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THE MAINSTAY FUNDS
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STATEMENT OF ADDITIONAL INFORMATION
MAY 1, 1998
As Supplemented July 27, 1998
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The MainStay Funds (the "Trust") is an open-end management investment
company (or mutual fund) currently consisting of fifteen series: 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, Strategic Value 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 fourteen 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 May 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 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....................5
INVESTMENT PRACTICES AND INSTRUMENTS COMMON TO MULTIPLE FUNDS..............8
Repurchase Agreements.............................................8
Lending of Portfolio Securities..................................10
Bank Obligations.................................................11
U.S. Government Securities.......................................12
Debt Securities..................................................12
Convertible Securities...........................................13
Arbitrage........................................................14
Foreign Securities...............................................15
Foreign Currency Transactions....................................16
Foreign Index-Linked Instruments.................................20
Brady Bonds......................................................20
Municipal Securities.............................................21
Industrial Development and Pollution Control Bonds...............26
Variable Rate Demand Notes ("VRDNs").............................27
Floating and Variable Rate Securities............................28
Zero Coupon Bonds................................................28
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............................................41
Options on Foreign Currencies....................................48
Securities Index Options.........................................50
Futures Transactions.............................................52
Swap Agreements..................................................63
Loan Participation Interests.....................................65
Risks Associated with Debt Securities............................68
Risks of Investing in High Yield Securities ("Junk Bonds").......68
HIGH YIELD CORPORATE BOND FUND, STRATEGIC
VALUE FUND AND STRATEGIC INCOME FUND
SPECIAL CONSIDERATIONS...........................................69
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EQUITY INDEX FUND
SPECIAL CONSIDERATIONS...........................................70
TOTAL RETURN FUND
SPECIAL CONSIDERATIONS...........................................71
CALIFORNIA TAX FREE FUND AND NEW YORK TAX FREE FUND
SPECIAL CONSIDERATIONS...........................................71
Risk Factors Affecting California Municipal Securities...........71
Risk Factors Affecting New York Municipal Securities.............83
Special Considerations Affecting Puerto Rico....................100
THE EQUITY INDEX FUND GUARANTEE..........................................106
FUNDAMENTAL INVESTMENT RESTRICTIONS......................................108
NON-FUNDAMENTAL INVESTMENT RESTRICTIONS..................................111
TRUSTEES AND OFFICERS....................................................116
THE MANAGER, THE SUB-ADVISERS AND THE DISTRIBUTOR........................125
Management Agreement............................................125
Distribution Agreement..........................................129
Other Services..................................................136
Expenses Borne by the Trust.....................................138
PORTFOLIO TRANSACTIONS AND BROKERAGE.....................................139
NET ASSET VALUE..........................................................144
SHAREHOLDER INVESTMENT ACCOUNT...........................................147
SHAREHOLDER SERVICING AGENT..............................................148
PURCHASES, REDEMPTION AND REPURCHASE.....................................148
Letter of Intent ("LOI")........................................148
Distributions in Kind...........................................148
Suspension of Redemptions.......................................149
CDSC Waivers....................................................149
TAX-DEFERRED RETIREMENT PLANS............................................150
Cash or Deferred Profit Sharing Plans Under Section 401(k)
for Corporations and Self-Employed Individuals................150
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Individual Retirement Account ("IRA")...........................150
403(b)(7) Tax Sheltered Account.................................153
General Information.............................................153
CALCULATION OF PERFORMANCE QUOTATIONS....................................154
TAX STATUS
................................................................163
Taxation of the Funds...........................................163
Character of Distributions to Shareholders -- General...........166
Character of Distributions to Shareholders -- The Tax-Free
Funds.........................................................168
Discount........................................................169
Users of Bond-Financed Facilities...............................170
Taxation of Options, Futures and Similar Instruments............170
Passive Foreign Investment Companies............................172
Foreign Currency Gains and Losses...............................173
Commodity Investments...........................................173
Dispositions of Fund Shares.....................................174
Tax Reporting Requirements......................................175
Foreign Taxes...................................................176
State and Local Taxes - General.................................177
Explanation of Fund Distributions...............................178
Additional Information Regarding the Equity Index Fund..........178
Additional Information Regarding the California Tax Free
Fund and New York Tax Free Fund...............................179
Annual Statements...............................................180
General Information.............................................181
ORGANIZATION AND CAPITALIZATION..........................................181
General.........................................................181
Voting Rights...................................................182
Shareholder and Trustee Liability...............................182
OTHER INFORMATION.......................................................183
Independent Accountants.........................................183
Legal Counsel...................................................183
Share Ownership of the Funds....................................183
Code of Ethics..................................................187
FINANCIAL STATEMENTS.....................................................187
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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; (2) if issued by
an issuer that has received a short-term rating from an NRSRO with
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respect to a class debt obligations that is comparable 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;(3) an unrated security that is
of comparable quality to a security in the highest rating category as determined
by the Sub-Adviser;(4)(i) with respect to a security that is subject to any
features that entitle the holder, under certain circumstances, to receive the
approximate amortized cost of the underlying security or securities plus accrued
interest "Demand Feature" or obligations of a person other than the issuer of
the security, under certain circumstances, to undertake to pay the principal
amount of the underlying security plus interest "Guarantees", the Guarantee has
received a rating from an NRSRO or the Guarantee is issued by a guarantor that
has received a rating from an NRSRO with respect to a class of debt obligations
that is comparable in priority and security to the Guarantee, with certain
exceptions, and (ii) the issuer of the Demand Feature or Guarantee, or another
institution, has undertaken promptly to notify the holder of the security in the
event that the Demand Feature or Guarantee is substituted with another Demand
Feature or Guarantee,(5) if it is a security issued by a money market fund
registered with the SEC under the 1940 Act; or (6) if it is a Government
Security. 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
securities of any one issuer and except that this limitation shall not apply to
U.S. government securities or securities subject to certain Guarantees. 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. Immediately after the
acquisition of any Demand Feature or Guarantee, the Fund, with respect to
seventy five percent of its total assets, shall not have invested more than ten
percent of its assets in securities issued by or subject to Demand Features or
Guarantees from the institution that issued the Demand Feature or Guarantee,
with certain exceptions. In addition, immediately after the acquisition of any
Demand Feature or Guarantee (or a security
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after giving effect to the Demand Feature or Guarantee) that is a not within the
highest rating category by NRSROs, the Fund shall not have invested more than
five percent of its total assets in securities issued by or subject to Demand
Features or Guarantees from the institution that issued the Demand Feature or
Guarantee. 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 shall promptly
reassess whether such security presents minimal credit risk and shall recommend
to the Valuation Committee of the Board (the "Valuation Committee") that the
Fund take such action as it determines is in the best interest of the Fund and
its shareholders. The Valuation Committee, after consideration of the
recommendation of the Sub-Adviser and such other information as it deems
appropriate, shall cause the Fund to take such action as it deems appropriate,
and shall report promptly to the Board the action it has taken and the reasons
for such action.
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.
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
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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.
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
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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 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
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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, Strategic Value 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. Each of the Strategic Income Fund and Strategic Value Fund will limit
its investments in 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
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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
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
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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-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
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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,
Strategic Value 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 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
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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) 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
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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 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
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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
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
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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 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
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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 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.
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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 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
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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"). 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, Strategic Value 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.
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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
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
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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 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
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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 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
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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 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
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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 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
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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 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
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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 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
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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
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
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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.
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
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<PAGE>
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, 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
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<PAGE>
to commitments for when-issued securities. Such segregated securities either
will mature or, if necessary, be sold on or before the settlement date.
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.
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<PAGE>
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 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.
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<PAGE>
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. 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
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<PAGE>
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 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,
Strategic Income and Strategic Value 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.
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<PAGE>
In a typical CMO transaction, a corporation ("issuer") issues multiple
series (e.g., A, B, C, Z) of CMO bonds ("Bonds"). 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.
The eligible Funds 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 a 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.
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.
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<PAGE>
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 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
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<PAGE>
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 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
B-37
<PAGE>
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 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.
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.
SMBS are usually structured with two classes that receive different
proportions of the interest and principal distributions on a pool of mortgage
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<PAGE>
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 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
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<PAGE>
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 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
B-40
<PAGE>
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
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
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<PAGE>
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.
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.
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<PAGE>
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 that all
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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 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.
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<PAGE>
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 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
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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 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.
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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 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.
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<PAGE>
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 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
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<PAGE>
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 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.
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<PAGE>
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.
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.
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<PAGE>
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
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
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<PAGE>
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, Strategic Value 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, Equity Index Fund, International Equity Fund, Strategic Income Fund,
Strategic Value 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
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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 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
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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.
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
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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.
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
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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
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
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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 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
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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 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
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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
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.
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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 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.
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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.
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
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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 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
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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.
SWAP AGREEMENTS
The International Bond Fund, International Equity Fund, Strategic Value
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
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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.
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.
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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.
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
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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 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
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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 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.
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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 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
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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, STRATEGIC
VALUE 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
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.
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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.
"Standard & Poor's", "S&P 500", "S&P", "S&P 500", "Standard & Poor's 500"
and "500" are trademarks of Standard & Poor's Corporation and have been licensed
for use by Monitor Capital Advisors, Inc. S&P does not sponsor, endorse, sell
or promote the Fund or represent the advisability of investing in the Fund.
The Fund is not sponsored, endorsed, sold or promoted by S&P. S&P makes no
representation or warranty, express or implied, to the owners of the Fund or any
member of the public regarding the advisability of investing in securities
generally or in the Fund particularly or the ability of the S&P 500 Index to
track general stock market performance. S&P's only relationship to Monitor is
the licensing of certain trademarks and trade names of S&P and of the S&P 500
Index which is determined, composed and calculated by S&P without regard to
Monitor or the Fund. S&P has no obligation to take the needs of Monitor or the
owners of the Fund into consideration in determining, composing or calculating
the S&P 500 Index. S&P is not responsible for and has not participated in the
determination of the prices and amount of the Fund or the timing of the issuance
or sale of the Fund or in the determination or calculation of the equation by
which the Fund is to be converted into cash. S&P has no obligation or liability
in connection with the administration, marketing or trading of the Fund.
S&P does not guarantee the accuracy and/or the completeness of the S&P 500
Index or any data included therein and S&P shall have no liability for any
errors, omissions, or interruptions
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therein. S&P makes no warranty, express or implied, as to results to be obtained
by Monitor, owners of the Fund, or any other person or entity from the use of
the S&P 500 Index or any data included therein. S&P makes no express or implied
warranties, and expressly disclaims all warranties of merchantability or fitness
for a particular purpose or use with respect to the S&P 500 Index or any data
included therein. Without limiting any of the foregoing, in no event shall S&P
have any liability for any special, punitive, indirect, or consequential damages
(including lost profits), even if notified of the possibility of such damages.
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
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
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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 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.
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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 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.
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
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to reduce or repeal previously-authorized taxes, assessments, fees and charges.
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 State tax revenues in excess of the Article XIIIB limit to
K-14 schools.
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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's 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 fiscal year 1994-95 and thereafter have resulted or will
result in retroactive increases in Proposition 98 appropriations from subsequent
fiscal years' budgets. Because of the State's increasing revenues, per-pupil
funding at the K-12 level has increased by about 22% from the level in place
from 1991-92 through 1993-94, and is estimated at about $5,150 per ADA in 1997-
98. A significant amount of the "extra" Proposition 98 monies in the last few
years have been allocated to special programs, most particularly an initiative
to allow each classroom from grades K-3 to have no more than 20 pupils by the
end of the 1997-98 school year. There are also new initiatives for reading
skills and to upgrade technology in high schools.
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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 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.
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
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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.
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.
As part of the 1997-98 Budget Act legislative package, the Legislature and
Governor agreed on a comprehensive reform of the State's public assistance
programs to implement the new federal law. The new basic State welfare program
is called California Work Opportunity and Responsibility to Kids Act
("CalWORKs"), which replaces the former Aid to Families with Dependent Children
(AFDC) and Greater Avenues to Independence (GAIN) programs effective January 1,
1998. Consistent with the federal law, CalWORKs contains new time limits on
receipt of welfare aid, both lifetime as well as for any current period of aid.
The centerpiece of CalWORKs is the linkage of eligibility to work participation
requirements. Administration of the new Welfare-to-Work programs will be
largely at the county level, and counties are given financial incentives for
success in this program.
Although the long-term impact of the new federal Law and CalWORKs cannot be
determined until there has been more experience, the State does not presently
anticipate that these new programs will have an adverse financial impact on the
General Fund. Overall TANF grants from the federal government are expected to
equal or exceed the amounts the State would have received under the old AFDC
program.
Pressures on the State's budget in the late 1980's and early 1990's were
caused by a combination of external economic conditions (including a recession
which began in 1990) and growth of the largest General Fund Programs - K-14
education, health, welfare and corrections - at rates faster than the revenue
base. During this period, expenditures exceeded revenues in four out of
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six years up to 1992-93, and the State accumulated and sustained a budget
deficit approaching $2.8 billion at its peak at June 30, 1993. Between the 1991-
92 and 1994-95 Fiscal Years, each budget required multibillion dollar actions to
bring projected revenues and expenditures into balance, including significant
cuts in health and welfare program expenditures; transfers of program
responsibilities and funding from the State to local governments; transfer of
about $3.6 billion in annual local property tax revenues from other local
governments to local school districts, thereby reducing State funding for
schools under Proposition 98; and revenue increases (particularly in the 1991-92
Fiscal Year budget), most of which were for a short duration.
