
ASSETS
------
<S> <C> <C>
Cash and cash equivalents $ 369,810 $ 302,780
Short-term investments 25 9,925
Premiums and accounts receivable less allowance for doubtful
accounts of $4,042 and $5,642, respectively 477,317 303,843
Liquidation advance recoverable 64,431 -
Interest and other receivables 60,318 74,580
Deferred distribution costs (net of accumulated amortization
of $229,711 and $172,254, respectively) 224,752 174,055
Investments:
Common stocks 7,042 5,520
Available for sale - bonds 200,442 611,644
Held to maturity - bonds 2,311 33,763
Insurance operations - bonds 32,411 29,201
Mortgage loans 6,769 116,963
Real estate 100,374 108,664
MainStay funds at fair value 47,263 33,762
Security alarm monitoring contracts held for sale 38,455 -
Security alarm monitoring contracts (net of accumulated amortization
of $22,499) - 48,425
Other investments and advances to affiliates 106,831 114,433
Statutory valuation of subsidiary in excess of GAAP net equity 99,527 406,834
Fixed assets (net of accumulated depreciation of $25,235 and
$59,044, respectively) 89,371 72,925
Income taxes receivable 11,345 2,412
Receivable from New York Life Insurance Company - 82,172
Net deferred tax asset and other assets 126,282 241,699
---------- ----------
Total assets $2,065,076 $2,773,600
========== ==========
LIABILITIES and STOCKHOLDER'S EQUITY
------------------------------------
Accrued HMO claims payable $ 229,802 $ 290,734
Policy and claim reserves - accident and health 127,722 225,000
Policy and claim reserves - life 67,657 95,885
Policyholder account balances and deposit funds - 304,214
Dividends payable to policyholders 30,100 28,926
Payable to New York Life Insurance Company 47,699 -
Accrued expenses and other payables 152,684 204,021
Payable on reinsurance assumed 26,507 -
Medical group risk sharing and unearned premiums 54,270 53,626
Notes payable 183,196 141,081
Net deferred tax liability and other liabilities 147,236 133,882
Accrued costs for liquidation of Limited Partnerships 10,404 137,000
---------- ----------
Total liabilities 1,077,277 1,614,369
---------- ----------
Minority interest 89,533 26,252
Stockholder's equity:
Common stock, par value $.10 per share (20,000 shares authorized,
3,850 shares issued and outstanding) and additional paid-in capital 1,066,921 946,546
Accumulated deficit (270,817) (240,623)
Investment valuation account 99,527 406,834
Net unrealized (losses) gains on available for sale investments (net of
taxes of $(764) and $8,832, respectively) (1,215) 19,099
Cumulative translation adjustment 3,850 1,123
---------- ----------
Total stockholder's equity 898,266 1,132,979
---------- ----------
Total liabilities and stockholder's equity $2,065,076 $2,773,600
========== ==========
The accompanying notes are an integral part of these financial statments
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF OPERATIONS
------------------------------------
<TABLE>
<CAPTION>
For the Years ended December 31,
-------------------------------
(Restated)
----------
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Revenues:
Premium revenue - net $2,363,290 $2,146,107 $1,989,309
Initial premiums on reinsurance assumed 478,145 - -
Fee income 988,957 762,149 541,101
Interest and dividend income 57,187 111,048 167,071
Commission income 95,858 50,378 26,068
Net realized and unrealized (losses) gains on investments (2,869) (7,418) 43,928
Realized gain on sale of interest in subsidiary 121,741 - 34,574
Equity in (loss) earnings of affiliates (699) 155 1,769
Gain on issuance of additional shares by public subsidiary 21,633 - -
Other income 20,936 12,282 3,708
---------- ---------- ----------
Total revenues 4,144,179 3,074,701 2,807,528
---------- ---------- ----------
Expenses:
HMO claims and capitation costs 1,402,025 1,184,977 1,034,071
Health, disability and death benefit claims 567,394 567,989 544,850
Cost of prescription sales 618,022 437,223 299,285
Initial reserve transfer on reinsurance assumed 478,147 - -
Increase in policy reserves - life 11,748 14,237 58,126
Employee compensation 339,974 286,811 259,850
Depreciation and amortization 112,794 103,779 70,764
Administrative charge from New York Life Insurance Company 64,605 40,848 41,956
Impairment of intangible asset 28,830 - -
Interest 15,594 29,784 46,719
Professional fees 38,407 32,822 26,792
Selling expenses 123,413 118,637 162,001
Rent expense 34,943 32,848 28,315
Interest crediting expense - 17,472 13,642
Administrative and other expenses 152,937 186,050 146,061
Provision for liquidation of Limited Partnerships - 137,000 -
---------- ---------- -----------
Total expenses 3,988,833 3,190,477 2,732,432
---------- ---------- -----------
Income (loss) before income taxes and minority
interest 155,346 (115,776) 75,096
Income tax expense (benefit) 76,325 (24,441) 22,435
---------- ---------- -----------
Income (loss) before minority interest 79,021 (91,335) 52,661
Minority interest 14,188 4,598 4,189
----------- ----------- -----------
Net income (loss) $ 64,833 $ (95,933) $ 48,472
=========== ============ ===========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY
---------------------------------------------------------
For the years ended December 31, 1996, 1995 (Restated) and 1994 (Restated)
<TABLE>
<CAPTION>
Common Net Unrealized
Stock & Gains (Losses)
Additional Investment on Available Cumulative Total
Paid-In Accumulated Valuation for Sale Translation Stockholder's
Capital Deficit Account Investments Adjustment Equity
---------- ----------- ---------- -------------- ----------- -------------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1993
as previously reported $482,390 $(122,303) $180,818 $ - $3,880 $544,785
Effect of business combination
(Note 1) - 55,376 - - - 55,376
---------- ----------- ---------- ----------- --------- -----------
Balance at December 31, 1993
as restated 482,390 (66,927) 180,818 - 3,880 600,161
Capital contributions 127,913 - - - - 127,913
Return of capital (11,230) - - - - (11,230)
Dividends - (72,946) - - (72,946)
Cumulative translation
adjustment - - - - (1,917) (1,917)
Statutory valuation of subsidiary
in excess of GAAP net equity - - 108,895 - - 108,895
Other equity adjustments - (10,768) (10,768)
Net unrealized losses on available
for sale investments - - - (26,213) - (26,213)
Net income - 48,472 - - - 48,472
---------- ---------- ------------ ------------ --------- ----------
Balance at December 31, 1994 599,073 (102,169) 289,713 (26,213) 1,963 762,367
Capital contributions 347,473 - - - - 347,473
Dividends - (41,900) - - - (41,900)
Cumulative translation adjustment - - - - (840) (840)
Statutory valuation of subsidiary
in excess of GAAP net equity - - 117,121 - - 117,121
Other equity adjustments - (621) - - - (621)
Net unrealized gains on available
for sale investments - - - 45,312 - 45,312
Net loss - (95,933) - - - (95,933)
---------- ---------- ------------ --------- ---------- ----------
Balance at December 31, 1995 946,546 (240,623) 406,834 19,099 1,123 1,132,979
Effect of business combination
(Note 1) - (88,130) - (17,375) - (105,505)
Capital contributions 120,375 - - - - 120,375
Change in prior year's retained
earnings - (7,102) - - - (7,102)
Cumulative translation adjustment - - - - 2,727 2,727
Statutory valuation of subsidiary
in excess of GAAP net equity - - (307,307) - - (307,307)
Other equity adjustments - 205 - - - 205
Net unrealized losses on available
for sale investments - - - (2,939) - (2,939)
Net income - 64,833 - - - 64,833
---------- ---------- ----------- ----------- ---------- -----------
Balance at December 31, 1996 $1,066,921 $(270,817) $ 99,527 $ (1,215) $ 3,850 $ 898,266
========== ========== ======== ========= ======= =========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CASH FLOWS
------------------------------------
Increase in Cash and Cash Equivalents
<TABLE>
<CAPTION>
For the Years ended December 31,
--------------------------------
(Restated)
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Cash flow from operating activities:
Net income (loss) $ 64,833 $ (95,933) $ 48,472
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 112,794 104,679 70,889
Impairment of intangible assets 28,830 - -
Insurance reserves 11,748 24,370 69,912
Gain on sale of shares of subsidiary (121,741) - (27,788)
Net realized and unrealized losses (gains) 2,869 9,870 (43,608)
Equity in loss (earnings) of affiliates 699 (155) (1,769)
Provision for deferred income tax expense (benefit) 87,295 (41,969) (494)
Minority interest 14,188 4,598 4,189
Gain on issuance of additional shares by public subsidiary (21,633) - -
Other 1,467 50 5,821
Change in assets and liabilities:
(Decrease) increase in bank overdrafts - (53,538) 53,538
Increase in premiums and accounts receivable (206,586) (95,884) (11,628)
(Increase) decrease in interest and other receivables (67,627) 3,632 (2,750)
Increase in liquidation advance recoverable (64,431) - -
Increase in deferred distribution costs and other assets (141,565) (93,479) (89,960)
Increase in accrued expenses and other payables 170,133 11,457 74,458
(Decrease) increase in accrued costs for liquidation of Limited
Partnership (126,596) 137,000 -
Increase (decrease) in payable to New York Life Insurance Company 28,970 (19,266) 12,249
Increase (decrease) in policy and claim reserves 143,096 (6,194) 1,707
Increase (decrease) in interest payable 211 (3,218) (9)
(Increase) decrease in income taxes receivable (57,330) 307 (30,551)
---------- ----------- ----------
Net cash (used in) provided by operating activities (140,376) (113,673) 132,678
---------- ----------- ----------
Cash flow from investing activities:
Capital expenditures (51,450) (44,854) (30,669)
Proceeds from sale of investments 209,383 857,479 1,252,103
Purchase of investments (229,664) (534,761) (1,381,194)
Sale of interest in subsidiaries, net of cash sold 138,497 - 34,574
Acquisition of subsidiaries, net of cash acquired (14,843) (15,765) (59,934)
Payments received on investments 46,423 6,992 45,231
Other 3,552 3,121 (3,373)
---------- --------- ------------
Net cash provided by (used in) investing activities $ 101,898 $ 272,212 $ (143,262)
---------- --------- ------------
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CASH FLOWS (cont.)