Despite these budget actions, the effects of the recession led to large,
unanticipated budget deficits. By the 1993-94 Fiscal Year, the accumulated
deficit was so large that it was impractical to budget to retire it in one year,
so a two-year program was implemented, using the issuance of revenue
anticipation warrants to carry a portion of the deficit over the end of the
fiscal year. When the economy failed to recover sufficiently in 1993-94, a
second two-year plan was implemented in 1994-95, again using cross-fiscal year
revenue anticipation warrants to partly finance the deficit into the 1995-96
fiscal year.
Another consequence of the accumulated budget deficits, together with other
factors such as disbursement of funds to local school districts "borrowed" from
future fiscal years and hence not shown in the annual budget, was to
significantly reduce the State's cash resources available to pay its ongoing
obligations. When the Legislature and the Governor failed to adopt a budget for
the 1992-93 Fiscal Year by July 1, 1992, which would have allowed the State to
carry out its normal annual cash flow borrowing to replenish its cash reserves,
the State Controller issued registered warrants to pay a variety of obligations
representing prior years' or continuing appropriations, and mandates from court
orders. Available funds were used to make constitutionally-mandated payments,
such as debt service on bonds and warrants. Between July 1 and September 4,
1992, when the budget was adopted, the State Controller issued a total of
approximately $3.8 billion of registered warrants.
For several fiscal years during the recession, the State was forced to rely
on external debt markets to meet its cash needs, as a succession of notes and
revenue anticipation warrants were issued in the period from June 1992 to July
1994, often needed to pay previously maturing notes or warrants. These
borrowings were used also in part to spread out the repayment of the accumulated
budget deficit over the end of a fiscal year, as noted earlier.
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The last and largest of these borrowings was $4.0 billion of revenue
anticipation warrants which were issued in July, 1994 and matured on April 25,
1996.
The State's financial condition improved markedly during the 1995-96 and
1996-97 fiscal years, with a combination of better than expected revenues,
slowdown in growth of social welfare programs, and continued spending restraint
based on the actions taken in earlier years. The State's cash position also
improved, and no external deficit borrowing has occurred over the end of these
two fiscal years.
The economy grew strongly during these fiscal years, and as a result, the
General Fund took in substantially greater tax revenues (around $2.2 billion in
1995-96 and $1.6 billion in 1996-97) than were initially planned when the
budgets were enacted. These additional funds were largely directed to school
spending as mandated by Proposition 98, and to make up shortfalls from reduced
federal health and welfare aid. The accumulated budget deficit from the
recession years was finally eliminated. In the Governor's 1998-99 Budget
Proposal, released January 9, 1998, the Department of Finance reported that the
State's budget reserve (the SFEU) totaled $461 million as of June 30, 1997.
On January 9, 1997, the Governor released his proposed budget for the 1997-
98 Fiscal Year (the "Proposed Budget"). The Proposed Budget estimated General
Fund revenues and transfers of about $50.7 billion, and proposed expenditures of
$50.3 billion. In May 1997, the Department of Finance increased its revenue
estimate for the upcoming fiscal year by $1.3 billion, in response to the
continued strong growth in the State's economy.
In May, 1997, action was taken by the California Supreme Court in an
ongoing lawsuit, PERS v. Wilson, which made final a judgment against the State
requiring an immediate payment from the General Fund to the Public Employees
Retirement Fund ("PERF") to make up certain deferrals in annual retirement fund
contributions which had been legislated in earlier years for budget savings, and
which the courts found to be unconstitutional. On July 30, 1997, following a
direction from the Governor, the Controller transferred $1.228 billion from the
General Fund to the PERF in satisfaction of the judgment, representing the
principal amount of the improperly deferred payments from 1995-96 and 1996-97.
In late 1997, the plaintiffs filed a claim with the State Board of Control
for payment of interest under the Court rulings in an amount of $308 million.
The Department of Finance has recommended approval of this claim. If approved by
the Board of
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Control, the claim would become part of a claims bill to be paid in the 1998-99
Fiscal Year.
Once the pension payment of $1.228 billion eliminated essentially all the
"increased" revenue in the budget, final agreement was reached within a few
weeks on a welfare reform package and the remainder of the budget. The
Legislature passed the Budget Bill on August 11, 1997, along with numerous
related bills to implement its provisions. On August 18, 1997, the Governor
signed the Budget Act, but vetoed approximately $314 million of specific
spending items, primarily in health and welfare and education areas from both
the General Fund and Special Funds. Most of this spending (approximately $200
million) was restored in later legislation passed before the end of the
Legislative Session.
The Budget Act anticipated General Fund revenues and transfers of $52.5
billion (a 6.8 percent increase over the final 1996-97 amount), and expenditures
of $52.8 billion (an 8.0 percent increase from the 1996-97 levels). The Budget
Act also included Special Fund expenditures of $14.4 billion (as against
estimated Special Fund revenues of $14.0 billion), and $2.1 billion of
expenditures from various Bond Funds. Following enactment of the Budget Act, the
State implemented its normal annual cash flow borrowing program, issuing $3.0
billion of notes which mature on June 30, 1998.
The following were major features of the 1997-98 Budget Act:
1. For the second year in a row, the Budget contained a large increase in
funding for K-14 education under Proposition 98, reflecting strong revenues
which exceeded initial budgeted amounts. Part of the nearly $1.75 billion in
increased spending was allocated to prior fiscal years. Funds were provided to
fully pay for the cost-of-living-increase component of Proposition 98, and to
extend the class size reduction and reading initiatives.
2. The Budget Act reflected the $1.228 billion pension case judgment
payment, and brought funding of the State's pension contribution back to the
quarterly basis which existed prior to the deferral actions which were
invalidated by the courts.
3. Funding from the General Fund for the University of California and
California State University was increased by about 6 percent ($121 million and
$107 million, respectively), and there was no increase in student fees.
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4. Because of the effect of the pension payment, most other State programs
were continued at 1996-97 levels, adjusted for caseload changes.
5. Health and welfare costs were contained, continuing generally the grant
levels from prior years, as part of the initial implementation of the new
CalWORKs program.
6. Unlike prior years, this Budget Act did not depend on uncertain federal
budget actions. About $300 million in federal funds, already included in the
federal FY 1997 and 1998 budgets, was included in the Budget Act, to offset
incarceration costs for illegal aliens.
7. The Budget Act contained no tax increases, and no tax reductions. The
Renters Tax Credit was suspended for another year, saving approximately $500
million.
At the end of the Legislative Session on September 13, 1997, the
Legislature passed and the Governor later signed several bills encompassing a
coordinated package of fiscal reforms, mostly to take effect after the 1997-98
Fiscal Year. Included in the package are a variety of phased-in tax cuts,
conformity with certain provisions of the federal tax reform law passed earlier
in the year, and reform of funding for county trial courts, with the State to
assume greater financial responsibility. The Department of Finance estimates
that the major impact of these fiscal reforms will occur in Fiscal Year 1998-99
and subsequent years.
On January 9, 1998, the Governor released his Budget Proposal for the 1998-
99 Fiscal Year (the "Governor's Budget"). The Governor's Budget projects total
General Fund revenues and transfers of $55.4 billion, a $2.5 billion increase
(4.7 percent) over revised 1997-98 revenues. This revenue increase takes into
account reduced revenues of approximately $600 million from the 1997 tax cut
package, but also assumes approximately $500 million additional revenues
primarily associated with capital gains realizations. The Governor's Budget
notes, however, that capital gains activity and the resultant revenues derived
from it are very hard to predict.
Total General Fund expenditures for 1998-99 are recommended at $55.4
billion an increase of $2.4 billion (4.5 percent) above the revised 1997-98
level. The Governor's Budget includes funds to pay the interest claim relating
to the court decision on pension fund payments, PERS v. Wilson. The Governor's
Budget projects that the State will carry out its normal intra-year cash flow
external borrowing in 1998-99, in an estimated amount of
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$3.0 billion. The Governor's Budget projects that the budget reserve, the SFEU,
will be $296 million at June 30, 1999, slightly lower than the projected level
at June 30, 1998 PERS liability.
The Governor's Budget projects Special Fund revenues of $14.7 billion, and
Special Fund expenditures of $15.2 billion, in the 1998-99 Fiscal Year. A total
of $3.2 billion of bond fund expenditures are also proposed.
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.
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.
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
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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. The fiscal stability of the State is related in part
to the fiscal stability of its public authorities.
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
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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.
On January 6, 1992, Moody's lowered from "A" to "Baa1" its rating of those
State bonds that are backed by annual legislative appropriations. 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 July 1998, S&P rated general
obligation bonds as an "A".
The Governor presented his 1998-99 Executive Budget to the Legislature on
January 20, 1998. The Executive Budget contains financial projections for the
State's 1997-98 through 2000-01 fiscal years, detailed estimates of receipts and
a proposed Capital Program and Financing Plan for the 1997-98 through 2002-03
fiscal years. It is expected that the Governor will prepare amendments to his
Executive Budget as permitted under law and that these amendments will be
reflected in a revised Financial Plan to be released on or before February 19,
1998. There can be no assurance that the Legislature will enact into law the
Executive Budget as proposed by the Governor, or that the State's
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adopted budget projections will not differ materially and adversely from the
projections set forth in this Update.
The 1998-99 Financial Plan is projected to be balanced on a cash basis in
the General Fund. Total General Fund receipts, including transfers from other
funds, are projected to be $36.22 billion, an increase of $1.02 billion over
projected receipts in the current fiscal year. Total General Fund
disbursements, including transfers to other funds, are projected to be $36.18
billion, an increase of $1.02 billion over the projected expenditures (including
prepayments), for the current fiscal year. As compared to the 1997-98 State
Financial Plan, the Executive Budget proposes year-to-year growth in General
Fund spending of 2.89 percent. State Funds spending (i.e., General Fund plus
other dedicated funds, with the exception of federal aid) is projected to grow
by 8.5 percent. Spending from All Governmental Funds (excluding transfers) is
proposed to increase by 7.6 percent from the prior fiscal year.
Current law and programmatic requirements are primarily responsible for the
year-to-date growth in General Fund spending. These include a current law
increase in school aid ($607 million), cost and enrollment growth in handicapped
education ($91 million) and Medicaid ($212 million), and employee contract
increases and inflation adjustments for State agency operations. The Executive
Budget also includes increases of $84 million for corrections programs to cover
new capacity demands and $152 million for mental health programs to finance
current law increases and the expansion of community beds. Other spending
growth reflects a requested increase of $108 million for the Judiciary and $117
million for long-term transfers due to the financing of CEFAP from resources
available in 1997-98, $37 million in welfare assistance savings, $36 million
from lower spending in General State charges, and $68 million in lower transfers
primarily due to the elimination of the Lottery transfer made in 1997-98.
The 1998-99 Financial Plan projects that the State will end 1998-99 with a
closing balance in the General Fund of $500 million, which reflects $400 million
in the TSRF and $100 million in the CRF, following an anticipated deposit of $35
million in the latter fund during the year. Detailed explanations of the 1998-
99 Financial Plan follow a discussion of the economic outlook.
Moderate growth is projected to continue in 1998 and 1999 for employment,
wages and personal income, although the growth rates will lessen gradually
during the course of the two years. Personal income is estimated to grow by 5.4
percent in 1997,
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fueled in part by a continued large increase in financial sector bonus payments,
and is projected to grow 4.7 percent in 1998 and 4.4 percent in 1999. Increases
in bonus payments at year-end 1998 are projected to be modest, a substantial
change from the rate of increase of the last few years. Overall employment
growth is expected to continue at a modest rate, reflecting the slowing growth
in the national economy, continued spending restraint in government, and
restructuring in the health care, social service, and banking sectors.
The 1998-99 Financial Plan projects General Fund receipts (including
transfers from other funds) of $36.22 billion, an increase of $1.02 billion over
the estimated 1997-98 level. Recurring growth in the State General Fund tax base
is projected to be approximately six percent during 1998-99, after adjusting for
tax law and administrative changes. This growth rate is lower than the rates for
1996-97 or currently estimated for 1997-98, but roughly equivalent to the rate
for 1995-96.
The forecast of General Fund receipts in 1998-99 incorporates several
Executive Budget tax proposals that, if enacted, would further reduce receipts
otherwise available to the General Fund by approximately $700 million during
1998-99. The Executive Budget proposes accelerating school tax relief for
senior citizens under STAR, which is projected to reduce General Fund receipts
by $537 million in 1998-99. The proposed reduction supplements STAR tax
reductions already scheduled in law, which are projected at $187 million in
1998-99. The Budget also proposes several new tax-cut initiatives and other
funding changes that include reducing the fee to register passenger motor
vehicles and earmarking a larger portion of such fees to dedicated funds and
other purposes; extending the number of weeks in which certain clothing
purchases are exempt from sales taxes; more fully conforming State law to
reflect recent Federal changes in estate taxes; continuing lower pari-mutuel tax
rates; and accelerating scheduled property tax relief for farmers from 1999 to
1998. In addition to the specific tax and fee reductions discussed above, the
Executive Budget also proposes establishing a reserve of $100 million to permit
the acceleration into 1998-99 of other tax reductions that are otherwise
scheduled in law for implementation in future fiscal years.