--------------------------------------------
Increase in Cash and Cash Equivalents
<TABLE>
<CAPTION>
For the Years ended Daecember 31,
---------------------------------
(Restated)
----------
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Cash flow from financing activities:
Capital contributions $97,784 $160,752 $114,226
Dividends paid (35,250) (32,584) (23,002)
Borrowings net of repayments under line of credit agreements 53,378 20,342 (72,896)
Payments applied against capital leases (779) (1,107) (1,251)
Proceeds from issuance of debt - 24,521 104,730
Principal repayment of debt (12,536) (310,644) (32,251)
Proceeds from issuance of shares by public subsidiary 52,592 - (3,499)
Other (Note 16) (52,839) 21,309 (36,459)
-------- --------- --------
Net cash provided by (used in) financing activities 102,350 (117,411) 49,598
-------- --------- --------
Effect of exchange rates on cash 3,158 (339) 4,997
-------- --------- --------
Net increase in cash and cash equivalents 67,030 40,789 44,011
Cash and cash equivalents at beginning of period 302,780 261,991 217,980
-------- --------- --------
Cash and cash equivalents at end of period $369,810 $ 302,780 $261,991
======== ========= ========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(AFFILIATES OF NEW YORK LIFE INSURANCE COMPANY)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
DECEMBER 31, 1996, 1995 AND 1994
NOTE 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS
- -------------------------------------------------
The accompanying financial statements reflect the consolidation of NYLIFE Inc.
("NYLIFE" or the "Company"), a wholly-owned subsidiary of New York Life
Insurance Company ("New York Life"), and its subsidiaries, each of which is
wholly-owned, except as noted:
Aegis Technologies, Inc. ("Aegis"), 94% owned
Eagle Strategies Corp. ("Eagle")
Greystone Realty Corporation ("Greystone")
MacKay-Shields Financial Corporation ("MacKay-Shields")
Monitor Capital Advisors, Inc.
MSC Holding, Inc. ("MSC"), 85% owned
New York Life Benefit Services Company, Inc. ("Benefit Services")
New York Life Capital Corporation ("Capital Corp.")
New York Life International Investment Inc. ("NYL International")
NYL Management Limited, formerly Quorum Capital Management
Monetary Research Limited ("MRL")
New York Life Irrevocable Trust of 1996 ("Trust")
New York Life Settlement Corporation ("NYLSET")
New York Life Worldwide Holding, Inc. ("Worldwide")
NYLCO, Inc.
NYLICO, Inc. ("NYLICO")
NYLIFE Administration Corp. ("NYLACOR")
NYL Trust Company ("NYL Trust")
NYLIFE Depositary Corporation ("Depositary")
NYLIFE Distributors Inc. ("NYLIFE Distributors")
NYLIFE Equity Inc. ("NYLIFE Equity")
NYLIFE Funding Inc. ("NYLIFE Funding")
NYLIFE HealthCare Management Inc. ("NYLIFE HealthCare"),
NYLCare Health Plans ("NYLCare"), formerly Sanus Corp. Health
Systems Express Scripts Inc. ("ESI"), 46% owned
NYLIFE Realty Inc. ("NYLIFE Realty")
NYLIFE Refinery Inc. ("NYLIFE Refinery")
NYLIFE Resources Inc. ("NYLIFE Resources")
NYLIFE Securities Inc. ("NYLIFE Securities")
NYLIFE SFD Holding, Inc.("SFD Holding"), formerly NAFCO, Inc. Auto
Funding II, LP, formerly NAFCO Auto Funding, LP
NYLINK Insurance Agency Corporation ("NYLINK")
NYLTemps Inc.
NYLIFE Inc., through its subsidiaries, offers health insurance, managed care and
related products and services, life insurance in certain international markets
and investment management, mutual fund, securities brokerage and pension
products and services. Through its health care related subsidiaries, primarily
NYLCare and ESI, the company develops and manages health maintenance
organizations ("HMOs"), markets mail order prescriptions and provides pharmacy
claims processing
<PAGE>
-2-
services and offers indemnity health insurance products and ancillary coverages
such as group life and disability insurance. HMO's are established under the
individual practice association model and provide comprehensive health care to
their members for a fixed monthly fee. Although indemnity products are offered
throughout the United States through the Company's group sales offices, HMO's
are centered in Texas, Washington, D.C., New York, New Jersey and Illinois.
International operations are conducted through Worldwide, which markets life
insurance and related products and services through joint ventures and equity
investments in Hong Kong, Korea, Indonesia, Mexico, Argentina, Bermuda and the
United Kingdom. Asset management operations primarily consist of institutional
asset management and mutual fund related products and services offered through
MacKay-Shields and the Mainstay Funds. Securities brokerage and mutual fund
distribution and administration services are conducted through NYLIFE Securities
and NYLIFE Distributors and pension and 401(k) products and services are offered
through Benefit Services and NYL Trust.
BUSINESS COMBINATION:
NYLCare was established on January 1, 1996 when New York Life combined certain
of its existing group life and health indemnity insurance operations with those
of Sanus Corp. Health Systems, an indirect wholly-owned managed care subsidiary
of New York Life, and renamed the company. Concurrently, New York Life also
transferred its ownership in New York Life and Health Insurance Company
(NYLHIC), a wholly-owned life insurance subsidiary, to NYLCare.
Also on January 1, 1996, NYLHIC entered into a modified coinsurance agreement
through which it assumed the risk on 90% of New York Life's group life and
health indemnity insurance business. Under the terms of the agreement, NYLHIC
assumes the risk for group life and health policies issued by New York Life;
however, New York Life retains the claim and policy reserves as well as the
related assets. The group life and health indemnity business will continue to be
written by New York Life and reinsured to NYLHIC until approval is granted by
various state insurance departments for NYLHIC to directly market such business.
For purposes of these financial statements, the combination has been treated as
a transaction between entities under common control and, accordingly, financial
statements presented for periods prior to January 1, 1996 have been restated to
include the assets, liabilities and operations of New York Life's group life and
health indemnity business during these periods. The approximate effects of
restatement are as follows: an increase in net income of $14,175,000 and
$18,579,000 for the years ended December 31, 1995 and 1994, respectively, and an
increase in total assets of $877,013,000 and an increase in stockholder's equity
of $105,505,000 as of December 31, 1995.
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
- ----------------------------------------
The accompanying statutory basis consolidated financial statements have been
prepared on the basis of accounting practices prescribed or permitted by the New
York State Insurance Department for valuing common stocks of subsidiaries (New
York statutory basis of accounting), which is a comprehensive basis of
accounting other than generally accepted accounting principles ("GAAP").
Prior to 1996 the New York statutory basis of accounting was considered GAAP for
mutual life insurance companies and their wholly-owned subsidiaries.
Accordingly, the Company's life insurance operations, which were presented on
the New York statutory basis of accounting, were
<PAGE>
-3-
described as presented in accordance with GAAP. However, in April 1995, the
Financial Accounting Standards Board issued Interpretation No. 40,
"Applicability of Generally Accepted Accounting Principles to Mutual Life
Insurance and Other Enterprises", which established a different definition of
GAAP for mutual life insurance companies and their subsidiaries. Under this
Interpretation, financial statements for mutual life insurance companies and
their subsidiaries, which are presented on the statutory basis of accounting,
can no longer be characterized as in conformity with GAAP.
The New York statutory basis of accounting for insurance subsidiaries varies
from those prepared under GAAP primarily as follows: (1) the costs relating to
acquiring business, principally commissions and certain policy issuance
expenses, are charged to income in the year incurred, whereas under GAAP, they
would be deferred and amortized over the periods benefited; (2) policy reserves
are based on different assumptions than under GAAP and dividends on
participating policies are provided when approved by the Board of Directors,
whereas under GAAP, they are provided when credited to the policies; (3) policy
reserves are recorded net of reinsurance, whereas under GAAP, such amounts are
reported gross; (4) the excess of purchase price over statutory net assets
acquired is charged to stockholder's equity in the year of acquisition, whereas
under GAAP, an intangible asset is established and amortized over a period of 15
to 25 years; (5) investments in bonds are generally carried at amortized cost,
whereas under GAAP, investments in bonds which are considered available for sale
or held for trading are generally carried at market value, with changes in
market value charged against equity or reflected in earnings; (6) certain assets
are considered 'non-admitted' and excluded from the statement of financial
position, whereas they are included under GAAP; (7) joint ventures and minority
stock investments are stated at the value of their underlying statutory net
assets, whereas under GAAP, such investments are stated on the equity basis; and
(8) deferred federal income taxes are not provided for as they are under GAAP.
In addition, goodwill arising from the purchase of non-insurance subsidiaries is
amortized over a period not to exceed ten years. Under GAAP, this goodwill would
be amortized over a period of 15 to 25 years. In 1993, New York Life received
authorization from the New York State Insurance Department to adopt approximate
market value as the carrying value for its investment in Express Scripts Inc., a
publicly traded 46% owned subsidiary of NYLIFE HealthCare. This practice is not
recognized under GAAP.
The approximate effects on the financial statements of the variances between the
practices described in the preceding paragraphs and generally accepted
accounting principles are as follows: a decrease in net income of $17,000,000,
$2,000,000 and $46,000,000 for the years ending December 31, 1996, 1995 and
1994, respectively, and an increase in total assets of $4,000,000 and a decrease
in total assets of $300,000,000, and a decrease in stockholder's equity of
$4,000,000 and $320,000,000 as of December 31, 1996 and 1995, respectively.
The consolidated statement of operations reflects the activities of purchased
subsidiaries from the acquisition date through the respective year-end date.
Intercompany accounts and transactions have been eliminated.