General Fund receipts in 1998-99 will also be affected by the loss of
certain one-time receipts recorded in 1997-98, the largest of which include
approximately $200 million in retroactive federal reimbursements for prior-year
social service spending recorded as a transfer from other funds and about $55
million in retroactive assessments on Office of Mental Retardation and
Developmental Disabilities facilities that were
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received in 1997-98 as miscellaneous receipts. Estimates for 1998-99 also
reflect the loss of one-time receipts from a tax amnesty program.
Personal income tax collections in the General Fund are projected to
increase by $1.32 billion over 1997-98, from $18.50 billion to $19.82 billion.
The increase reflects growth in constant law liability of over six percent in
1998, down from an estimated 12 percent growth in 1997. Growth in personal
income tax liability in 1997 benefitted from a temporary surge in capital-gains
income in response to 1997 reductions in the federal tax rate on such income.
In addition to the General Fund receipts, approximately $724 million in personal
income tax collections will be deposited in special revenue funds to finance the
School Tax Assistance Program (STAR).
User tax collections and fee receipts are projected to reach $7.2 billion
in 1988-99, an increase of $144 million over the current year. The largest
source of receipts in this category is the sales and use tax, which accounts for
nearly 80 percent of projected receipts. Sales tax receipts are the most
responsive to economic trends such as nominal growth in income, prices,
employment, and consumer confidence. The strong growth in income experienced
this year produced continuing growth in the base of the sales and use tax of 5.2
percent in 1997-98. The sales tax growth rate projected for the coming year is
expected to be marginally higher.
The 1998-99 forecast for user taxes and fees also reflects the impact of
scheduled tax reductions that will lower receipts by $38 million, as well as the
impact of two Executive Budget proposals that are projected to lower receipts by
an additional $79 million. The first proposal would divert $30 million in motor
vehicle registration fees from the General Fund to the Dedicated Highway and
Bridge Trust Fund; the second would reduce fees for motor vehicle registrations,
which would further lower receipts by $49 million. The underlying growth of
receipts in this category is projected at 4 percent, after adjusting for these
scheduled and recommended changes.
In comparison to the current fiscal year, business tax receipts are
projected to decline slightly in 1998-99, falling from $4.98 billion. The
decline in this category is largely attributable to scheduled tax reductions.
In total, collections for corporation and utility taxes and the petroleum
business tax are projected to fall by $107 million from 1997-98. The decline in
receipts in these categories is partially offset by growth in the corporation
franchise, insurance and bank taxes, which are projected to grow by $88 million
over the current fiscal year.
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Receipts from other taxes, which include taxes on estate and gifts, real
property gains, and pari-mutuel wagering, are projected to total $1.01 billion
in 1998-99, a decline of $78 million from the current year. The main reason for
the decline is an expected fall in the number and value of large estate tax
payments from the extraordinary level achieved in 1997-98. The decline also
reflects the first full-year impact of the repeal of the gains tax.
Miscellaneous receipts, which include license revenues, fee and fine
income, investment income and abandoned property proceeds, as well as the yield
of the largest share of the State's medical provider assessments, are projected
to fall from $1.57 billion in the current year to $1.4 billion in 1998-99, a
decline of $170 million. The decline is largely a result of the loss of over
$90 million in one-time transactions and $56 million in statutory reductions in
medical provider assessments.
Transfers to the General Fund from other funds consist primarily of tax
revenues in excess of debt service requirements. Proceeds from the one-cent
sales tax in excess of those used to support debt service payments to the Local
Government Assistance Corporation (LGAC) account for 85 percent of the 1998-99
receipts in this category. LGAC transfers to the General Fund are projected to
increase by $72 million to $1.55 billion in 1998-99, consistent with estimates
for sales and use receipts. Other transfers periodically include non-recurring
transactions, which result in significant annual increases and decreases for
this category. All other transfers are projected to decrease by $250 million to
$270 million in 1998-99 and thereafter.
The 1998-99 Financial Plan projects General Fund disbursements of $36.18
billion, an increase of $1.02 billion over projected spending for the current
year.
Disbursements from the category of Grants to Local Governments constitute
approximately 67.9 percent of all General Fund spending, and include payments to
local governments, non-profit providers and individuals. Disbursements in this
category are projected to increase by $931 million to $24.55 billion in 1998-99,
or 3.9 percent above 1997-98. The largest increases are for school aid and
Medicaid.
School aid is projected at $9.47 billion in 1998-99, an increase of $607
million on a State fiscal year basis. This increase funds both the balance of
aid payable for the 1997-98 school year and a proposed 1998-99 school year
increase of $518 million. Medicaid costs are estimated to increase $212 million
to $5.68 billion, about the same spending level as in 1994-95.
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After adjusting 1997-98 spending for the one-time acceleration of a 53rd weekly
Medicaid payment scheduled for 1998-99, Medicaid spending is projected to
increase by $348 million or 6.5 percent. The adjustment eliminates this
extraordinary payment in 1997-98 for purposes of comparison with 1998-99.
Spending in local assistance programs for higher education, handicapped
education, mental hygiene, local public health and revenue sharing are also
proposed to increase.
Support for State operations, which pays for the costs of operating the
Executive, Legislative, and Judicial branches of government, is projected to
increase by $524 million to $6.73 billion, or 8.4 percent higher than 1997-98.
This projected increase is primarily due to costs associated with an additional
27th payroll and current collective bargaining agreements, the loss of Federal
disproportionate share receipts that offset General Fund spending in mental
hygiene programs, and a $108 million requested increase in the Judiciary's
budget. Adjusting for the extra payroll, State operations spending increases by
a projected 6.1 percent. The State workforce is roughly 191,000 at present and
is projected to remain stable over the year.
Total spending in General State charges is projected to decline slightly
from 1997-98 to $2.23 billion. This annual decline reflects projected decreases
in one-time costs for pension and Court of Claims payments, offset by projected
increases for health insurance contributions, social security costs, and the
loss of reimbursements due to a reduction in the fringe benefit rate charged to
positions financed by non-General funds.
Transfers in support of debt service are projected to grow at 5.8 percent
in 1998-99, from $2.03 billion to $2.15 billion. Transfers in support of capital
projects for 1998-99 are estimated to total $190 million, a decrease of $453
million from 1997-98, reflecting the absence of one-time transfers for the
Hudson River Park and CEFAP in 1997-98.
All other transfers reflect remaining transfers from the General Fund to
other funds. These transfers decline by $68 million to $323 million in 1998-99,
reflecting non-recurring transfers in 1997-98 to the State University Tuition
Stabilization Fund ($29 million) and to the Lottery fund to support school aid
as a result of lower-than-projected 1997-98 Lottery receipts ($70 million),
offset by a $34 million increase in the State subsidy to the Roswell Park Cancer
Institute.
The Division of the Budget estimates that the 1998-99 Financial Plan
includes approximately $62 million in non-
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recurring resources, comprising less than two-tenths of one percent of General
Fund disbursements. The non-recurring resources projected for use in 1998-99
consist of $27 million in retroactive federal welfare reimbursements for family
assistance recipients with HIV/AIDS, $25 million in receipts from the Housing
Finance Agency that were originally anticipated in 1997-98, and $10 million in
other measures, including $5 million in asset sales.
For 1998-99, the Financial Plan projects disbursements of $30.16 billion
from Special Revenue Funds (SRFs), an increase of $2.32 billion or 8.3 percent
over 1997-98. Disbursements in State SRFs are projected at $8.29 billion, an
increase of $1.09 billion or 15.2 percent from 1997-98. Disbursements from
federal funds, which account for approximately three-quarters of all SRF
spending, are estimated at $21.87 billion in 1998-99, an increase of $1.22
billion or 5.9 percent from 1997-98.
The implementation of the first phase of the STAR program accounts for $724
million of the 1.09 billion increase in proposed State SRF spending in 1998-99.
Other projected State SRF spending increases include: $149 million in additional
operating assistance for mass transit systems; $82 million to expand the Child
Health Plus program, which provides health insurance for uninsured children
under 19 years of age; and $138 million for various State agency activities.
Spending from the State Lottery Fund is projected to increase slightly over
1997-98, while disbursements from the Indigent Care Fund are projected to remain
flat.
The $1.22 billion year-to-year growth in federal SRF spending is primarily
due to increases in Medicaid ($433 million), Children and Family Assistance
Programs ($297 million), education programs ($172 million), the expanded Child
Health Plus program ($144 million), and the welfare program ($50 million).
Disbursements from Capital Projects funds in 1998-99 are estimated at $4.82
billion, or $1.07 billion higher than 1997-98. The proposed spending plan
includes: $2.51 billion in disbursements for transportation purposes, including
the State and local highway and bridge program; $815 million for environmental
activities; $379 million for correctional services; $228 million for SUNY and
CUNY; $290 million for mental hygiene projects; and $375 million for CEFAP.
The projected 1998-99 General Fund cash flow will not depend on either
short-term spring borrowing or the issuance of LGAC bonds. The new-money bond
issuance portion of the LGAC program was completed in 1995-96, and provisions
prohibiting the State
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from returning to a reliance upon cash flow manipulation to balance its budget
will remain in bond covenants until the LGAC bonds are retired.
The 1998-99 cash flow projects substantial closing balances in each quarter
of the fiscal year, with excesses in receipts over disbursements in every
quarter of the fiscal year and no monthly balance (prior to March) lower than
$1.5 billion. The closing fund balance is projected at $500 million.
The Executive Budget projects budget gaps of approximately $1.75 billion in
1999-00 growing to $3.75 billion in 2000-01.
General Fund receipts are projected at $36.14 billion and $35.75 billion
for 1999-00 and 2000-01, respectively. The receipt projections were prepared on
the basis of an economic forecast of a steadily growing national economy, in an
environment of low inflation and slow employment growth. The forecast for the
State's economic performance likewise is for slow but steady economic growth.
Personal income is expected to rise between 4.25 and 4.5 percent over this
period, with average total employment growth of slightly less than one percent a
year. Private sector employment is expected to rise slightly more rapidly.
Statutory changes affecting General Fund receipts are dominated by the
dedication of a portion of the income tax to fund school tax reductions under
STAR. Personal income receipts dedicated to STAR are estimated at $1.39 billion
in 1999-00 and at $2.04 billion in 2000-01. The General Fund tax relief
provided by the estate and gift tax reduction program, sales tax reductions and
other 1997 enactments further reduce taxes and fees by roughly $1 billion by the
last year of the forecast period. Other 1998-99 budget proposals that lower
General Fund taxes and fees will annualize to approximately $110 million in
1999-00 and $100 million in 2000-01.
The receipt projections reflect constant law income tax liability growth of
approximately 5.3 percent annually and sales tax growth averaging slightly less
than 5 percent over the period. Constant law business tax liability is
projected to rise slowly over the two years.
Miscellaneous receipt projections reflect $250 million in each of the
outyears as the potential State benefit from a broader national settlement
involving tobacco taxes and health liability.
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Disbursements from the General Fund are projected at $37.84 billion in
1999-00 and $39.45 billion in 2000-01, after assuming implementation of spending
proposals contained in the Executive Budget, the value of which is annualized
and assumed to continue. The projections include additional school aid increases
of roughly 7 percent annually to finance present law and implement proposals
enacted under the STAR/School Aid program. Additional funding to implement
welfare reform is also included, as well as funding for mental health community
reinvestment, prison expansion, and other previous multi-year spending
commitments. Growth in General Fund Medicaid spending is projected at just over
6 percent annually. Other spending growth is projected to follow recent trends.
Consistent with past practice, funding is not included for any costs associated
with new collective bargaining agreements after the expiration of the current
round of contracts at the end of the 1998-99 fiscal year.
Savings actions totaling $600 million in 1999-00 and growing to $800
million in 2000-01 are assumed in these spending projections. It is expected
that the 1999-00 Financial Plan will include continued actions by State agencies
to deliver services more efficiently, continued savings from workforce
management efforts, aggressive efforts to maximize federal and other non-General
Fund spending offsets, and other efforts to control State spending.
The Governor is required by law to propose a balanced budget each year. In
order to address any potential remaining budget gap, the Governor is expected to
make additional proposals to bring receipts in line with disbursements. The
State has closed projected budget gaps of $5.0 billion, $3.9 billion and $2.3
billion in its 1995-96, 1996-97 and 1997-98 fiscal years, respectively.
The Division of the Budget believes that the economic assumptions and
projections of receipts and disbursements accompanying the 1998-99 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
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. For example, there can be no assurance that the
Legislature will enact the Governor's proposals or that the State's actions will
be sufficient to
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preserve budgetary balance or to align recurring receipts and disbursements in
either 1998-99 or in future fiscal years.