FEE INCOME:
The Company through its subsidiaries receives fees for services provided under
agreements with its clients. The Company accrues fee income when earned.
Additionally, the Company derives monitoring revenues from customer payments for
alarm monitoring services. The Company recognizes revenue as the monitoring
services are provided.
<PAGE>
-4-
FOREIGN CURRENCY TRANSLATION:
Assets and liabilities denominated in foreign currency have been translated into
U.S. dollars at the respective year end exchange rates. Operating results are
translated at the average exchange rates for the year. Foreign currency
translation gains and losses are credited or charged directly to the Cumulative
Translation Adjustment account in stockholder's equity. The change in the
Cumulative Translation Adjustment account is due to the current year effect of
the translation adjustment. Foreign currency transaction gains and losses are
included in net income.
CASH AND CASH EQUIVALENTS:
Cash equivalents are short-term, highly liquid investments that are readily
convertible to known amounts of cash and have original maturities at purchase of
three months or less. The carrying value of cash and cash equivalents
approximates fair value.
ACCOUNTS RECEIVABLE:
The carrying value of accounts receivable at December 31, 1996 and 1995
approximates fair value.
DEFERRED DISTRIBUTION COSTS:
Deferred distribution costs relate to commission expenses and certain other
costs related to the distribution of MainStay Funds which have a contingent
deferred sales charge, and are deferred and amortized over a six year period on
a straight-line basis, adjusted for related contingent deferred sales charge
income earned.
INVESTMENTS:
Short-term investments are carried at cost which approximates fair value. Common
stocks are stated at market value. At December 31, 1996 and 1995, bonds, other
than those associated with insurance operations, are either classified as held
to maturity and are reported at amortized cost or classified as available for
sale and are reported at estimated fair value, with unrealized gains and losses
reported as a separate component of stockholder's equity, net of deferred tax.
The investment in the MainStay Funds is primarily held by NYLIFE Securities and
NYLIFE Distributors, broker-dealers, and in accordance with specialized
accounting practices in their industry, is recorded at fair value, with
unrealized gains and losses included in income.
Mortgage loans are generally stated at the aggregate principal balance due,
except when in management's opinion collection of the loan is doubtful, in which
case the loan is written down to the appraised value of the underlying property.
Such writedowns are recorded as net losses on investments. Interest income is
recorded on the accrual basis, except where collection is 90 days past due or is
considered uncertain. Real estate acquired through foreclosure is valued at the
lower of the mortgage loan carrying value or the appraised (fair market) value
of the property at the time of foreclosure plus certain directly related
expenses. Any excess of the carrying value of the loan over the appraised value
is recorded as a realized loss. Prior to December 30, 1996, alarm monitoring
contracts were recorded at cost net of accumulated amortization. Effective on
this date, such contracts are recorded at the lower of carrying value or fair
value less cost to sell and the amortization of the contracts has been
discontinued (see Note 4). Investments in limited partnerships are generally
accounted for under the equity method of accounting. Under this method, net
earnings or losses are included in income currently.
FAIR VALUES OF FINANCIAL INSTRUMENTS:
Fair values of various assets and liabilities are included throughout the notes
to financial statements. Specifically, fair value disclosure of bonds, mortgage
loans, real estate and the investment in the
<PAGE>
-5-
MainStay Funds is reported in Note 6, and fair value disclosure of notes payable
is reported in Note 9. Fair values of bonds and the investment in the MainStay
Funds are based on published or quoted market values, respectively. Fair value
of mortgage loans is estimated based on discounted cash flow analyses prepared
for each loan using interest rates approximating the current rates for new
mortgages with similar remaining maturities.
FIXED ASSETS:
Fixed assets are recorded at cost and are depreciated over the estimated useful
lives of the assets, generally 3 to 10 years, using the double-declining balance
and straight-line methods of depreciation.
INTANGIBLE ASSETS:
Intangible assets primarily consist of goodwill arising from acquisitions.
Goodwill, which represents the cost in excess of the value assigned to net
assets acquired in connection with acquisitions, is being amortized over 10
years, unless deemed to be impaired, in which case it is written off to the
extent considered unrecoverable (see Note 4).
PREMIUM REVENUE RECOGNITION:
Premium revenue for indemnity health insurance and managed health care and other
ancillary coverage is recorded as income over the premium paying period of the
policies. Revenue on premiums collected in advance is deferred.
Revenues from dispensing prescription and non-prescription medical products from
ESI's mail service pharmacies are recorded upon shipment. Revenue from sales of
prescription drugs by pharmacies in ESI's nationwide network and pharmacy claims
processing revenues are recognized when the claims are processed. When ESI has
an independent contractual obligation to pay its network pharmacy providers for
benefits provided to members of its clients' pharmacy benefit plans, ESI
includes payments from plan sponsors for these benefits as prescription sales
and fees and payments to these pharmacy providers in cost of prescription sales.
If ESI is only administering the plan sponsors' network pharmacy contracts, ESI
records fees derived from ESI's contracts with plan sponsors as net revenue.
CLAIMS, BENEFITS AND CAPITATION COSTS:
Claims and benefits include estimates of payments to be made on individual
claims for medical and ancillary services and for death benefits. The cost of
claims incurred but not reported is estimated using actuarial techniques based
on current membership statistics, current utilization and historical claims data
and trends. These estimates are continually reviewed and revised as changes in
these factors occur and revisions are reflected in the current year's statement
of income. Capitation costs represent monthly charges paid to participating
physicians as compensation for providing continuing medical care.
COST OF PRESCRIPTION SALES:
Costs of prescription sales includes product costs, pharmacy claims payments and
other direct costs associated with dispensing prescription and non-prescription
medical products and claims processing operations, offset by fees received from
pharmaceutical manufacturers in connection with ESI's drug purchasing and
formulary management programs.
POLICYHOLDER ACCOUNT BALANCES AND DEPOSIT FUNDS:
Policyholders' account balances for investment-type contracts and dividends and
policy proceeds deposited with the Company are equal to the policy account
values. The policy account values
<PAGE>
-6-
represent an accumulation of gross premium payments plus credited interest less
expense and mortality charges and withdrawals. Dividends and policy proceeds
deposited with the Company consist of dividend accumulations and supplementary
contracts without life contingencies. The statement value for these liabilities
approximates fair value.
DIVIDENDS PAYABLE TO POLICYHOLDERS:
The liability for dividends payable to policyowners consists principally of
dividends earned as of the statement date. The allocation of dividends is
determined by means of formulas which reflect the relative contribution of each
group of policies to the results of operations.
ACCRUED EXPENSES AND OTHER PAYABLES:
The carrying value of accrued expenses and other payables at December 31, 1996
and 1995 approximates fair value.
MEDICAL GROUPS' RISK SHARING:
NYLCare compensates primary care physicians on a capitation basis. NYLCare has
in place an incentive program whereby primary care physicians are eligible to
receive a bonus based on quality and cost utilization criteria. An accrual is
made for the estimate of the amount of bonus which will be paid to medical care
providers based upon quality cost utilization criteria.
NYLCare also has risk contracts with provider groups covering certain medical
services. To the extent medical expenses differ from budget, NYLCare and the
providers share any savings or deficit as defined in the contracts.
NOTE 3 - BUSINESS RISKS AND UNCERTAINTIES:
- -----------------------------------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual
results could differ from those estimates.
At December 31, 1996, the Company's investments were comprised of common stock,
bonds, real estate properties and mortgage loans. Significant changes in
prevailing interest rates and geographic conditions may adversely affect the
timing and amount of cash flows on such investments, as well as their related
values. In addition, the value of these investments is often derived from an
appraisal, an estimate or opinion of value. A significant decline in the market
value of these investments could have an adverse affect on the Company's balance
sheet.
During 1993, New York Life received authorization from the New York State
Insurance Department to adopt approximate market value as the carrying value for
its investment in ESI. Accordingly, the Company recorded adjustments of
$99,527,000 and $406,834,000 for the statutory valuation of ESI in excess of its
GAAP net equity at December 31, 1996 and 1995, respectively. These adjustments
are included as a component of stockholder's equity. Based upon the market value
of ESI's common stock at April 11, 1997, the amount of the statutory valuation
of subsidiary in excess of GAAP net equity was approximately $94,036,000. A
significant decline in the value of this stock could have an adverse effect on
the Company's stockholder's equity.
<PAGE>
-7-
As providers of life and health insurance products, the operating results of
certain subsidiaries in any given period depend upon estimates of policy
reserves required to provide for future policyholder benefits. The development
of policy reserves for the products of these companies requires management to
make estimates and assumptions regarding mortality, morbidity, health care
costs, lapses, expenses and investment experience. Such estimates, including
provisions for incurred but not reported claims, are primarily based on
historical experience and, at times, the specific requirements of local
insurance regulators. Actual results could differ from these estimates.
Management monitors actual experience, and, where circumstances warrant, revises
its assumptions and the related estimates of policy reserves and claim
liabilities.
As substantially all of the net assets of Worldwide's subsidiaries are held in
foreign countries, there is a potential for adverse impact on net assets arising
from economic and political changes in these countries.
NOTE 4 - CHANGES IN ACCOUNTING PRINCIPLES
- -----------------------------------------
NYLCARE:
During 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 121 ("SFAS 121"), "Accounting for the
Impairment of Long-lived Assets to be Disposed Of," which is effective for the
fiscal years beginning after December 15, 1995. SFAS 121 establishes accounting
standards for the impairment of long-lived assets, certain identifiable
intangibles and goodwill related to those assets to be held and used and for
long-lived assets and certain identifiable intangibles to be disposed of.
In connection with the adoption of SFAS 121 in 1996, NYLCare determined that
continuing operating losses of certain subsidiaries which perform administrative
services for physician groups, were indicators of potential impairment. The
estimated undiscounted cash flows anticipated from these subsidiaries indicated
that a write-down of the goodwill related to these subsidiaries was required
under SFAS 121. As a result of the above, approximately $28,830,000 of goodwill
and other intangibles was written off in 1996.
SFD HOLDING AND DEPOSITARY:
On December 30, 1996, Westinghouse Electric Corporation ("Westinghouse") (the
servicer of the security alarm contracts) sold its security alarm business to
WestSec Inc. As part of this transaction, NYLIFE Structured Asset Management
Company Ltd. ("SAMCO", a subsidiary of SFD Holding - 83% and Depositary -17%),
Westinghouse, WestSec Inc. and an affiliate of WestSec Inc. entered into a
Consent, Assignment, Assumption, and Modification Agreement ("the Consent
Agreement"). In connection with the Consent Agreement, WestSec has committed to
purchase, and SAMCO has committed to sell, the security alarm contracts ("the
Contracts") securing each series of notes used to finance the acquisition of the
Contracts at fixed dates in the future for a determinable price. In accordance
with SFAS 121, SAMCO has reported such Contracts at the lower of carrying amount
or fair value less cost to sell and has discontinued amortization of the
Contracts effective December 30, 1996.
ESI
CONTRACTUAL AGREEMENTS:
ESI enters into corporate alliances with certain of its clients whereby shares
of ESI's class A common stock are awarded as advance discounts to the client.
Prior to December 15, 1995, the stock is valued utilizing the quoted market
value at the date the agreement is consummated if the number
<PAGE>
-8-
of shares to be issued is known. If the number of shares to be issued is
contingent upon the occurrence of future events, the stock is valued utilizing
the quoted market value at the date the contingency is satisfied and the number
of shares is determinable. The value of the shares of stock awarded as advance
discounts is recorded as a deferred cost and included in other assets. The
deferred cost is recognized in selling, administrative and other expenses over
the period of the contract.
In October 1995, the Financial Accounting Standards Board issued Statement 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), effective for all stock
issued to non-employees subsequent to December 15, 1995. SFAS 123 requires that
all stock issued to non-employees be accounted for based on the fair value of
the consideration received or the fair value of the equity instruments issued
instead of the intrinsic value method utilized for stock issued or to be issued
under alliances entered into prior to December 15, 1995. ESI has adopted SFAS
123 as it relates to stock issued under alliances consummated subsequent to
December 15, 1995, based on fair value at the date the agreement is consummated.
ACCOUNTING FOR STOCK-BASED COMPENSATION:
ESI accounts for employee stock options in accordance with Accounting Principles
Board No. 25 (APB 25), "Accounting for Stock Issued to Employees." Under APB 25,
ESI applies the intrinsic value method of accounting and, therefore, does not
recognize compensation expense for options granted, because options are only
granted at a price equal to market value at the time of grant. SFAS 123
prescribes the recognition of compensation expense based on the fair value of
options determined on the grant date. However, SFAS 123 grants an exception that
allows companies currently applying APB 25 to continue using that method. ESI
has, therefore, elected to continue applying the intrinsic value method under
APB 25.
NOTE 5 - ACQUISITIONS AND DISPOSITIONS
- --------------------------------------
NYLIFE HEALTHCARE:
During 1996 and 1995, NYLIFE Inc. paid $7,076,000 and $10,800,000, respectively,
to the three original Founders of NYLIFE HealthCare to purchase their remaining
NYLIFE HealthCare shares in accordance with their Termination, Severance and
Stock Buyback Agreements. Subsequent to the purchase of these shares, NYLIFE's
ownership of NYLIFE HealthCare increased to 100%.
During 1995 and 1994, NYLCare completed four acquisitions for cash, as described
below. Each transaction was accounted for as a purchase and accordingly, the
purchase price was allocated to the fair values of assets acquired and
liabilities assumed. The remaining excess of the purchase price over such fair
values was allocated to goodwill. The operating results of each acquisition have
been included in consolidated net income of the Company from the date of
acquisition.
In July 1995, NYLCare acquired the minority shareholder's interest in
Lonestar Holding Company for approximately $4,100,000 in cash. As a
result of the transaction, the Houston HMO became a wholly-owned
subsidiary of NYLCare. Goodwill related to the purchase of
approximately $2,700,000 is being amortized over an estimated useful
life of 10 years.
In November 1994, NYLCare purchased 100% of the outstanding stock of
The Ethix Corporation, which included 13% owned by NYLIFE, for a
purchase price of approximately $32,900,000. The fair values of
assets acquired and liabilities assumed were $25,800,000
<PAGE>
-9-
and $16,200,000, respectively. Goodwill of approximately $23,300,000
related to the purchase is being amortized over an estimated useful
life of 10 years. The acquisition agreement provides for additional
consideration to be paid based on membership increases over the five
year period ending November 1999. No such amounts were incurred
through 1996.
In June 1994, NYLCare acquired certain assets and assumed certain
liabilities of two partnerships which performed administrative
services for a physician group in the New York City metropolitan
area. Cash paid totaled $10,000,000 plus the assumption of an excess
of the fair value of liabilities over assets acquired of $17,200,000.
Goodwill associated with the acquisition of $27,200,000 is being
amortized over an estimated useful life of 10 years.
In May 1994, NYLCare purchased the remaining 12% minority interest in
Avanti Health Systems. The entire purchase price of $10,000,000 was
allocated to goodwill, which was being amortized over an estimated
useful life of 10 years, but was written off in 1996 under SFAS 121.
In April 1996, ESI completed a public offering of 1,150,000 shares of Class A
common stock and received $52,592,000 in net proceeds. NYLIFE HealthCare
recognized a pre-tax gain of $21,633,000, representing the difference between
NYLIFE HealthCare's interest in the net assets of ESI immediately after the
public offering and the historical book value of its investment in ESI. As part
of the same stock offering, NYLIFE HealthCare converted 2,990,000 shares of ESI
Class B Common Stock to Class A Common Stock. Net proceeds from the sale totaled
$138,497,000 and a pre-tax gain of approximately $121,741,000 was recognized. As
a result of these transactions, NYLIFE HealthCare's ownership of ESI decreased
from 70% to 46% and its voting stock from 96% to 90%.
WORLDWIDE HOLDING
UNITED KINGDOM:
On December 22, 1994, New York Life UK Limited ("NYLUK"), a wholly-owned
subsidiary of New York Life Worldwide Holding, Inc., sold 68.75% of the common
stock of its wholly-owned subsidiary, Windsor Life Assurance Company Ltd., to
outside investors. Also during December, 1994, NYLUK and the new stockholders of
Windsor Life exchanged all of their common stock of Windsor Life for common
stock of Life Assurance Holding Corporation Limited ("LAHC"), a new holding
company. NYLUK is party to the Warranty Indemnity Deed (guaranteed by Worldwide)
relating to the sale of the common stock of Windsor Life. Under the terms of
this deed, NYLUK has undertaken to indemnify the outside investors against
liabilities, costs and expenses incurred with regard to specified matters. Any
claims under the deed require NYLUK to subscribe for deferred shares in LAHC at
par value. Management believes that adequate provision has been made for
potential claims that may arise.
The total income, total benefits and expenses and realized gains on investments
of Windsor Life presented in the Consolidated Statement of Operations during
1994 amounted to $212,326,000, $259,151,000 and $58,617,000, respectively.
Dividend income earned by NYLUK on it's investment in LAHC during the year ended
December 31, 1996, amounted to $3,673,000.
<PAGE>
-10-
NYL BENEFIT SERVICES COMPANY, INC.
Effective June 6, 1994, NYLIFE acquired Benefit Services, a provider of
consulting, administrative, actuarial, communications and investment advisory
services for employee benefit plan sponsors, with an initial cash payment of
$8,000,000, plus a series of future cash payments, exercisable from the fifth to
tenth year. The future cash payments are based on the joint assets of New York
Life and its affiliates related to the Company's 401(k) Complete product.
Approximately $6,640,000 of the original purchase price plus $1,800,000 of the
estimated future cash payments has been allocated to goodwill, which is being
amortized over an estimated useful life of 10 years.
MSC HOLDING, INC.
During 1995, the assets of the Health and Investment Divisions were sold to
Meritech, a subsidiary of Summit Technologies and Melson Technologies, an
indirect subsidiary of Aegon Insurance, respectively. Meritech purchased the
Health Division assets for approximately $750,000 which included contracts,
licenses, equipment and various receivables. Melson Technologies purchased the
Investment Division assets for a contingent purchase price of $3,500,000.
$1,000,000 of the purchase price is guaranteed and is expected to be received by
MSC within three years. As of December 31, 1996, $77,000 has been received. The
remaining $2,500,000 is contingent upon the amount of licensing fees the buyers
receive over the next 10 years relating to the SMS Investment System, which is
currently under development. A total gain of approximately $1,695,000 was
recognized on these transactions.
NEW YORK LIFE CAPITAL CORP.
New York Life Capital Corp. was incorporated in Delaware in June 1995. Capital
Corp's activities will primarily consist of issuing commercial paper and
borrowing from other sources for the purpose of making loans to New York Life
and its affiliates. Capital Corp. has not yet commenced operations.
NYLINK INSURANCE AGENCY CORPORATION
NYLINK Insurance Agency Corporation was incorporated in Delaware in November
1996. NYLINK's activities will primarily consist of the facilitation of sales of
non-proprietary insurance products by New York Life registered representatives.
NYLINK has not yet commenced operations.
NYL TRUST COMPANY
NYL Trust was incorporated in New York on February 2, 1995 as a limited purpose
trust company chartered by the New York State Banking Department to act as a
fiduciary for pension, profit sharing and other employee benefit plans. NYL
Trust's responsibilities include acting as a trustee or custodian for 401(k)
plans and Individual Retirement Accounts.
NYL MANAGEMENT LTD.
On June 18, 1996, Quorum Capital Management Ltd. ("Quorum") transferred its
assets and business operations to Westdeutsche LandesBank (West LB) for
approximately $1,125,000. A gain of approximately $969,000 has been recognized
on this transaction. Quorum subsequently changed its name to NYL Management Ltd.
and substantially ceased on-going operations.