Uncertainties with regard to the economy present the largest potential risk
to future budget balance in New York State. This risk includes either a
financial market or broader economic "correction" during the period, a risk
heightened by the relatively lengthy expansions currently underway. The
securities industry is more important to the New York economy than the national
economy, and a significant deterioration in stock market performance could
ultimately produce adverse changes in wage and employment levels. In addition,
a normal "forecast error" of one percentage point in the expected growth rate
could cumulatively raise or lower receipts by over $1 billion by the last year
of the 1998 through 2001 projection period. 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.
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
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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 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.
Section 22-c of the State Finance Law, as amended by Chapter 389 of the
Laws of 1997, now requires the Governor to submit the five-year Capital Program
and Financing Plan with the Executive Budget. That Plan also is required to be
updated by the later of July 30 or 90 days after enactment of the State budget.
The Update to the five-year Capital Program and Financing Plan was released
on November 18, 1997. The Update reflected voter disapproval of the School
Facility Health and Safety Bond Act, additional issuances for 1997-98 of
approximately $225 million for CEFAP, $42 million for the Albany County Airport,
and $228 million in Certificates of Participation (COPs) to finance welfare
information systems.
The proposed 1997-98 through 2002-03 Capital Program and Financing Plan was
released with the 1998-99 Executive Budget on January 20, 1998. As a part of
that Plan, changes were proposed to the State's 1997-98 borrowing plan,
including: the delay in the issuance of COPs to finance welfare information
systems until 1998-99 to permit a thorough assessment of needs; and the
elimination of issuances for the CEFAP to reflect the proposed conversion of
that bond-financed program to pay-as-you-go financing.
As a result of these changes, the State's 1997-98 borrowing plan now
reflects: $501 million in general obligation bonds (including $140 million for
purposes of redeeming outstanding BANs) and $140 million in general obligation
commercial paper; the issuance of $83 million in COPs for equipment purchases;
and approximately $1.8 billion in borrowings by public authorities pursuant to
lease-purchase and contractual-obligation financings for capital programs of the
State, including costs of issuance, reserve funds, and other costs, net of
anticipated refundings and other adjustments for 1997-98 capital projects. The
projection of State borrowings for the 1997-98 fiscal year is subject to
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change as market conditions, interest rates and other factors vary through the
end of the fiscal year.
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. States 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.
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 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
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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.
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.
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An additional risk to the 1998-99 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.
The State is a defendant in numerous legal proceedings pertaining to
matters incidental to the performance of routine governmental operations. Such
litigation includes, but is not limited to, claims asserted against the State
arising from alleged torts, alleged breaches of contracts, condemnation
proceedings and other alleged violations of State and Federal laws.
Included in the State's outstanding litigation are a number of cases
challenging the legality or the adequacy of a variety of significant social
welfare programs primarily involving the State's Medicaid and mental health
programs. Adverse judgments in these matters generally could result in
injunctive relief coupled with prospective changes in patient care which could
require substantial increased financing of the litigated programs in the future.
Because of the prospective nature of these matters, no provision for this
potential exposure has been made in the accompanying general purpose financial
statements.
Actions commenced by several Indian nations claim that significant amounts
of land were unconstitutionally taken from the Indians in violation of various
treaties and agreements during the eighteenth and nineteenth centuries. The
claimants seek recovery of approximately six million acres of land as well as
compensatory and punitive damages.
In addition, the State is party to other claims and litigation which its
legal counsel has advised are not probable
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of adverse court decisions. Although the amounts of potential losses, if any,
are not presently determinable, it is the State's opinion that its ultimate
liability in these cases is not expected to have a material adverse effect on
the State's financial position.
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. As of July 1998, Moody's rated New
York City general obligation bonds "A3" and S+P rated the same bonds "A-".
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.
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 1998-1999
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.
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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. 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.
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.
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. 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.
Puerto Rico's more than decade-long economic expansion continued throughout
the five-year period from fiscal 1993 through fiscal 1997. Almost every sector
of the economy participated and record levels of employment were achieved.
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Factors behind this expansion included government-sponsored economic development
programs, periodic declines in the exchange value of the United States dollar,
increases in the level of federal transfers, and the relatively low cost of
borrowing.
Gross product in fiscal 1993 was $25.1 billion ($24.5 billion in 1992
prices) and gross product in fiscal 1997 was $32.0 billion ($27.6 billion in
1992 prices). This represents an increase in gross product of 27.5% from fiscal
1993 to 1997 (12.6% in 1992 prices). Since fiscal 1985, personal income, both
aggregate and per capita, has increased consistently each fiscal year. In
fiscal 1996, aggregate personal income was $29.4 billion ($27.8 billion in 1992
prices) and personal income per capita was $7,882 ($7,459 in 1992 prices).
Puerto Rico's economy continued to expand throughout the period from fiscal
1990 through fiscal 1997. 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.
According to the Labor Department's Household Employment Survey, during the
first five months of fiscal 1998, total employment increased 1.9% over fiscal
1997. Total employment averaged 1,137,200 during the first five months of
fiscal 1998, compared to 1,115,600 in the same period of fiscal 1997. The
seasonally adjusted unemployment rate for November 1997 was 14.0%.
The Planning Board's gross product forecast for fiscal 1998, made in
February 1997, projected an increase of 2.6% over fiscal 1997.
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. According to the Planning Board's preliminary
figures, in fiscal 1996 manufacturing generated $18.9 billion, or 41.4% of gross
domestic product and accounted for 15.3% of total employment; as compared with
fiscal 1995, when it generated $17.9
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billion, or 41.9%, of gross domestic product and accounted for 16.4% of total
employment. Manufacturing in Puerto Rico is now more diversified than during the
earlier phases of its industrial development. In the last two decades,
industrial development has tended to be more capital intensive and more
dependent on skilled labor. This gradual shift in emphasis is best exemplified
by the heavy investment in the pharmaceutical, scientific instruments, computer,
microprocessor, medical product and electrical product industries over the last
decade. One of the factors assisting the development of the manufacturing sector
has been the tax incentives offered by the federal and Puerto Rico governments.
Recently enacted federal legislation amending Internal Revenue Code Section 936,
however, phases out the federal tax incentives during a ten-year period.
The service sector, which includes hotel and related services and which,
during fiscal 1997, accounted for approximately 48.8% of total employment,
accounted for $17.1 billion, or 37.6%, of Puerto Rico's gross domestic product
in fiscal 1996, as compared with $16.2 billion, or 38.1%, of gross domestic
product in fiscal 1995. The services sector, particularly wholesale and retail
trade and finance, insurance and real estate, has experienced significant growth
partly in response to the expansion of the manufacturing sector.
Growth in construction and tourism has also contributed to increased
economic activity in fiscal 1997. The growth in the construction industry has
been evidenced by a nominal increase of 14.7% in construction investment for
fiscal 1997 over fiscal 1996. Tourism has grown in each fiscal year since
fiscal 1985. More than 4.3 million visitors spent over $2.0 billion in Puerto
Rico in fiscal 1997. San Juan has become the largest home port for cruise ships
in the Caribbean and the second largest home port for cruise ships in the world.
Twenty-four U.S. and international airlines offer scheduled service to and from
San Juan, and a major U.S. airline uses San Juan as a hub for its intra-
Caribbean operations. This reflects the importance of Puerto Rico as a tourist
destination and as a transportation hub in the Caribbean.
For many years, United States companies operating in Puerto Rico enjoyed a
special tax credit that was available under Section 936 of the Internal Revenue
Code. Originally, the credit provided an effective 100% federal income tax
exemption for most operating income, as well as qualifying investment income
from Puerto Rico sources. Amendments to Section 936 made in 1993 (the "1993
Amendments") instituted two alternative methods for calculating the tax credit
and limited the amount of the credit that a qualifying company can claim. These
limitations are based
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on a percentage of qualifying income (the "percentage of income limitation") and
on qualifying expenditures for wages, other wage related benefits and other
qualifying costs and expenses (the "economic activity limitation", also known as
the "wage credit limitation").
As a result of amendments incorporated in the Small Business Job Protection
Act of 1996, enacted by the United States Congress and signed into law by
President Clinton on August 20, 1996 (the "1996 Amendments"), the tax credit is
now being phased out over a ten-year period for existing 936 credit claimants
and is no longer available for corporations that establish operations in Puerto
Rico after October 13, 1995 (including existing Section 936 Corporations, if
they establish new product lines in Puerto Rico). The 1996 Amendments also
moved the credit based on the economic activity limitation to Section 30A of the
Code and phased it out over 10 years.
In addition, the 1996 Amendment eliminated the credit previously available
for income derived from certain qualified investments in Puerto Rico.
During 1997, the Governor proposed to Congress the enactment of a new
permanent federal incentive program similar to what is now provided under
Section 30A. Such program would provide U.S. companies a tax credit based on
qualifying wages paid and other wage related expenses, such as fringe benefits,
as well as depreciation expenses for certain tangible assets and research and
development expenses. Under the Governor's proposal, the credit granted to
qualifying companies would continue in effect until Puerto Rico shows, among
other things, substantial economic improvements in terms of certain economic
parameters. The fiscal 1998 federal budget submitted by President Clinton to
Congress in February 1997, included a proposal to modify Section 30A to extend
the availability of the Section 30A credit indefinitely, make it available to
companies establishing operations in Puerto Rico after October 13, 1995, and
eliminate the income cap. However, President Clinton's proposal was not included
in the fiscal 1998 federal budget. While the Government of Puerto Rico intends
to continue lobbying for this proposal, it is not impossible at this time to
predict whether the Section 30A credit will be modified, nor to determine the
long term effect on the Puerto Rico economy of the enactment of the 1996
Amendments. The Commonwealth of Puerto Rico does not believe there will be
short-term or medium-term material adverse effects on Puerto Rico's economy as a
result of the enactment of the 1996 Amendments. The Commonwealth of Puerto Rico
further believes that the phase-out period allows sufficient time to implement
additional incentive programs to safeguard Puerto Rico's competitive position.
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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. Under the 1987 Act, as amended, applications for
grants of tax exemption could be filed until December 31, 1996. On September 12,
1996 the Governor of Puerto Rico signed into law Act No. 212 which postponed the
deadline for filing applications until December 31, 1997.
On December 2, 1997 the Governor of Puerto Rico signed into law Act No. 135
(the "1998 Tax Incentives Law"), a new industrial incentives law aimed at
attracting and retaining foreign investment in Puerto Rico.
The benefits provided by the 1998 Tax Incentives Law are available to new
companies as well as companies currently conducting tax exempt operations in
Puerto Rico which choose to renegotiate their existing tax exemption grant. The
activities eligible for tax exemption include manufacturing, certain designated
services performed for markets outside Puerto Rico, the production of energy
from local renewable sources for consumption in Puerto Rico and laboratories for
scientific and industrial research. For companies qualifying thereunder, the
1998 Tax Incentive Law would impose income tax rates ranging from 2% to 75%. In
addition, it would grant 90% exemption from property taxes, 100% exemption from
municipal license taxes during the first eighteen months of operation and
between 80% and 60% thereafter, and 100% exemption from municipal excise taxes.
The 1998 Tax Incentive Law also provides various special deductions designed to
stimulate employment and productivity, research and development and capital
investment in Puerto Rico.
Under the 1998 Tax Incentives Law, companies can repatriate or distribute
their profits free of tollgate taxes. In addition, passive income derived from
the investment of eligible funds in Puerto Rico financial institutions,
obligations of the Government of Puerto Rico and other designated investments
continue to be fully exempt from income and municipal license taxes. Individual
shareholders of an exempted business are allowed a credit against their Puerto
Rico income taxes equal to 30% of their proportionate share in the exempted
business' income tax liability. Gain from the sale or exchange of shares of an
exempted business by its shareholders during the exemption period is subject to
a 4% income tax rate.
The Constitution authorizes the contracting of debts as determined by the
Legislature. Nevertheless, the Constitution provides that direct obligations of
the Commonwealth evidenced by
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bonds or notes and backed by the full faith, credit and taxing power of the
Commonwealth, shall not be issued if the amount of the principal of, and
interest on, such bonds and notes and on all such bonds and notes issued
thereafter which is payable in any fiscal year, together with any amount paid by
the Commonwealth in the preceding fiscal year on account of bonds or notes
guaranteed by the Commonwealth, exceed 15% of the average annual revenues raised
under the provisions of Commonwealth legislation and conveyed into the Treasury
(hereinafter "internal revenues") in two fiscal years preceding the then current
fiscal year. Section 2, Article VI of the Constitution does not limit the amount
of debt that the Commonwealth may guarantee so long as the 15% limitation is not
exceeded. Internal revenues consist principally of income taxes and excise
taxes. Certain revenues, such as federal excise taxes on offshore shipments of
alcoholic beverages, tobacco products and customs duties, which are collected by
the United States Government and returned to the Commonwealth, and motor vehicle
fuel taxes and license fees, which are allocated to the Puerto Rico Highway and
Transportation Authority, a blended component unit, are not included as revenues
for the purpose of calculating the debt limit, although they may be available
for the payment of debt service. The Commonwealth has never defaulted on the
payment of principal or interest on any of its general long-term debt
obligations. At June 30, 1997, the Commonwealth was in compliance with the debt
limitation requirement.
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 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.