AUTO FUNDING II, LP
NAFCO Auto Funding L.P. ("Funding") was organized as a limited partnership in
1993. Depositary was the general partner and SFD Holding was the limited
partner. On August 15, 1996, Funding assigned all of its financial assets and
liabilities to Auto Funding II L.P. ("Funding II"), a limited partnership with
an ownership structure identical to Funding. Subsequent to the assignment of
assets
<PAGE>
-11-
to Funding II, Depositary and SFD Holding sold their interests in Funding to an
unaffiliated third party. Consideration for the sale of Funding included
$200,000 in cash and $2,000,000 of 6% cumulative preferred stock and 10% of the
common stock of NAFCO Holding Company, Inc., a subsidiary of the purchaser. The
cumulative preferred stock is redeemable under various circumstances, but in any
event within 10 years.
NYLIFE EQUITY AND NYLIFE REALTY
In 1995, New York Life, NYLIFE, and certain other affiliated and unaffiliated
entities, entered into a Stipulation of Settlement (the "Settlement Agreement")
of a class action lawsuit related to the sale of units in, and the operation of,
the Company's proprietary limited partnership programs. In connection with the
Settlement Agreement, New York Life announced a plan to dissolve the partnership
programs (the "Plan"), contingent upon the consent of the Limited Partnership
Investors (the "Investors"). In 1995, NYLIFE recorded a provision of
$137,000,000 to reflect the estimated costs of discontinuing the partnership
operations and certain claims in connection therewith, including settlement of
the class action lawsuit. Both the Settlement Agreement and the Plan were
approved during 1996.
Pursuant to the Plan, NYLIFE Equity and NYLIFE Realty, as liquidators, have
commenced the process of winding up the partnership programs. Substantially all
of the property interests of the partnership programs were sold prior to
December 31, 1996. As of December 31, 1996, pursuant to the Settlement
Agreement, NYLIFE has advanced $174,000,000 to the Investors and has paid
$35,397,000 to other unaffiliated entities for costs of the liquidation,
primarily from proceeds from a $200,000,000 line of credit with New York Life.
In exchange for advances received under the Settlement Agreement, each Investor
granted a security interest to NYLIFE (up to the amount of advances) in any
future distributions from liquidation of the partnerships. Through December 31,
1996, the Company has recovered $18,734,000 from liquidating dividends and has a
liquidation advance recoverable of $64,431,000 as of December 31, 1996.
NEW YORK LIFE IRREVOCABLE TRUST
On February 13, 1996, The New York Life Irrevocable Trust of 1996, (the "Trust")
was created to hold the stock of NYLSET. NYLIFE, as Grantor of the Trust,
transferred its 100% ownership of NYLSET to the Trust, making NYLIFE the
beneficiary.
AEGIS TECHNOLOGIES
In December 1995, the Aegis Technologies' Board of Directors approved a plan to
close the business and dissolve Aegis in the event a suitable buyer could not be
found. On March 5, 1996, the decision to dissolve Aegis and its subsidiary,
Personal Financial Assistant Financial Centers was announced.
The assets were liquidated and a loss of $5,420,000 was recognized.
NYLIFE RESOURCES
In December 1993, NYLIFE Resources became a limited partner in the Ancon
Partnership Limited ("Ancon"). The partnership was formed to acquire, explore,
develop, and operate oil and gas properties.
<PAGE>
-12-
In December 1996, NYLIFE Resources, along with New York Life and New York Life
Insurance and Annuity Corporation (a wholly owned subsidiary of New York Life)
entered into a purchase and sale agreement with American Exploration Company,
the general partner. NYLIFE Resources sold its remaining 11.23% in Ancon for
$1,813,000 in cash. The estimated investment value was $2,173,000, resulting in
a loss of $360,000.
NOTE 6 - INVESTMENTS
- --------------------
COMMON STOCK:
The common stock portfolio, which is stated at market value, primarily consists
of securities issued in the United Kingdom which are denominated in British
Pounds Sterling at December 31, 1996 and 1995.
BONDS:
At December 31, 1996, the maturity distribution of bonds was as follows (in
thousands):
<TABLE>
<CAPTION>
Available for Sale Held to Maturity Life Insurance Operations
------------------ ---------------- -------------------------
Amortized Estimated Amortized Estimated Statement Estimated
Cost Fair Value Cost Fair Value Value Fair Value
--------- ---------- --------- ---------- --------- ----------
<S> <C> <C> <C> <C> <C> <C>
Due in one year or less $ 39,797 $ 39,830 $ - $ - $ 716 $ 716
Due in years two through five 85,322 85,670 - - 6,572 6,703
Due in years six through ten 59,969 58,908 - - 17,595 19,107
Due after ten years 13,088 12,399 2,311 2,431 7,528 8,274
--------- --------- --------- --------- --------- ----------
Sub-total 198,176 196,807 2,311 2,431 32,411 34,800
Asset-backed securities 3,658 3,635 - - - -
--------- ---------- --------- --------- -------- ---------
Total $201,834 $200,442 $ 2,311 $ 2,431 $ 32,411 $ 34,800
======== ======== ========= ========= ======== =========
</TABLE>
At December 31, 1996 and 1995, the distribution of unrealized gains and losses
on bonds was as follows (in thousands):
DECEMBER 31, 1996
<TABLE>
<CAPTION>
Amortized Unrealized Unrealized Estimated
Available for sale Cost Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury and other
U.S. Governmental Agencies $ 97,430 $ 256 $ 880 $ 96,806
Commercial paper and Corporate notes 99,983 682 1,450 99,215
Other 4,223 - - 4,223
Certificates of deposit 198 - - 198
-------- ------ ------- --------
Total $201,834 $ 938 $ 2,330 $200,442
======== ====== ======= ========
<CAPTION>
Amortized Unrealized Unrealized Estimated
Held to maturity Cost Gains Losses Fair Value
- ---------------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury and other
U.S. Governmental Agencies $2,311 $ 120 $ - $2,431
====== ======= ============ ======
</TABLE>
<PAGE>
-13-
<TABLE>
<CAPTION>
Statement Unrealized Unrealized Estimated
Insurance Operations: Value Gains Losses Fair Value
- -------------------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Foreign Governments $ 10,782 $ 1,281 $ - $12,063
Corporate 15,520 951 190 16,281
Other 6,109 384 37 6,456
-------- ---------- --------- -------
Total $ 32,411 $ 2,616 $ 227 $34,800
======== ========== ========= =======
<CAPTION>
DECEMBER 31, 1995
Amortized Unrealized Unrealized Estimated
Available for sale Cost Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury and other
U.S. Governmental Agencies $318,830 $12,101 $ 224 $ 330,707
Commercial paper and Corporate notes 265,170 16,455 1,039 280,586
Certificates of deposit 337 14 - 351
-------- ------- ------ ---------
Total $584,337 $28,570 $1,263 $611,644\
======== ======= ====== =========
<CAPTION>
Amortized Unrealized Unrealized Estimated
Held to Maturity Cost Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Commercial paper and Corporate notes $33,763 $3,397 $ - $37,160
======= ====== ========== =======
<CAPTION>
Statement Unrealized Unrealized Estimated
Insurance Operations: Value Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Foreign Governments $ 12,240 $ 869 $ 4 $ 13,105
Corporate 16,961 1,548 358 18,151
-------- ---------- -------- ---------
Total $ 29,201 $ 2,417 $ 362 $ 31,256
======== ========== ======== =========
</TABLE>
Proceeds from investments in bonds sold, matured, or repaid were $182,786,000,
$624,801,000, and $651,365,000 for 1996, 1995 and 1994, respectively. Realized
gains from investments in bonds sold, matured, or repaid were $705,000,
$10,164,000 and $6,551,000 for 1996, 1995 and 1994, respectively, and realized
losses were $12,000, $3,844,000 and $3,796,000 for 1996, 1995 and 1994
respectively.
Investment in bonds include $65,610,000 and $58,585,000 of restricted securities
on deposit to meet statutory solvency requirements, for 1996 and 1995,
respectively.
<PAGE>
-14-
MORTGAGE LOANS:
At December 31, 1996 and 1995 the geographic diversification of the mortgage
loan portfolio was as follows (in millions):
1996 1995
---- ----
United States:
Pacific $6.8 $33.8
Central - 20.8
Middle Atlantic - 36.6
South Atlantic - 20.2
New England - .5
Mountain - 2.8
Other - 2.3
---- ------
Total $6.8 $117.0
==== ======
Mortgage loans are secured by first liens on all properties. The mortgage loan
portfolio consisted of one loan at December 31, 1996 is summarized below (in
thousands):
Statement
Property Type State Loan Period Interest Rate Value
- ------------- ----- ----------- ------------- ---------
Shopping Center CA 1993 - 1998 8.750% $6,769
The fair value of the mortgage loan portfolio was $6,769,000 and $116,488,000 at
December 31, 1996 and 1995, respectively, estimated based on discounted cash
flow analyses prepared for each loan using interest rates approximating the
current rates for new mortgages with similar remaining maturities. Fair values
do not necessarily represent the values for which these loans could have been
sold at December 31, 1996 or 1995; therefore, care should be exercised in
drawing any conclusions from these fair values.
Write downs related to declines in the appraised value of properties underlying
mortgage loans totaled $0 and $9,335,000 in 1996 and 1995, respectively.
During 1996, Funding foreclosed on two mortgage loans and collected a prepayment
on one mortgage loan. Funding recorded a realized loss of $929,000 as a result
of these transactions.
During 1995, fourteen loans were sold to New York Life (see note 11).
<PAGE>
-15-
REAL ESTATE:
At December 31, 1996 and 1995, real estate included the following properties
which were acquired through foreclosure (in millions):
Carrying Value
Year ----------------
Property Type State Acquired 1996 1995
- ------------- ----- -------- ---- ----
Office MD 1991 $75.8 $ 74.5
Shopping Center FL 1991 3.5 -
Office NY 1992 18.8 17.6
Office TX 1933 - 3.0
Office MI 1994 - 4.0
Office CT 1994 - 5.0
Office NJ 1995 - 2.5
----- -------
Total $98.1 $106.6
----- ===== ======
At December 31, 1996 and 1995, real estate also included $2,300,000 and
$2,100,000 associated with Worldwide operations.