With respect to pending and threatened litigation, excluding the litigation
mentioned in the following paragraph, the Commonwealth has reported liabilities
of approximately $106 million for awarded and anticipated unfavorable judgments.
This amount was included as other long-term liabilities in the general long-term
debt account group and represents the amount estimated as a probable liability
or a liability with a fixed or expected
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due date which will require future available financial resources for its
payment. Management believes that the ultimate liability in excess of amounts
provided, if any, would not be significant.
The Commonwealth and various component units are defendants in a lawsuit
alleging violations of civil rights. Preliminary hearings and discovery
proceedings are in progress. The amounts claimed exceed $50 billion; however,
the ultimate liability cannot be presently determined. It is the opinion of
management that the claim is excessive and exaggerated. No provision for any
liability that may result upon adjudication of this lawsuit has been recognized
in the financial statements by the Commonwealth.
On January 22, 1996, the US District Court in Puerto Rico consolidated all
cases against the Commonwealth related to the complaints filed in 1979 by the
inmates of the correctional facilities in Puerto Rico. The Court ruled a
permanent order requiring the Commonwealth to comply with the requirement of the
minimum fixed living space per inmate. In the opinion of management, based on
advice of their legal counsel, this order will limit the imposition of further
fines and the fines already paid together with the accrued liability the general
long-term debt account group, (which amount to approximately $200 million at
June 30, 1997) shall be sufficient to carry out the Court's requirements.
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
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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.
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.
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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. 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.
FUNDAMENTAL INVESTMENT RESTRICTIONS
The following restrictions 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 in the 1940 Act). Investment restrictions that appear
below or elsewhere in this Statement of Additional Information that involve a
maximum percentage of securities or assets shall not be
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considered to be violated unless an excess over the percentage occurs
immediately after, and is caused by, an acquisition or encumbrance of securities
or assets of, or borrowings by or on behalf of, a Fund.
The Trust may not, on behalf of any Fund:
1. With respect to 75% of each Fund's total assets invest more than 5% of
the value of the total assets of a Fund in the securities of any one issuer,
except U.S. government securities, or purchase the securities of any issuer if
such purchase would cause more than 10% of the voting securities of such issuer
to be held by a Fund. This restriction does not apply to the California Tax
Free Fund, Equity Index Fund, International Bond Fund and New York Tax Free
Fund.
2. Borrow money except from banks on a temporary basis for extraordinary
or emergency purposes, including the meeting of redemption requests, or by
engaging in reverse repurchase agreements or comparable portfolio transactions
provided that these Funds maintain asset coverage of at least 300% for all such
borrowings, and no purchases of securities will be made while such borrowings
exceed 5% of the value of the Fund's total assets (10% in the case of the
California Tax Free Fund and New York Tax Free Fund).
3. Purchase securities (or with respect to the California Tax Free Fund,
New York Tax Free Fund, and Tax Free Bond Fund purchase (i) Pollution Control
and Industrial Development Bonds or (ii) securities the interest from which is
not exempt from regular federal income tax) if such purchase would cause 25% or
more in the aggregate of the market value of the total assets of a Fund to be
invested in the securities of one or more issuers having their principal
business activities in the same industry, provided that there is no limitation
in respect to investments in U.S. government securities or, with respect to each
Fund except Strategic Value Fund, investments in repurchase agreements with
respect thereto (for the purposes of this restriction, telephone companies are
considered to be a separate industry from gas or electric utilities, and wholly
owned finance companies are considered to be in the industry of their parents if
their activities are primarily related to financing the activities of the
parents) except that (a) the above limitation does not apply to the Equity Index
Fund to the extent that the Standard & Poor's 500 Composite Stock Price Index is
so concentrated; (b) up to 40% of the High Yield Corporate Bond Fund's,
Strategic Income Fund's
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and Strategic Value Fund's total assets, taken at market value, may be invested
in each of the electric utility and telephone industries, but each Fund will not
invest 25% or more in either of those industries unless yields available for
four consecutive weeks in the four highest rating categories on new issue bonds
in such industry (issue size of $50 million or more) have averaged in excess of
105% of yields of new issue long-term industrial bonds similarly rated (issue
size of $50 million or more); (c) 25% or more of the market value of the total
assets of the Money Market Fund will be invested in the securities of banks and
bank holding companies, including certificates of deposit and bankers'
acceptances; and (d) at such time that the 1940 Act is amended to permit a
registered investment company to elect to be "periodically industry
concentrated" (i.e., a fund that does not concentrate its investments in a
particular industry would be permitted, but not required, to invest 25% or more
of its total assets in a particular industry) the Funds elect to be so
classified and the foregoing limitation shall no longer apply with respect to
the Funds. With respect to the California Tax Free Fund and New York Tax Free
Fund, private activity bonds ultimately payable by companies within the same
industry are treated as if they were issued by issuers in the same industry for
purposes of this restriction.
4. Purchase or sell real estate (excluding securities secured by real
estate or interests therein or issued by companies that invest in or deal in
real estate) or, in the case of the California Tax Free Fund and New York Tax
Free Fund, real estate investment trust securities; commodities and commodity
contracts. The Trust reserves the freedom of action to hold and to sell real
estate acquired for any Fund as a result of the ownership of securities.
Purchases and sales of foreign currencies on a spot basis and forward foreign
currency exchange contracts, options on currency, futures contracts on
currencies (securities, with respect to the Strategic Value Fund) or securities
indices and options on such futures contracts are not deemed to be an investment
in a prohibited commodity or commodity contract for the purpose of this
restriction.
5. Make loans to other persons, except loans of portfolio securities (in
the case of the California Tax Free Fund and New York Tax Free Fund, in an
amount not to exceed 10% of the value of each Fund's total assets in accordance
with applicable guidelines approved by the Board of Trustees and 30% in the case
of the Equity Index Fund). The purchase of debt obligations (and bankers'
acceptances and commercial paper in the case of the
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Equity Index Fund) and the entry into repurchase agreements in accordance with
such Fund's investment objectives and policies are not deemed to be loans for
this purpose.
6. 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.
7. 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.
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, Strategic Income Fund and
Strategic Value 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;
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(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 or Section 4(1) under the
Securities Act of 1933 determined to be liquid pursuant to guidelines
adopted by the Board), 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 are deemed
illiquid;
(c) purchase the securities of other investment companies, except to
the extent permitted by the 1940 Act or in connection with a merger,
consolidation, acquisition or reorganization.
(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 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
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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.
(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 or Section
4(1) under the Securities Act of 1933 determined to be liquid pursuant to
guidelines adopted by the Board).
(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 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).
B-113
<PAGE>
The following investment restrictions are non-fundamental, operating
policies of the International Bond Fund, International Equity Fund, Strategic
Income Fund and Strategic Value 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 disposition of which is restricted under
federal securities laws (collectively, "illiquid securities"), other than
Rule 144A securities or Section 4(2) commercial paper 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
B-114
<PAGE>
purchase the securities of other investment companies, except to the extent
permitted by the 1940 Act or 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."
The Trustees have the ultimate responsibility for determining whether
specific securities are liquid or illiquid. The Trustees have delegated the
function of making day-to-day determinations of liquidity to the Sub-Advisers,
pursuant to guidelines approved by the Trustees.
Each Sub-Adviser takes into account a number of factors in determining
whether a Rule 144A security being considered for purchase by a Fund is liquid,
including at least the following:
(i) the frequency and size of trades and quotes for the Rule 144A
security relative to the size of the Fund's holding;
(ii) the number of dealers willing to purchase or sell the 144A
security and the number of other potential purchasers;
(iii) dealer undertakings to make a market in the 144A security; and
B-115
<PAGE>
(iv) the nature of the 144A security and the nature of the market for
the 144A security (i.e., the time needed to dispose of the security, the method
----
of soliciting offers, and the mechanics of transfer).
To make the determination that an issue of 4(2) commercial paper is liquid, a
Sub-Adviser must conclude that the following conditions have been met:
(a) the 4(2) commercial paper is not traded flat or in default as
to principal or interest;
(b) the 4(2) commercial paper is rated:
(i) in one of the two highest rating categories by at least two
nationally recognized statistical rating organizations ("NRSROs");or
(ii) if only one NRSRO rates the security, the 4(2) commercial paper
is rated in one of the two highest rating categories by that NRSRO; or
(iii) if the security is unrated, the Sub-Adviser has determined that
the security is of equivalent quality based on factors commonly used by rating
agencies; and
(c) there is a viable trading market for the specific security,
taking into account all relevant factors (e.g., whether the security is the
-----
subject of a commercial paper program that is administered by an issuing and
paying agent bank and for which there exists a dealer willing to make a market
in the security, the size of trades relative to the size of the Fund's holding
or whether the 4(2) commercial paper is administered by a direct issuer pursuant
to a direct placement program).
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.
TRUSTEES AND OFFICERS
Information pertaining to the Trustees and officers of the Trust is set
forth below. Trustees deemed to be "interested
B-116
<PAGE>
persons" of the Trust for purposes of the 1940 Act are indicated by an asterisk.
B-117
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
Donald K. Ross* Chairman and Trustee Retired Chairman and Chief Executive Officer,
953 Cherokee Lane New York Life Insurance Company; Director, New York Life Insurance
Franklin Lakes, NJ 07417 Company, 1978 to 1996; President, New York Life Insurance Company, 1986 to
Age: 72 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 Executive Director and Chairperson, MainStay Institutional Funds, Inc., 1997 to
51 Madison Avenue Officer and Trustee present; Senior Vice President, New York Life Insurance Company, 1997 to
New York, NY 10010 present; Senior Vice President, Smith Barney, 1994 to and Division Sales
Age: 34 Manager, Prudential Securities, 1989 to 1994.
Harry G. Hohn* Trustee Retired Chairman and Chief Executive Officer, New York Life Insurance
51 Madison Avenue Company; Chairman of the Board and Chief Executive Officer, New York Life
New York, NY 10010 Insurance Company, 1990 to 1997; Vice Chairman of the Board, New York Life
Age: 66 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>
B-118
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
Edward J. Hogan Trustee Rear Admiral U.S. Navy (Retired); Independent Management Consultant, 1992
Box 2321 to 1997.
Sun Valley, ID 83353
Age: 65
Richard M. Kernan, Jr. * Trustee Director of MainStay VP Series Fund, Inc. from January 1987 to present;
51 Madison Avenue Chairman of the Board and Chief Executive Officer of MainStay VP Series
New York, NY 10010 Fund, Inc. from August 1989 to present; Executive Vice President and Chief
Age: 57 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, New York, NY, 1991 to present;
Kissinger Trustee, Rockefeller University, 1995 to present; Trustee, Animal Medical
Henderson Road Center, 1993 to present; and Trustee, The Masters School, 1994 to present;
South Kent, CT 06785 Member, Board of Overseers, Rockefeller Institute of Government, Albany,
Age: 64 NY, 1983-1992 (Board dissolved).
Terry L. Lierman Trustee President, Capitol Associates, Inc., 1984 to present; President, Employee
426 C Street, N.E. Health Programs, 1990 to present; Vice Chairman, TheraCom Inc., 1994 to
Washington, D.C. 20002 present; Member, UNICEF National Board, 1993 to present; Director, Harvard
Age: 50 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, 1997 to present; and Board Member, Hollings Cancer Center,
Medical University of South Carolina, 1993 to present.
</TABLE>
B-119
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
John B. McGuckian Trustee Chairman of the Board, Ulster Television plc, 1990 to present; Director,
Ardverna Ulster Television plc, 1970 to present; Chairman of the Board, Tedcastle
Cloughmills Holding Ltd. (energy), 1995 to present; Director, Cooneen Textiles Ltd.
Northern Ireland (clothing manufacturer), 1967 to present; Director Allied Irish Banks plc,
BT4 49NL 1977 to present; Director, First Trust Bank, 1991 to present; Director,
Age: 58 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 1997; and Chairman of Senate and Senior
Pro-Chancellor, Queen's University, 1986 to present.
Donald E. Nickelson Trustee Vice Chairman, Harbour Group Industries, Inc., 1991 to present;
1701 Highway A-1-A Director, PaineWebber Group, 1980 to 1993; President, PaineWebber Group,
Suite 218 1988 to 1990; Chairman of the Board, Paine Webber Properties, 1985 to 1989;
Vero Beach, FL 32963 Director, Harbour Group, 1986 to present; Chairman of the Board and
Age: 65 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, Sugen, Inc., 1992 to
present; Chairman of the Board, Omniquip International, Inc., 1996 to
present; Director, Carey Diversified, L.L.C., January 1,1998 to present.
</TABLE>
B-120
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
Richard S. Trutanic Trustee Managing Director, The Somerset Group (financial advisory firm), 1990 to
1155 Connecticut Ave. present; Chief Executive Officer and President, Americap L.L.C. (Financial
N.W., Suite 400 Advisory Firm), 1997 to present; Senior Vice President, Washington
Washington, DC 20036 National Investment Corporation (financial advisory firm), 1985 to 1990;
Age: 45 Director, Allin Communications Corporation, 1996 to 1997; and Director and
Member of Executive Committee, Southern Net, Inc., 1986 to 1990.