During 1996, Funding foreclosed on two delinquent mortgage loans and transferred
them at their appraisal value to real estate. Funding recorded a realized gain
of $773,000 as a result of these transactions.
In January 1995, a previously acquired apartment property was sold to New York
Life for cash (see Note 11).
MAINSTAY FUNDS:
At December 31, 1996 the total investment in the MainStay Funds includes
investments in individual funds as follows (in thousands):
Fund Cost Fair Value
- ------------------------ ---- -----------
California Tax Free $ 3,867 $ 3,751
Capital Appreciation 56 137
Convertible 81 115
Corporate Bond 539 521
Equity Index 122 234
Institutional Growth 1,124 1,106
International Equity 8,428 8,806
International Bond 8,578 9,353
High Yield Corporate Bond 91 112
Short-Term Bond 15,859 15,130
New York Tax Free 6,232 6,049
Total Return 55 90
Value 1,830 1,859
------- --------
Total 1996 $46,862 $47,263
======= =======
Total 1995 $33,084 $33,762
======= =======
<PAGE>
-16-
SECURITY ALARM CONTRACTS:
At December 31, 1996, the carrying amount of security alarm monitoring contracts
held for sale includes Contracts collateralizing Series A, B and C Notes (see
Note 7) as follows (in thousands):
Series A Series B Series C Total
Carrying amount $9,112 $3,711 $25,632 $38,455
Investment in security alarm monitoring contracts at December 31, 1995 includes
Contracts collateralizing Series A, B and C Notes as follows (in thousands):
<TABLE>
<CAPTION>
Series A Series B Series C Total
-------- -------- -------- -----
<S> <C> <C> <C> <C>
Investment in security alarm monitoring contracts $23,000 $8,665 $44,604 $76,269
Less: Purchase Price Refunds 2,234 890 2,221 5,345
Accumulated Amortization 9,322 3,187 9,990 22,499
------------ ------- --------- --------
Net investment $11,444 $4,588 $32,393 $48,425
============ ====== ======= =======
</TABLE>
Prior to the reclassification of the Contracts as held for sale effective
December 30, 1996, the Contracts were being amortized over an estimated life of
12 years, as adjusted for attrited Contracts. Amortization expense for the
period January 1, 1996 to December 30, 1996 for Series A, B and C Contracts was
$9,924,000. Amortization expense for the years ended 1995 and 1994 was
$10,292,000 and $7,573,000, respectively.
TIME DEPOSITS:
Time deposits, included in cash and cash equivalents, at December 31, 1996 and
1995 amounted to $11,889,000 and $8,155,000, respectively.
OTHER INVESTMENTS:
Other investments include interests in limited partnerships which consist
primarily of an oil refinery and oil and gas producing properties valued at
$32,403,000 and $38,966,000 at December 31, 1996 and 1995, respectively.
As described in Note 5, in connection with the Settlement Agreement, the
Investors approved a plan to dissolve the partnership programs in which NYLIFE
Equity and NYLIFE Realty have interests in. Substantially all of the property
interests of these partnership programs have been sold prior to December 31,
1996. Accordingly, NYLIFE Equity's and NYLIFE Realty's interests in the
partnership programs at December 31, 1996 are comprised principally of cash
received from the sales and other miscellaneous assets and liabilities.
<PAGE>
-17-
NOTE 7 - FIXED ASSETS
- ---------------------
At December 31, 1996 and 1995 fixed assets, at cost, are comprised of the
following (in thousands):
1996 1995
---- ----
Furniture $ 7,825 $ 22,021
Equipment 73,481 41,737
Computer hardware 7,725 30,315
Computer software 7,275 7,646
Leasehold improvements 5,687 19,084
Other 12,613 11,166
-------- --------
114,606 131,969
Less accumulated depreciation and amortization 25,235 59,044
-------- --------
Total $ 89,371 $ 72,925
======== ========
NOTE 8 - POLICY AND CLAIM RESERVES - ACCIDENT AND HEALTH
- --------------------------------------------------------
Activity in the liability for policy and claim reserves for accident and health
insurance for 1996 and 1995 is summarized as follows (in millions):
<TABLE>
<CAPTION>
1996 1995
---- ----
<S> <C> <C>
Gross balance at January 1 $225 $199
Effect of business combination (Note 1) (225) -
---- ----
Gross balance at January 1, as adjusted - $199
---- ----
Gross incurred related to:
Current year 459 465
Prior years - 6
Initial transfer for reserves under the modco reinsurance
agreement 478 -
----- ----
Total gross incurred 937 471
----- ----
Gross paid related to:
Current year 331 342
Prior years - 103
Retransfer of reserves under the modco reinsurance
agreement 478 -
----- ----
Total gross paid 809 445
----- ----
Gross balance at December 31 $ 128 $225
===== ====
</TABLE>
On January 1, 1996, in accordance with the terms of the initial settlement of
the modified coinsurance agreement, New York Life transferred $478,149,000 to
NYLHIC representing reserves and an equal amount of premiums on existing
business. NYLHIC immediately retransferred the reserves back to New York Life.
As a result of the above transactions, NYLHIC recorded premiums assumed and an
increase in policy reserves on the initial settlement of $478,149,000 in the
statement of operations.
<PAGE>
-18-
The modified coinsurance reserve retained by New York Life related to the
reinsured group life and health indemnity business is $498,255,000 at December
31, 1996.
NOTE 9 - NOTES PAYABLE
- ----------------------
Notes payable, generally carried at the unpaid principal balance, consisted of
the following at December 31, 1996 and 1995 (in thousands):
<TABLE>
<CAPTION>
1996 1995
---------- -------
<S> <C> <C>
Worldwide-Loan from Windsor Life $ 6,103 $ 6,434
Series A and B, Floating Rate Secured Five Year Notes 17,146 20,628
Series C 9% Fixed Rate Secured Five Year Notes 26,596 32,218
Loans payable to New York Life 113,220 59,842
Bank borrowings and revolving line of credit with financial institutions 14,222 15,732
Other (including current portion) 5,909 6,227
-------- --------
$183,196 $141,081
======== ========
</TABLE>
The carrying value of notes payable approximates fair value.
The $17,146,000 of Series A and B Floating Rate Secured Five Year Notes are
collateralized by security alarm monitoring contracts, and pay interest
quarterly at a per annum floating rate based on the minimum denomination
five-year certificate of deposit average rate as reported by Bank Rate Monitor.
Principal is paid down on a quarterly basis. At December 31, 1996, the rate on
these Notes was 9%. In addition, $1,720,000 of these notes are payable during
1997.
The $26,596,000 of Series C 9% Fixed Rate Secured Five Year Notes are
collateralized by security alarm monitoring contracts, and pay interest
quarterly at the fixed rate. Principal is paid down on a quarterly basis. In
addition, $2,250,000 of these notes are payable during 1997.
In January 1995, NYLIFE entered into a credit agreement, expiring January 1,
1997, with New York Life whereby NYLIFE can borrow up to an aggregate principal
amount of $200,000,000 at any one time. This agreement and any loans made shall
be automatically extended and renewed for additional one year periods, unless
either NYLIFE or New York Life notifies the other of its desire to terminate the
agreement. At December 31, 1996 the total principal borrowed under this
agreement was $91,131,000. Interest expense amounted to $2,598,000.
On November 1, 1993, SFD Holding entered into a loan agreement with New York
Life. The agreement allows SFD Holding to borrow money pursuant to one or more
master notes (individually, a "Master Note", collectively, "Master Notes") each
of which will not exceed one year in maturity and for amounts, in aggregate, not
to exceed $35,000,000 at any one time. Interest on any Master Note borrowings
accrues at the rate which is the annual simple interest equivalent (computed on
the actual daily principal balance based on a 360 day year of 12 30-day months)
of 225 basis points above the one month LIBOR published in the Wall Street
Journal on the 15th day of the proceeding calendar month (or if such day is not
a day on which such newspaper is published, the next succeeding day of such
publication). In 1995, the loan agreement between SFD Holding and New York Life
was amended to accommodate the acquisition of prime auto loans. The amendment
provides for the following: (i) an increase in the maximum borrowings to
$70,000,000, (ii) an interest rate of 200 basis points above the one month LIBOR
for borrowings related to prime auto
<PAGE>
-19-
loan acquisitions, and (iii) a change in the monthly interest payment date to
the 20th of each month. During 1996 and 1995, SFD Holding made interest payments
totaling $2,805,000 and $2,636,000, respectively, to New York Life pursuant to
the Master Notes. At December 31, 1996 and 1995, the amounts outstanding under
the Master Notes are $22,089,000 and $32,484,000, respectively. Accrued interest
at December 31, 1996 and 1995 is $145,000 and $278,000, respectively.
On December 11, 1992, SFD Holding entered into a revolving credit agreement (the
"Credit Agreement") with Barclays Bank PLC ("Barclays"). The Credit Agreement
allows SFD Holding to borrow an aggregate principal amount not to exceed
$15,000,000 at any one time. Interest on any borrowing accrues at a rate equal
to either (i) the rate of interest per annum declared by Barclays as its prime
rate in effect at its branch in New York City or (ii) LIBOR plus 1%. During 1996
and 1995, SFD Holding recorded interest expense of approximately $980,000 and
$138,000, respectively, to Barclays pursuant to the Credit Agreement. At
December 31, 1996, borrowings under the credit agreement are $13,700,000. At
December 31, 1995, borrowings under the credit agreement were $15,000,000. All
borrowings under the credit agreement are guaranteed by NYLIFE.
Along with New York Life, Capital Corp. is party to a credit agreement with a
consortium of banks. The credit agreement consists of a $150,000,000, 364 day
revolving credit facility ("Facility A"), and a $350,000,000, 5 year revolving
credit facility ("Facility B"). Annual facility fees are .04% and .06%, for
Facility A and B, respectively, and borrowing rates are capped at spreads of
.16% and .14% over LIBOR, respectively. In addition, the credit agreement
contains various covenants pertaining to allowable activities of Capital Corp.
Neither Capital Corp. nor New York Life have utilized the credit facility to
date.
ESI maintains two $25,000,000 unsecured lines of credit with two separate
financial institutions. One agreement will expire on May 29, 1997 and the other
on October 30, 1997. Terms of both lines are essentially the same and are as
follows: interest is charged on the principal amount outstanding at a rate equal
to any of the following options which ESI, at its option shall select: (i) the
bank's "prime rate", (ii) a floating rate equal to the Bank's cost of funds rate
plus 50 basis points, or (iii) a fixed rate for periods of 30, 60, 90 or 180
days equal to the LIBOR rate plus 50 basis points. Fees under these agreements
on any unused portion are charged at ten hundredths of one percent per year. At
December 31, 1996 and 1995, ESI had no outstanding borrowings under these
agreements, nor did it borrow any amounts under these agreements during 1996.
NYLCare had a loan agreement with New York Life under which NYLCare borrowed
amounts as mutually agreed. Under the provisions of this agreement, interest was
payable at the end of each calendar quarter at a rate of 1% over the prime rate
as announced by a specified New York money center bank. The applicable interest
rates during 1995 ranged from 9.5% to 10.0% and 1994 ranged from 7.0% to 9.5%.
NYLCare borrowed $4,000,000 during 1995 and $57,889,000 during 1994, primarily
to finance acquisitions. Effective December 31, 1995 the loan balance, along
with accrued interest, in the total amount of $82,898,000 was contributed to
NYLCare as additional paid-in-capital and the loan agreement, which was to
mature on October 1, 1997, was terminated. Interest expense on such borrowings
during 1995 was $7,854,000.
On May 15, 1995, NYLIFE Funding repaid the principal and remaining interest on
9.25% Guaranteed Notes which totaled $300,000,000 and $9,250,000, respectively.
<PAGE>
-20-
NOTE 10 - REINSURANCE
- ---------------------
MODIFIED COINSURANCE:
As described in Note 1, in 1996, NYLHIC entered into a modified coinsurance
reinsurance agreement with New York Life, whereby 90% of New York Life's group
life and health indemnity insurance business was reinsured with NYLHIC. In 1996,
NYLHIC assumed $613,632,000 in premiums under this agreement. In addition, in
1996 NYLHIC recorded a commission and expense allowance of $142,725,000, a modco
reserve adjustment of $13,135,000, and benefit payments of $507,055,000 under
this agreement. Settlement on the net amount due is made 90 days after the end
of each quarter. At December 31, 1996, premiums receivable were $191,922,000,
claims payable were $143,096,000, commission and expense allowances payable were
$34,191,000, dividends payable were $27,777,000 and payable on reinsurance
assumed was $26,507,000.
OTHER REINSURANCE:
Certain subsidiaries enter into reinsurance agreements in the normal course of
their insurance business. Reinsurance on certain individual lives is ceded to
reduce the risk on any one life. These subsidiaries remain liable for the
reinsurance ceded, if the reinsurer fails to meet its obligations. Premiums
ceded by these subsidiaries for the years ended December 31, 1996, 1995 and 1994
in connection with reinsurance agreements totaled $29,434,000, $3,201,000 and
$75,971,000, respectively. Policy reserves are recorded net of reinsurance
receivables of $7,709,000 and $649,000 at December 31, 1996 and 1995,
respectively.
NOTE 11 - RELATED PARTY TRANSACTIONS
- ------------------------------------
NYLIFE and several of its subsidiaries are party to a service agreement with New
York Life, whereby New York Life provides services to NYLIFE and such
subsidiaries, including office space, legal, accounting, administrative,
personnel and other services for which NYLIFE and its subsidiaries are billed.
NYLIFE and its subsidiaries are charged for these services based upon (a) actual
costs incurred, where they are separately identifiable and (b) allocation of
costs incurred by New York Life developed through analyses of time spent on
matters relating to NYLIFE and its subsidiaries.
Investment management fees of $40,864,000, $35,089,000, and $32,684,000 were
received from New York Life and certain of its affiliates during the years ended
December 31, 1996, 1995 and 1994, respectively.
Certain subsidiaries earned premiums and fees related to health care services
provided to New York Life of $14,447,000, $14,301,000 and $14,137,000 in 1996,
1995 and 1994, respectively.
During 1995, one of NYLCare's HMO subsidiaries paid hospital service claims of
approximately $7,000,000, respectively, to its minority shareholders.
NYLACOR has eight offices which market the New York Life long-term care product.
Beginning in 1995, all the expenses incurred by New York Life sales agents to
market the New York Life long-term care product are paid by NYLACOR and
reimbursed by New York Life. These expenses and the associated reimbursements
totaled $5,859,000 and $3,266,000, respectively, for the year ended December 31,
1996 and 1995.
<PAGE>
-21-
At December 31, 1996 and 1995, New York Life owned approximately 3.5% and 8.7%,
respectively, of the outstanding common stock of American Exploration Company
("American"), the parent of NYLIFE Equity's co-general partner (American
Exploration Production Company) and had invested approximately $18,954,000 in
partnerships it managed in 1995. During 1996, such investments were sold to
American. In addition, New York Life provided a $40,000,000 bridge facility for
American through February 1995 to finance the consolidation of its institutional
oil and gas limited partnerships.
As distributor, NYLIFE Distributors has entered into agreements with the
MainStay Funds, pursuant to Rule 12b-1 under the Investment Act of 1940, to
compensate it for the distribution expenses it incurs. Although the plans are
required to be approved annually by the Trustees of the board of NYLIFE
Distributors, the management of NYLIFE Distributors believes that such annual
approval will continue indefinitely. Distribution fee income for 1996 was
$36,826,000. At December 31, 1996 and 1995 receivables from the MainStay Funds
approximated $8,539,000 and $6,493,000, respectively for distribution, services
and administration fees.
NYLIFE Securities earned commission revenue of approximately $61,438,000,
$29,910,000 and $16,855,000 on transactions with affiliates during 1996, 1995
and 1994, respectively.
At December 31, 1995, Greystone had an intercompany payable to New York Life of
$3,387,000 which requires minimum annual installments of $250,000 until the
balance of the account is liquidated. Greystone paid installments of $750,000
and $1,279,000 in 1996 and 1995, respectively.
Such liability is non-interest bearing.
During 1995, NYLIFE Funding sold fourteen mortgage loans and one foreclosed
property with a total statement value of $119,314,000 to New York Life and
received a capital infusion of $115,000,000 from New York Life through NYLIFE.
The cash received in these two transactions was used to repay the principal and
interest obligations on the 9.25% Guaranteed Notes.
<PAGE>
-22-
NOTE 12 - FOREIGN OPERATIONS
- ----------------------------
NYLIFE subsidiaries conduct insurance and investment management operations in
the United Kingdom, Argentina, Bermuda, Hong Kong, Japan, Korea, Indonesia and
Mexico. The assets, liabilities, and net income of these foreign operations at
December 31, 1996 and 1995 and for the years then ended are as follows (in
thousands):
CONSOLIDATED SUBSIDIARIES:
1996 1995
---- ----
Assets $128,526 $90,614
Liabilities 98,180 70,326
Revenue 43,760 29,854
Net Loss (20,735) (14,384)
NON-CONSOLIDATED SUBSIDIARIES
1996 1995
---- ----
Assets $3,961,499 $3,261,163
Liabilities 3,807,416 3,178,398
Revenue 330,529 352,057
Net Income 25,852 3,231
The cumulative translation adjustment for 1996 is $3,850,000.
NOTE 13 - INCOME TAXES
- ----------------------
NYLIFE and its subsidiaries are members of an affiliated group which joins in
the filing of a consolidated federal income tax return with New York Life. The
consolidated income tax provision or benefit is allocated among the members of
the group in accordance with a tax allocation agreement. The tax allocation
agreement provides that each member of the group is allocated its share of the
consolidated tax provision or benefit determined generally on a separate return
basis, but may, where applicable, recognize the tax benefits of net operating
losses or capital losses utilizable in the consolidated group. Estimated
payments for taxes are made between the members of the consolidated group during
the year. State, local, and foreign tax returns are filed separately. The income
tax receivable included $14,481,000 and $5,141,000 due from New York Life as of
December 31, 1996 and 1995, respectively pursuant to the tax allocation
agreement.