Walter W. Ubl* Trustee Senior Vice President, New York Life Insurance Company, 1995 to 1997; Vice
85 East End Avenue President, 1984 to 1995; Vice President in charge of Mutual Funds
Apt. 2N Department, 1989 to 1997 ; Director and Vice President, NYLIFE
New York, NY 10028 Distributors Inc., 1993 to 1997; and Director and Senior Vice President
Age: 56 NYLIFE Securities Inc., 1996 to 1997.
- ------------------------------------------------------------------------------------------------------------------------------------
OFFICERS (OTHER THAN TRUSTEES)
- ------------------------------------------------------------------------------------------------------------------------------------
Jefferson C. Boyce Senior Vice President Chairman, Monitor Capital Advisors, Inc., 1997 to present; Senior Vice
51 Madison Avenue President, MainStay Institutional Funds Inc., 1995 to present; Senior Vice
New York, NY 10010 President, New York Life Insurance Company, 1994 to present; Director,
Age: 40 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.
Frank A. Mistero Senior Vice President Senior Vice President, New York Life Insurance Company, 1990 to present;
51 Madison Avenue and Director, Senior Vice President and Chief Operating Officer, MainStay
New York, NY 10010 Management, Inc., 1997 to present.
Age: 52
</TABLE>
B-121
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
Anthony W. Polis Vice President and Chief Vice President, New York Life Insurance Company, 1988 to present;
51 Madison Avenue Financial Officer Director, Vice President and Chief Financial Officer, NYLIFE Securities
New York, NY 10010 Inc., 1988 to present; Vice President and Chief Financial Officer,
Age: 54 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>
B-122
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
Richard Zuccaro Tax Vice President Vice President, New York Life Insurance Company, 1995 to present;
51 Madison Avenue Vice President -- Tax, New York Life Insurance Company, 1986 to 1995;
New York, NY 10010 Tax Vice President, NYLIFE Securities Inc., 1987 to present;
Age: 48 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>
B-123
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation(s)
Name, Address and Age Position with Trust During Past 5 years
- --------------------- ------------------- ----------------------
<S> <C> <C>
A. Thomas Smith III Secretary Vice President and Associate General Counsel, New York Life Insurance
51 Madison Avenue Company, 1997 to present; Associate General Counsel, New York Life
New York, NY 10010 Insurance Company, 1996 to 1997; Assistant General Counsel, New York Life
Age: 41 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, 1997, 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:
B-124
<PAGE>
<TABLE>
<CAPTION>
Total Compensation
Aggregate From Registrant
Name of Compensation and Fund Complex
Trustee from the Trust Paid to Trustees
- --------------------- -------------- ----------------
<S> <C> <C>
Edward J. Hogan $48,000 $48,000
Nancy M. Kissinger $46,000 $46,000
Terry L. Lierman $48,000 $48,000
Donald E. Nickelson $52,000 $52,000
Richard S. Trutanic $46,000 $46,000
John B. McGuckian* $12,000 $12,000
</TABLE>
* Mr. McGuckian was elected to his position as Trustee of the Trust on July
28, 1997.
As of April 1, 1998, 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 other than the Strategic Value Fund approved
the Management Agreement. The Management Agreement for the Strategic Value Fund
was approved by the Fund's sole shareholder on October 21, 1997. 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
B-125
<PAGE>
persons" of the Trust or the Manager (as the term is defined in the 1940 Act).
The Management Agreement for each Fund was last approved by the Trustees,
including a majority of the Trustees who are not "interested persons" of the
Trust or the Manager (as that term is defined in the 1940 Act), at a meeting
held on April 27, 1998.
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.
B-126
<PAGE>
On October 24, 1997, the shareholders of each of the Funds other than the
Strategic Value Fund approved the Sub-Advisory Agreements with MacKay-Shields
and Monitor. The Sub-Advisory Agreement with respect to the Strategic Value Fund
was approved by that Fund's sole shareholder on October 21, 1998. 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 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-Advisory Agreements for each Fund were last approved by the Trustees,
including a majority of the Trustees who are not "interested persons" of the
Trust, the Manager, MacKay-Shields or Monitor (as defined in the 1940 Act), at a
meeting held on April 27, 1998.
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.
For the period from October 27, 1997 through December 31, 1997, the amount
of the Management fee paid and waived and/or reimbursed by each Fund; the amount
of the Sub-Advisory fee paid by the Manager from the Management fee; and the
amount of the Sub-Advisory fee waived and/or reimbursed were as follows:
B-127
<PAGE>
<TABLE>
<CAPTION>
Management Sub-Advisory
Management Fee Waived Sub-Advisory Fee Waived
Fund Fee Paid* and/or Reimbursed Fee Paid* and/or Reimbursed
- --------------------------- ---------- ----------------- ------------ -----------------
<S> <C> <C> <C> <C>
California Tax Free Fund... $ 22,562 $ -- $ 11,281 $ --
Capital Appreciation Fund.. 1,996,154 -- 998,077 --
Convertible Fund........... 1,210,730 -- 605,365 --
Equity Index Fund+......... 149,354 223,441 74,559 --
Government Fund............ 712,902 -- 356,451 --
High Yield Corporate Bond
Fund................... 3,590,202 -- 1,795,101 --
International Bond Fund.... 24,178 18,134 15,111 12,089
International Equity Fund.. 145,829 -- 87,497 --
Money Market Fund.......... 165,694 205,316 82,847 102,658
New York Tax Free Fund..... 11,863 5,413 5,932 2,707
Strategic Income Fund++.... -- 74,218 -- 37,109
Strategic Value Fund++..... 23,276 -- 11,638 --
Tax Free Bond Fund......... 533,914 -- 266,957 --
Total Return Fund.......... 1,431,434 -- 715,717 --
Value Fund................. 1,479,934 -- 739,967 --
</TABLE>
* After expense reimbursement or waiver.
+ The Equity Index Fund's expense limitation was terminated April 1, 1998.
++ The Strategic Income Fund commenced operations on February 28, 1997.
Effective February 28, 1998, the Fund's expense cap was terminated.
The Strategic Value Fund commenced operations on October 21, 1997.
In previous years, prior to a change in management structure, the Funds
paid an advisory fee directly to MacKay-Shields or Monitor. For the period from
January 1, 1997 through October 26, 1997 and the fiscal years ended December 31,
1996 and 1995, the amount of the advisory fee paid and waived and/or reimbursed,
by each Fund to MacKay-Shields or Monitor was as follows:
<TABLE>
<CAPTION>
1997 1996 1995
------------- ---------- -------------
Advisory Fee Advisory Fee Advisory Fee
Advisory Waived and/or Advisory Waived and/or Advisory Waived and/or
Fee Paid* Reimbursed Fee Paid* Reimbursed Fee Paid* Reimbursed
---------- ------------- ---------- ------------- ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
California Tax Free Fund... $ 44,678 $ 2,589 $ 45,307 $ 11,228 $ 29,964 $ 16,845
Capital Appreciation Fund.. 3,934,494 -- 3,429,258 -- 2,155,386 --
Convertible Fund........... 2,710,393 -- 2,444,000 -- 1,027,604 --
Equity Index Fund.......... 256,066 -- 163,785 -- 81,072 --
Government Fund............ 1,760,807 -- 2,643,801 -- 3,056,716 --
High Yield Corporate Bond
Fund................... 6,921,965 5,816,110 -- 3,930,939 --
International Bond Fund.... 65,696 52,556 68,489 54,933 52,534 42,028
International Equity Fund.. 384,003 -- 342,100 -- 166,703 --
Money Market Fund.......... 407,638 396,862 397,071 473,155 391,304 282,975
New York Tax Free Fund..... 25,025 13,579 29,457 19,911 31,482 14,241
Strategic Income Fund+..... 61,282 40,291 N/A N/A N/A N/A
Strategic Value Fund+...... N/A N/A N/A N/A N/A N/A
Tax Free Bond Fund......... 1,217,473 -- 1,579,820 -- 1,610,982
Total Return Fund.......... 3,025,045 -- 3,087,111 -- 2,396,247
</TABLE>
B-128
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C> <C>
Value Fund................. 2,976,469 -- 2,682,642 1,932,406
</TABLE>
- -------------------------
+ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 21, 1997.
* After expense reimbursement or waiver.
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 period from January 1, 1997 through October 26, 1997 and
the fiscal years ended December 31, 1996 and 1995 the amount of the
administration fee paid and waived and/or reimbursed by each Fund was as
follows:
<TABLE>
<CAPTION>
1997 1996 1995
-------- ---------- ----------
Fee Waived Fee Waived Fee Waived
and/or and/or and/or
Fee Paid* Reimbursed Fee Paid* Reimbursed Fee Paid* Reimbursed
---------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
California Tax Free Fund... $ 44,678 $ 2,589 $ 45,307 $ 11,228 $ 29,964 $ 16,845
Capital Appreciation Fund.. 3,934,494 -- 3,429,258 -- 2,155,386 --
Convertible Fund........... 2,710,393 -- 2,444,000 -- 1,027,604 --
Equity Index Fund.......... 605,767 418,496 365,118 290,022 324,287
Government Fund............ 1,760,807 -- 2,643,801 -- 3,056,716
High Yield Corporate Bond
Fund...................... 6,921,965 -- 5,816,110 -- 3,930,939
International Bond Fund.... 39,417 26,278 41,100 27,467 31,522 21,013
International Equity Fund.. 256,002 -- 228,066 -- 111,135 --
Money Market Fund.......... 407,638 396,862 397,071 473,155 391,304 282,975
New York Tax Free Fund..... 25,025 13,579 29,457 19,911 31,481 14,242
Strategic Income Fund+..... 61,282 40,291 N/A N/A N/A N/A
Strategic Value Fund+...... N/A N/A N/A N/A N/A N/A
Tax Free Bond Fund......... 1,217,473 -- 1,579,820 -- 1,610,982 --
Total Return Fund.......... 3,025,045 -- 3,087,111 -- 2,396,247 --
Value Fund................. 2,976,469 -- 2,682,642 -- 1,932,406 --
</TABLE>
- -----------------------
+ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 21, 1997.
* After expense reimbursement or waiver.
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
B-129
<PAGE>
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 Agreement for the Strategic Value Fund was approved by the
Trustees, including a majority of the Independent Trustees, at a meeting held on
July 28, 1997. The Distribution Agreements were reapproved by the Trustees,
including a majority of the Independent Trustees, at a meeting held on April 27,
1998.
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" 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 and by
the sole initial shareholder of the Strategic Value Fund on October 21, 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
B-130
<PAGE>
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 October 21, 1997 by the sole initial Class B shareholder of the
Strategic Value Fund, 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, 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
B-131
<PAGE>
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. 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 Strategic Income Fund on January 27, 1997. 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 Strategic Value Fund on July 28, 1997.
On October 24, 1997, Class B shareholders for each of the Funds, other than
the Equity Index Fund, Money Market Fund, Strategic Income Fund and Strategic
Value 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 Independent Trustees, approved the revision at an in-person
meeting held July 28, 1997. The Class B shareholders approved the revision at a
meeting held October 24, 1997.
Under the current 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.
B-132
<PAGE>
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).
For the fiscal year ended December 31, 1997, the Funds paid distribution
and service fees pursuant to the Class A and Class B Plans as follows:
B-133
<PAGE>
<TABLE>
<CAPTION>
Amount of Fee Amount of Fee
Pursuant to Pursuant to
Class A Plan Class B Plan
------------- -------------
<S> <C> <C>
California Tax Free Fund+........ $ 43,324 $ 29,795
Capital Appreciation Fund+....... 436,614 12,479,365
Convertible Fund+................ 160,596 7,496,884
Equity Index Fund................ 826,562 N/A
Government Fund+................. 41,839 5,572,110
High Yield Corporate Bond Fund+.. 447,670 25,344,441
International Bond Fund+......... 29,391 188,387
International Equity Fund+....... 44,218 567,206
Money Market Fund................ N/A N/A
New York Tax Free Fund+.......... 35,389 23,696
Strategic Income Fund++.......... 58,867 226,126
Strategic Value Fund++........... 5,136 10,314
Tax Free Bond Fund+.............. 32,364 2,207,368
Total Return Fund+............... 229,294 8,376,017
Value Fund+...................... 241,617 9,356,170
</TABLE>
_______________________
+ The Class B Plan was amended effective October 27, 1997. Figures
reflect calculation of fee pursuant to previous method for the period
from January 1, 1997 through October 26, 1997 and calculation of fee
pursuant to the current method for the period from October 27, 1997
through December 31, 1997.
++ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 21, 1997.
For the fiscal year ended December 31, 1997, 1996 and 1995, NYLIFE
Distributors retained the following amounts in sales charges for sales of Class
A shares of the Funds:
<TABLE>
<CAPTION>
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
California Tax Free Fund.... $ 6,958 $ 35,009 $ 57,181
Capital Appreciation Fund+.. 201,562 1,430,417 718,806
Convertible Fund+........... 39,646 903,782 529,361
Equity Index Fund........... 329,059 1,968,993 308,486
Government Fund+............ 5,803 96,545 95,975
High Yield Corporate Bond
Fund+................... 308,282 1,413,313 782,534
International Bond Fund+.... 5,235 54,586 10,984
International Equity Fund+.. 121,009 91,571 63,684
Money Market Fund+.......... N/A N/A N/A
New York Tax Free Fund...... 2,297 22,774 35,722
Strategic Income Fund++..... 14,008 N/A N/A
Strategic Value Fund++...... 344 N/A N/A
Tax Free Bond Fund+......... 5,710 51,345 62,656
Total Return Fund+.......... 50,232 334,470 233,202
Value Fund+................. 112,844 574,807 413,692
- -----------------------
</TABLE>
+ The Fund began offering Class A shares on January 3, 1995.
++ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 21, 1997.
B-134
<PAGE>
For the fiscal years ended December 31, 1997 and 1996, contingent deferred
sales charges were paid by investors on the redemption of Class B shares of each
Fund, as follows:
<TABLE>
<CAPTION>
Year Ended
Year Ended December 31,
December 31, 1997 1996
----------------- ------------
<S> <C> <C>
California Tax Free Fund........ $ 3,586 $ 2,008
Capital Appreciation Fund....... 1,485,899 966,555
Convertible Fund................ 1,466,588 852,359
Equity Index Fund............... N/A N/A
Government Fund................. 788,647 952,234
High Yield Corporate Bond Fund.. 2,684,352 1,482,294
International Bond Fund......... 31,152 27,332
International Equity Fund....... 88,010 48,979
Money Market Fund+.............. 779,844 640,623
New York Tax Free Fund.......... 2,531 2,810
Strategic Income Fund++......... 11,479 N/A
Strategic Value Fund++.......... -- N/A
Tax Free Bond Fund.............. 492,542 605,386
Total Return Fund............... 871,336 745,382
Value Fund...................... 996,052 712,915
</TABLE>
_______________________
+ 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.
++ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 21, 1997.
For the fiscal year ended December 31, 1997, it is estimated that the
following amounts were spent on compensation to dealers with respect to the
Class A shares of each Fund: California Tax Free Fund spent $36,835; Capital
Appreciation Fund spent $1,231,407; Convertible Fund spent $246,918; Equity
Index Fund spent $3,332,052; Government Fund spent $33,248; High Yield Corporate
Bond Fund spent $2,144,790; International Bond Fund spent $34,080; International
Equity Fund spent $75,027; New York Tax Free Bond Fund spent $16,433; Strategic
Income Fund spent $169,199; Strategic Value Fund spent $141,685 Tax Free Bond
Fund spent $32,283; Total Return Fund spent $307,772; and Value Fund spent
$665,119.
B-135
<PAGE>
For the fiscal year ended December 31, 1997, 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>
Approximate
Printing And Total Amount
Mailing Spent by
Sales Prospectuses to Compensation NYLIFE
Material other than to Compensation Sales Distributors
and Current Distribution to Sales Distribution With Respect
Advertising Shareholders Personnel Personnel Other Costs to Each Fund
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
California Tax Free $ 451 $ 5,941 $ 12,935 $ 4,638 $ 7,356 $ 84,185 $ 115,506
Fund
Capital Appreciation 87,010 1,547,023 3,159,974 625,088 1,888,695 13,803,858 21,111,648
Fund
Convertible Fund 22,979 727,746 537,699 88,566 279,208 4,640,527 6,296,725
Govt. Fund 8,234 547,016 323,510 72,554 178,934 1,867,222 2,997,470
High Yield Corp. Fund 130,347 2,796,481 4,100,335 771,492 2,419,468 41,119,642 51,337,765
International Bond 1,446 17,869 52,794 8,395 29,550 249,823 359,877
Fund
International Equity 5,115 53,876 185,125 32,625 106,364 756,109 1,139,214
Fund
New York Tax Free 1,345 4,517 6,991 2,553 6,197 64,232 85,835
Fund
Tax Free Fund 3,774 407,263 269,467 53,290 172,880 1,277,394 2,184,068
Total Return Fund 39,072 1,007,008 1,307,798 262,631 777,495 5,737,640 9,131,644
Value Fund 56,482 1,149,205 1,983,639 394,408 1,177,580 9,955,251 14,716,565
Strategic Income 5,873 33,872 209,498 38,134 119,979 1,062,130 1,469,486
Fund*
Strategic Value Fund* (535) 6,051 (60,004) 12,737 (18,061) 286,835 227,023
=================================================================================================================================
Total 361,593 8,303,868 12,089,761 2,367,111 7,145,645 80,904,848 111,172,826
=================================================================================================================================
</TABLE>
_______________________
* The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 22, 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.
B-136
<PAGE>
For the period from October 27, 1997 through December 31, 1997, the amount
of recordkeeping fees paid to the Manager by each Fund was as follows:
<TABLE>
<CAPTION>
Year Ended
December 31,
1997
------------
<S> <C>
California Tax Free Fund... N/A
Capital Appreciation Fund.. 41,466
Convertible Fund........... 21,595
Equity Index Fund.......... N/A
Government Fund............ 16,639
High Yield Corporate Bond
Fund................... 68,994
International Bond Fund.... 2,608
International Equity Fund.. 5,460
Money Market Fund.......... 12,407
New York Tax Free Fund..... N/A
Strategic Income Fund...... 4,701
Strategic Value Fund....... 2,323
Tax Free Bond Fund......... 13,665
Total Return Fund.......... 28,016
Value Fund................. 31,142
</TABLE>
For the period January 1, 1997 through October 26, 1997 and the fiscal
years ended December 31, 1996 and 1995, the amount of recordkeeping fee paid to
NYLIFE Distributors, the previous Accounting Agent, by each Fund was as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended Year Ended
December 31, 1997 December 31, 1996 December 31, 1995
<S> <C> <C> <C>
California Tax Free Fund $ N/A $ N/A $ N/A
Capital Appreciation Fund....... 164,868 145,721 95,042
Convertible Fund................ 108,332 81,568 57,184
Equity Index Fund............... N/A N/A N/A
Government Fund................. 80,879 114,622 128,798
High Yield Corporate Bond Fund.. 270,515 233,333 164,329
International Bond Fund......... 11,358 12,511 12,000
International Equity Fund....... 24,683 22,075 12,668
Money Market Fund............... 54,915 62,593 53,064
New York Tax Free Fund.......... N/A N/A N/A
Strategic Income Fund +......... 13,624 N/A N/A
Strategic Value Fund +.......... N/A N/A N/A
Tax Free Bond Fund.............. 60,703 80,430 79,801
Total Return Fund............... 119,962 126,154 103,032
Value Fund...................... 125,541 16,985 85,935
</TABLE>
________________
+ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operation on October 21, 1997.
B-137
<PAGE>
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.
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 Trustees who are not affiliated with the Manager or Sub-Advisers,
(iii) certain fees and expenses of the Trust's Custo dians and Transfer
Agent,(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,(xii)
all taxes and business fees payable by a Fund to federal, state or other
governmental agencies, and (xiii) costs associated with the pricing of the
Funds' shares. 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
B-138
<PAGE>
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 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
B-139
<PAGE>
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 on an exchange, the commissions, 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
B-140
<PAGE>
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") 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
B-141
<PAGE>
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 to the Sub-Advisers in carrying out their obligations to the
Funds.
For the fiscal years ended December 31, 1997, 1996 and 1995 each of the
following Funds paid brokerage commissions as follows:
<TABLE>
<CAPTION>
Total Brokerage Total Brokerage Commissions
Commissions Paid Paid to Affiliated Persons
---------------- --------------------------
Year ended Year ended Year ended Year ended Year ended Year ended
Dec. 31, 1997 Dec. 31, 1996 Dec. 31, 1995 Dec. 31, 1997 Dec. 31, 1996 Dec. 31, 1995
------------- ------------- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Capital Appreciation Fund.. 1,349,716 $ 882,877 $ 681,250 $ -- $ --- $ ---
Convertible Fund........... 1,728,411 1,952,991 674,139 -- --- ---
Equity Index Fund.......... 24,704 63,111 7,018 -- --- ---
Government Fund............ 1,719 20,809 71,818 -- --- ---
High Yield Corporate Bond
Fund...................... 1,297,005 1,187,150 1,207,587 -- --- 1,970(0%)(1)
International Equity Fund. 239,373 215,696 135,267 -- --- ---
Strategic Income Fund+..... 11,739 N/A N/A -- N/A N/A
Strategic Value Fund+...... 21,314 N/A N/A -- N/A N/A
Total Return Fund.......... 609,009 399,858 436,507 -- --- ---
Value Fund................. 2,347,711 1,354,707 1,055,169 -- --- 5,074(0%)(1)
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
Total Brokerage
Commissions Paid
Total Amount of Transactions to Brokers that
Where Commissions Paid Provided Research
------------------------------------------------------------------- ----------------------
Year Ended Year Ended Year Ended Year ended
December 31, 1997 December 31, 1996 December 31, 1995 December 31, 1997
----------------- ----------------- ----------------- -----------------
<S> <C> <C> <C> <C>
Capital Appreciation Fund.. 987,618,526 $ 571,478,397(0.0%)(2) $ 391,017,677(0.0%)(2) 1,349,716
Convertible Fund........... 1,608,359,897 1,296,465,108(0.0%)(2) 395,570,645(0.0%)(2) 1,728,411
Equity Index Fund.......... 21,540,769 64,348,135(0.0%)(2) 5,863,505(0.0%)(2) 24,704
Government Fund............ 12,111,250 275,083,720(0.0%)(2) 712,117,650(0.0%)(2) 1,719
High Yield Corporate Bond
Fund...................... 1,451,737,826 2,471,387,854(0.0%)(2) 1,414,045,455(0.0%)(2) 1,297,005
International Equity Fund.. 60,462,344 49,098,906(0.0%)(2) 33,559,758(0.0%)(2) 239,373
Strategic Income Fund+..... 41,537,454 N/A N/A 11,739
Strategic Value Fund+...... 12,723,841 N/A N/A 21,314
Total Return Fund.......... 459,057,404 271,187,968(0.0%)(2) 604,631,476(0.0%)(2) 609,009
Value Fund................. 1,523,756,743 848,170,710(0.0%)(2) 544,224,812(0.0%)(2) 2,347,711
</TABLE>
_________________________
(1) Percent of total commissions paid.
(2) Percent of total transactions involving the payment of commissions effected
through affiliated persons.
+ The Strategic Income Fund commenced operations on February 28, 1997.
The Strategic Value Fund commenced operations on October 21, 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 fiscal years ended December 31, 1997, 1996 and 1995.
Capital Appreciation Fund held commercial paper of American Express Credit
Corp. valued at $30,000,000 and commercial paper of Prudential Funding Corp.
valued at $62,926,000; Equity Index Fund held common stock in Merrill Lynch &
Co., Inc. valued at $1,358,753, common stock of Schwab (Charles) Corp. valued at
$624,156, common stock of American Express Co. valued at $2,333,620 and common
stock of Morgan Stanley, Dean Witter, Discover & Co. valued at $1,970,814;
International Equity Fund held commercial paper of Merrill Lynch & Co. Inc.
valued at $3,599,399 and common stock of HSBC Holdings PLC valued $258,829;
Convertible Fund held commercial paper of American Express Credit Corp. Valued
at $1,700,000, and common stock and preferred stock of Merrill Lynch & Co., Inc.
valued at $10,913,400 and $1,228,200, respectively; Total Return Fund held
commercial paper of American Express Credit Corp. valued at $43,450,000, and
bonds of Lehman Brothers Holdings Inc., 7.375%, due 5/15/07, valued at $984,537;
Value Fund held commercial paper of American Express Credit Corp. valued at
$29,820,000 and commercial paper of Prudential Funding Corp. valued at
$20,694,000; Government Fund held commercial paper of American
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Express Credit Corp. valued at $32,000,000 and commercial paper of Prudential
Funding Corp. Valued at $6,000,000; High Yield Corporate Bond Fund held
commercial paper of American Express Credit Corp. valued at $137,292,000 and
commercial paper of Prudential Funding Corp. valued at $25,000,000; Money Market
Fund held commercial paper of American Express Credit Corp. valued at $3,173,000
and commercial paper of Goldman Sachs Group L.P. valued at $14,483,450;
Strategic Income Fund held commercial paper of American Express Credit Corp.
valued at $3,000,000, bonds of Lehman Large Loan, Series 1997-LL1 Class A,
6.79%, due 6/12/04, valued at $203,666 and bonds of Merrill Lynch Mortgage
Investors, Inc., Series 1995-C2 Class A1, 7.1817%, due 6/15/21, valued at
$238,560; and Strategic Value Fund held commercial paper of American Express
Credit Corp. valued at $1,187,000 and commercial paper of Prudential Funding
Corp. valued at $1,115,000.
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
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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
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
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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 currency 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 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 recognized 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
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<PAGE>
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 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.
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<PAGE>
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")
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.
DISTRIBUTIONS IN KIND
The Trust has agreed to redeem shares of each Fund solely in cash up to the
lesser of $250,000 or 1% of the net asset value of the Fund during any 90-day
period for any one shareholder. The Trust reserves the right to pay other
redemptions, either total or partial, by a distribution in kind of securities
(instead of cash) from the applicable Fund's portfolio. The
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<PAGE>
securities distributed in such a distribution would be valued at the same value
as that assigned to them in calculating the NAV of the shares being redeemed. If
a shareholder receives a distribution in kind, he or she should expect to incur
transaction costs when he or she converts the securities to cash.