<PAGE>
-23-
The components of income tax expense (benefit) for each year are as follows:
1996 1995 1994
------ ------ ------
(in thousands)
Current
Federal $ (20,135) $ 9,119 $12,275
State 8,973 8,771 8,366
Foreign 190 (363) 2,570
------- -------- -------
Total Current (10,972) 17,527 23,211
------- -------- -------
Deferred
Federal 86,686 (41,370) 3,040
State 611 (598) (3,816)
------- ------- -------
Total Deferred 87,297 (41,968) (776)
------- ------- -------
Total $76,325 $(24,441) $22,435
======= ======== =======
Total income tax expense (benefit) is different from the amount computed using
the statutory federal tax rate of 35% in 1996, 1995 and 1994 for the following
reasons:
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Income tax expense (benefit) at statutory rate $54,371 $ (40,522) $26,284
Tax exempt investment income and capital gains (216) (231) (136)
State and local taxes, net of federal income tax benefit 6,256 5,288 2,952
Amortization of goodwill 6,155 6,219 913
Net foreign taxes 183 (1,904) (2,642)
Equity in non-consolidated affiliates 6,447 4,518 (6,100)
Non-deductible losses with respect to foreign operations 349 1,378 -
Undistributed earnings of subsidiaries 1,237 896 634
Issuance of additional shares by public subsidiary 2,689 - -
Provision to return reconciliation 217 (1,126) (23)
Other (1,363) 1,043 553
------- --------- -------
Total income tax expense (benefit) $76,325 $ (24,441) $22,435
======= ======== =======
</TABLE>
<PAGE>
-24-
The net deferred tax asset (liability) as of December 31, 1996 and 1995,
respectively is attributable to the following temporary differences (in
thousands):
<TABLE>
<CAPTION>
1996 1995
---- ----
<S> <C> <C>
Deferred tax asset:
Non-deductible reserves $ 14,389 $ 71,022
Net operating losses 4,448 6,244
Deferred compensation 13,417 17,267
Impairments 2,133 5,787
Investments in affiliates and partnerships 652 735
Leasehold improvements 2,607 1,935
Deferred rent 2,365 2,943
Depreciation 912 1,046
Unrealized investment losses 764 -
Employee benefits 4,867 -
Deferred tax on sale of shares of subsidiary stock 2,614 -
Other 2,212 1,519
-------- ---------
Gross deferred tax asset 51,380 108,498
Deferred tax liability:
Deferred distribution costs (78,663) (60,919)
Unrealized appreciation of subsidiary (11,456) (1,713)
Investments in affiliates and partnerships (5,204) (6,736)
Depreciation (1,729) (1,363)
Unrealized net appreciation (9,102) (7,780)
Software development costs - (322)
Unrealized investment gains - (8,832)
Forgiveness of subsidiary loan (4,340) -
Other (492) (615)
--------- --------
Gross deferred tax (liability) (110,986) (88,280)
Valuation allowance (4,445) (6,236)
--------- --------
Net deferred tax (liability) asset $ (64,051) $ 13,982
========= ========
</TABLE>
The December 31, 1995 valuation allowance principally relates to foreign net
operating losses, the utilization of which is subject to limitations in the
United Kingdom, and net operating loss limitations.
NOTE 14 - COMMITMENTS AND CONTINGENCIES
- ---------------------------------------
LEASES:
The subsidiaries lease office space, a telephone system, and certain computer
and office equipment under agreements with various expiration dates. The leases
contain provisions for payment of real estate taxes, building maintenance,
electricity, and other escalations.
<PAGE>
-25-
Future minimum lease payments under capital and noncancelable operating leases
with original or remaining lease terms in excess of one year at December 31,
1996, are as follows (in thousands):
<TABLE>
<CAPTION>
Capital Leases Operating Leases
-------------- ----------------
<S> <C>
1997 $ 816 $ 27,959
1998 1,127 26,856
1999 1,206 25,817
2000 1,290 23,358
2001 1,380 19,880
2002 & thereafter 1,100 71,182
--------- --------
Total 6,919 195,052
--------- --------
Less future sublease rental receipts - 3,293
--------- --------
Present value of future minimum lease payments 6,919 191,759
--------- --------
Less amount due in one year 816 -
--------- --------
Total $ 6,103 $191,759
========= ========
</TABLE>
Assets recorded under capital leases and the related accumulated depreciation
are listed below. Amortization of these assets is included in depreciation and
amortization expense (in thousands):
December 31,
------------------------------
1996 1995
---- ----
Assets recorded under leases $12,286 $12,871
Accumulated depreciation (1,910) (2,794)
-------- --------
Total $10,376 $10,077
======= =======
Rent expense for the years ended December 31, 1996, 1995 and 1994 was
approximately $34,943,000, $32,848,000 and $28,315,000, respectively.
Windsor Construction Company Limited, a wholly owned subsidiary of NYLUK,
entered into two contracts with Balfour Beatty Limited on January 11, 1994, for
the construction of phases II and III of NYLUK's head office development in the
United Kingdom amounting to $3,945,000 for Phase II and $4,190,000 for Phase
III. The contract for Phase II must begin by January 8, 1997, and the contract
for Phase III must begin by December 31, 1999.
New York Life has a guarantee, dated December 19, 1995, on behalf of NYLCare for
the rents due by NYLCare to its landlord, Olympia & York OLP Company. New York
Life will only be responsible upon the occurrences of certain events. The total
remaining amount of rental payments for the five year lease is $20,000,000.
<PAGE>
-26-
INTEGRATION COSTS:
During 1995, NYLCare recorded a pretax charge of $10,000,000 relating to
expenses incurred for the integration of NYLCare operations and certain of New
York Life's group operations. Such costs related primarily to consulting, public
relations and relocation charges. A remaining liability of $5,000,000 is
included in accounts payable and accrued expenses as of December 31, 1995 and
the related charge was included in selling, administrative and other costs for
1995.
OTHER:
During 1990, NYLIFE entered into an agreement to provide a guarantee for the
benefit of the shareholders of the MainStay Equity Index Fund. The guarantee
provides that if, after ten years from date of purchase, the net asset value,
with all dividend and capital gains distributions reinvested, is less than the
original offering price, NYLIFE will reimburse the shareholders for their loss
of principal and restore the net asset value to the original offering price,
including the return of any front-end sales charge. If shares are redeemed prior
to or after the one day guarantee date, the investor loses the benefit of the
guarantee with respect to those shares.
New York Life and NYLIFE have an indemnification agreement dated September 29,
1995, on behalf of MacKay-Shields. Under this agreement, New York Life and
NYLIFE have agreed to indemnify a client of MacKay-Shields for any actions,
omissions, or liabilities that MacKay-Shields is unable to satisfy under an
investment management agreement, pursuant to which MacKay-Shields acts as an
investment manager for $431,000,000 of the clients assets.
The Company and its subsidiaries are also defendants in other individual and
alleged class actions arising from its operations. Most of these actions seek
substantial or unspecified compensatory and punitive damages. The Company is
also from time to time involved as a party in various governmental,
administrative and investigative proceedings and inquiries. Given the uncertain
nature of litigation and regulatory inquiries, the outcome of the above and
other actions pending against the Company cannot be predicted. The Company
nevertheless believes that the ultimate outcome of all pending litigation should
not have a material adverse effect on the Company's financial position; however,
it is possible that settlements or adverse determinations in one or more actions
or other proceedings in the future could have a material adverse effect on the
Company's operating results for a given year.
Additionally, certain subsidiaries are subject to minimum net worth restrictions
pursuant to regulatory requirements and the terms of limited partnership and
debt agreements. At December 31, 1996 and 1995, the net worth of these
subsidiaries exceeded the related requirements.
For the year ended December 31, 1996, approximately 79% of ESI's pharmaceutical
purchases were through one wholesaler. ESI believes that other alternative
sources are readily available.
<PAGE>
-27-
NOTE 15 - EMPLOYEE BENEFIT PLANS
- --------------------------------
LONG TERM PERFORMANCE PLAN:
MacKay-Shields adopted Long-Term Performance Plans ("the Plans") in 1988 and
1995. These Plans grant awards calculated based upon the attainment of specific
goals as set forth in each plan.
Payments under the 1988 plan commenced in 1996 and extend through 2000. In
accordance with the provisions of the 1988 Plan, participants are also entitled
to income on the unpaid amount of their award. For certain individuals, a
portion of this amount may be adjusted based upon the investment performance of
certain registered investment companies managed by MacKay-Shields. In 1996
MacKay-Shields recorded dividend and interest income in the amount of $1,678,000
on the cash and investments segregated to fund the Plan obligation.
Awards under the 1995 Plan are based on cumulative growth during the 1995 to
1997 time period, and are payable commencing in 1999 and extending through 2001.
An accrual was recorded as a liability based on asset growth through December
31, 1996.
The Plan is long-term in nature and requires participants to enter into
multi-year employment contracts.
OTHER:
Certain subsidiaries sponsor defined contribution retirement, 401(k) and profit
sharing plans for employees. Contributions to these plans during 1996, 1995 and
1994 totalled $9,011,000, $1,794,000 and $548,000, respectively.
NOTE 16 - SUPPLEMENTAL CASH FLOW INFORMATION
- --------------------------------------------
SUPPLEMENTAL NON-CASH ACTIVITY:
The terms of the modified coinsurance agreement between NYLHIC and New York Life
(see Note 1) effective January 1, 1996, specify that NYLHIC assumes the risk for
group life and health policies issued by New York Life; however, New York Life
retains the claim and policy reserves as well as the related assets. As such,
the assets and liabilities of New York Life's group life and health operations
included in the Company's restated consolidated statement of financial position
at December 31, 1995 are not reflected in the Company's December 31, 1996
accounts. The change in the related assets and liabilities between 1995 and 1996
had no impact on the Company's 1996 cash flows other than a reduction in
reported cash balances of $50,140,000 reflected as other financing activities.
New York Life made net non-cash capital contributions of $21,798,000 and
$82,898,000, respectively, during 1996 and 1995.
OTHER:
Net cash paid for income tax expense was $50,245,000, $16,234,000 and
$26,752,000 during 1996, 1995 and 1994, respectively.
<PAGE>
-28-
Interest paid during 1996, 1995 and 1994 was $15,075,000, $18,931,000 and
$43,675,000, respectively.
NYLUK sold 68.75% of the common stock of Windsor Life, effective December 22,
1994, for $77,596,000. The statement value of the cash and cash equivalents of
Windsor Life at the date of sale was $43,022,000.
NOTE 17 - SUBSEQUENT EVENTS
- ---------------------------
On February 15, 1997 SAMCO distributed $2,886,000 to the Series A, B and C note
holders, which included interest, quarterly principal repayment and additional
principal repayment.
On February 20, 1997, SFD Holding borrowed $12,833,000 under the Master Note
Agreement with New York Life. Those funds were used to repay all amounts then
outstanding under the Credit Agreement with Barclays Bank PLC. Concurrent with
the repayment, the Credit Agreement was terminated.
On March 4, 1997, MainStay Shareholder Services Inc. ("MSS") was created to
assume certain shareholder servicing functions currently handled by NYLIFE
Distributors. MSS was funded with a $2,000,000 cash contribution and $973,000 of
furniture and equipment. Operations have not yet commenced.
As of April 11, 1997, NYLIFE has received $29,000,000 of cash contributions from
New York Life.