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 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;
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<PAGE>
(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.
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
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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 penalty tax. For
distributions made after 1997, the penalty tax does not apply to
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<PAGE>
withdrawals up to a total of $10,000 for qualified 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, a
penalty tax will generally apply as well. Any balance remaining in an Education
IRA when the beneficiary becomes 30 years old must
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be distributed and any earnings will be taxable and subject to a penalty tax
upon distribution.
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.
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<PAGE>
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.
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 December 31, 1997 was
5.07% and 5.07%, 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 December 31, 1997 was 5.20% and
5.20%, 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
4.77% and 4.88%, respectively, for Class A shares and 4.77% and 4.88%,
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respectively, for Class B shares for the seven-day period ended December
31, 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.
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 and
reflects fee waivers and reimbursements in effect for each 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 nth power = ERV
B-155
<PAGE>
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)
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
December 31, 1997 and the period from inception to December 31, 1997 were as
follows:*
B-156
<PAGE>
<TABLE>
<CAPTION>
Average
Year Five Years Ten Years Annual
Ended Ended Ended Total Inception
Fund 12/31/97 12/31/97 12/31/97 Return(a) Date
- ---- -------- -------- -------- -------- ----
<S> <C> <C> <C> <C> <C>
California Tax Free Fund....... 3.04% 5.64% N/A 6.11% 10/1/91
Capital Appreciation Fund (b).. 17.27% 16.33% 18.28% 14.88% 5/1/86
Convertible Fund (b)........... 5.24% 12.38% 12.65% 9.99% 5/1/86
Equity Index Fund.............. 28.30% 18.45% N/A 17.83% 12/20/90
Government Fund (b)............ 4.21% 4.93% 6.69% 6.54% 5/1/86
High Yield Corporate
Bond Fund (b)................ 7.16% 13.11% 11.79% 10.49% 5/1/86
International Bond Fund (b).... -2.75% N/A N/A 8.69% 9/13/94
International Equity Fund (b).. -1.23% N/A N/A 3.35% 9/13/94
New York Tax Free Fund......... 3.52% 5.74% N/A 6.36% 10/1/91
Strategic Income Fund.......... N/A N/A N/A 1.83% 2/28/97
Strategic Value Fund........... N/A N/A N/A -1.61% 10/22/97
Tax Free Bond Fund (b)......... 4.11% 5.18% 6.58% 6.19% 5/1/86
Total Return Fund (b).......... 11.74% 11.91% 12.48% 12.50% 12/29/87
Value Fund (b)................. 15.18% 15.40% 16.43% 12.68% 5/1/86
</TABLE>
- ----------
* Assumes the deduction of the maximum applicable initial sales charge.
(a) From inception to 12/31/97.
(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
December 31, 1997, and the period from inception to December 31, 1997 were as
follows*:
<TABLE>
<CAPTION>
Average
Year Five Years Ten Years Annual
Ended Ended Ended Total Inception
Fund 12/31/97/*/ 12/31/97/*/ 12/31/97/*/ Return(a) Date
- ---- ----------- ----------- ----------- --------- ----------
<S> <C> <C> <C> <C> <C>
California Tax Free Fund (b).. 2.63% 6.14% N/A 6.75% 10/1/91
Capital Appreciation Fund..... 18.45% 17.08% 18.77% 15.29% 5/1/86
Convertible Fund.............. 5.67% 13.00% 13.08% 10.35% 5/1/86
Government Fund............... 3.54% 5.19% 6.99% 6.79% 5/1/86
High Yield Corporate
Bond Fund................... 6.55% 13.53% 12.11% 10.76% 5/1/86
International Bond Fund....... -3.85% N/A N/A 9.08% 9/13/94
International Equity Fund..... -1.22% N/A N/A 3.85% 9/13/94
New York Tax Free Fund (b).... 3.14% 6.26% N/A 7.03% 10/1/91
Strategic Income Fund......... N/A N/A N/A 1.02% 2/28/97
Strategic Value Fund.......... N/A N/A N/A -0.96% 10/22/97
Tax Free Bond Fund............ 3.80% 5.70% 7.01% 6.56% 5/1/86
Total Return Fund............. 12.65% 12.60% 12.93% 12.97% 12/29/87
Value Fund.................... 16.29% 16.11% 16.89% 13.07% 5/1/86
</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 12/31/97.
(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
B-157
<PAGE>
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:
<TABLE>
<CAPTION>
Average
Year Five Years Ten Years Annual
Ended Ended Ended Total Inception
Fund 12/31/97 12/31/97 12/31/97 Return(a) Date
- ---- -------- -------- -------- --------- ----
<S> <C> <C> <C> <C> <C>
California Tax Free Fund....... 7.90% 6.62% N/A 6.89% 10/1/91
Capital Appreciation Fund (b).. 24.10% 17.65% 18.95% 15.44% 5/1/86
Convertible Fund(b)............ 11.36% 13.66% 13.29% 10.52% 5/1/86
Equity Index Fund.............. 32.26% 19.17% N/A 18.35% 12/20/90
Government Fund(b)............. 9.12% 5.90% 7.18% 6.96% 5/1/86
High Yield Corporate
Bond Fund (b)................ 12.20% 14.15% 12.30% 10.92% 5/1/86
International Bond Fund (b).... 1.83% N/A N/A 10.22% 9/13/94
International Equity Fund (b).. 4.52% N/A N/A 5.14% 9/13/94
New York Tax Free Fund......... 8.39% 6.72% N/A 7.15% 10/1/91
Strategic Income Fund.......... N/A N/A N/A 6.62% 2/28/97
Strategic Value Fund........... N/A N/A N/A 4.11% 10/22/97
Tax Free Bond Fund (b)......... 9.02% 6.15% 7.08% 6.61% 5/1/86
Total Return Fund (b).......... 18.24% 13.18% 13.10% 13.14% 12/29/87
Value Fund (b)................. 21.88% 16.72% 17.09% 13.23% 5/1/86
</TABLE>
- ----------
(a) From inception to 12/31/97.
(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:
B-158
<PAGE>
<TABLE>
<CAPTION>
Average
Year Five Years Ten Years Annual
Ended Ended Ended Total Inception
Fund 12/31/97 12/31/97 12/31/97 Return(a) Date
- ---- -------- -------- -------- --------- ----
<S> <C> <C> <C> <C> <C>
California Tax Free Fund (b).. 7.63% 6.45% N/A 6.75% 10/1/91
Capital Appreciation Fund..... 23.45% 17.29% 18.77% 15.29% 5/1/86
Convertible Fund.............. 10.67% 13.24% 13.08% 10.35% 5/1/86
Government Fund............... 8.54% 5.51% 6.99% 6.79% 5/1/86
High Yield Corporate
Bond Fund................... 11.55% 13.77% 12.11% 10.76% 5/1/86
International Bond Fund....... 1.15% N/A N/A 9.57% 9/13/94
International Equity Fund..... 3.78% N/A N/A 4.40% 9/13/94
New York Tax Free Fund (b).... 8.14% 6.57% N/A 7.03% 10/1/91
Strategic Income Fund......... N/A N/A N/A 6.02% 2/28/97
Strategic Value Fund.......... N/A N/A N/A 4.04% 10/22/97
Tax Free Bond Fund............ 8.80% 6.02% 7.01% 6.56% 5/1/86
Total Return Fund............. 17.65% 12.85% 12.93% 12.97% 12/29/87
Value Fund.................... 21.29% 16.33% 16.89% 13.07% 5/1/86
</TABLE>
- ----------
(a) From inception to 12/31/97.
(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:
Yield = 2[(a-b +1) to the 6th power -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
B-159
<PAGE>
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 December 31, 1997, the yield of each of the
following Funds was:
<TABLE>
<CAPTION>
30-Day
Period Ended
December 31,
1997
-------------
Fund Class A Class B
---- ------- -------
<S> <C> <C>
California Tax Free Fund........ 4.74% 4.71%
---- ----
Government Fund................. 4.84% 4.34%
---- ----
High Yield Corporate Bond Fund.. 6.77% 6.33%
---- ----
International Bond Fund......... 4.57% 4.02%
---- ----
New York Tax Free Fund.......... 4.72% 4.69%
---- ----
Tax Free Bond Fund.............. 4.81% 4.79%
---- ----
Strategic Income Fund........... 5.93% 5.30%
---- ----
</TABLE>
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 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%.*+
B-160
<PAGE>
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% 7.97%
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 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
B-161
<PAGE>
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 shareholders, to: (i)
unmanaged indexes, such as the Standard &
B-162
<PAGE>
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. Advertisements for a Fund may also include general information
about the performance of unmanaged indexes with investment parameters similar
to the Fund's. 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 retroactive. Prospective
B-163
<PAGE>
investors should consult their own tax advisors with regard to the federal tax
consequences of the purchase ownership, and disposition of Fund 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
B-164
<PAGE>
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.
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, under the
Code, 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.
B-165
<PAGE>
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 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. The 45-day holding period must occur during
the 90-day period beginning 45 days before the date on which the shares become
ex-dividend. In the case of dividends on certain preferred stock, the holding
period requirement is 90 days during a 180-day period. 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% Rate Gain"
or "28% Rate Gain," depending upon the Fund's holding period for the assets
sold. "20% Rate Gains" arise from sales of assets held by a Fund for
B-166
<PAGE>
more than 18 months and are subject to a maximum tax rate of 20%; "28% Rate
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. 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, such 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.
B-167
<PAGE>
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 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
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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 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.
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
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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.
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
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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 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. 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
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not exempt from Federal income tax, will be taxable income to those Funds.
The International Bond Fund, International Equity Fund, Strategic Value 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.
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. Alternatively, a Fund may elect to mark to
market its PFIC shares at the end of each
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taxable year, with the result that unrealized gains are treated as though they
were realized and reported as ordinary income. Any mark-to-market losses and any
loss from an actual disposition of PFIC Shares would be deductible as ordinary
losses to the extent of any net mark-to-market gains included in income in prior
years.
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 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
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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 the hands of the shareholder, and generally will be taxable to
stockholders as "20% Rate Gain" if the shares had been held for more than 18
months or as "28% Rate 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 disadvan tageous. 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.
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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 reflected in their basis.
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.
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
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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 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 share holders 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
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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.
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
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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.
ADDITIONAL INFORMATION REGARDING THE EQUITY INDEX FUND
If Shareholders receive distributions of amounts paid pursuant to the
Guarantee, 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 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
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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.
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
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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 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
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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.
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
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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 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
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negligence or reckless disregard of the duties involved in the conduct of his or
her office.
OTHER INFORMATION
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 1177 Avenue of the Americas, New York, New York,
10036, has been selected as independent accountants of the Trust. The Funds'
Annual Reports, which are incorporated by reference in this SAI, have been so
incorporated in reliance on the reports of Price Waterhouse, independent
accountants, given on the authority of said firm as experts in auditing and
accounting.
LEGAL COUNSEL
Dechert Price & Rhoads, 1775 Eye Street, N.W., Washington, D.C. 20006,
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 April 1, 1998, of the Funds' shares by each person who
beneficially or of record owns more than five percent of the voting securities
of any Fund:
B-183
<PAGE>
<TABLE>
<CAPTION>
Shares Percentage
Name and Address Beneficially Outstanding
Name of Fund of Shareholder Owned (1) Shares Owned
- ------------------ -------------- --------- ------------
<S> <C> <C> <C>
California NYLIFE Distributors Inc.(2) 14.43% 271,121
Tax Free Fund 300 Interpace Parkway
Class A Parsippany, NJ 07054
California Otto V. & Yvonne Louise-Ericksen 9.22% 173,217
Tax Free Fund Tschudi Revoc. Living Trust
Class A 1805 St. Andrews Dr.
Moraga, CA 94668
California William J. & Elinor Potikian 10.36% 83,366
Tax Free Fund Family Revocable Trust
Class B 4475 N. College
Fresno, CA 93704
Capital New York Life Trust Company 24.26% 1,541,608
Appreciation Client Accounts
Class A 51 Madison Avenue, Rm 117A
New York, NY 10010-1603
Convertible New York Life Trust Company 10.45% 468,409
Fund Client Accounts
Class A 51 Madison Avenue, Rm 117A
New York, NY 10010-1603
New York Tax NYLIFE Distributors Inc.(2) 35.07% 499,488
Free Fund 300 Interpace Parkway
Class A Parsippany, NJ 07054
New York Tax Felice Brand 9.33% 53,769
Free Fund 158 Wright Avenue
Class B Deer Park, NY 11729-2224
New York Tax Henry Sheimann Irrevocable Trust 5.59% 32,224
Free Fund 11-31 Jackson Avenue
Class B Scardsdale, NY 10583
New York Tax Smith Barney Inc. 5.45% 77,602
Free Fund 388 Greenwich St.
Class A New York, NY 10013
International NYLIFE Distributors Inc.(2) 55.90% 770,905
Bond Fund 300 Interpace Parkway
Class A Parsippany, NJ 07054
</TABLE>
B-184
<PAGE>
<TABLE>
<S> <C> <C> <C>
International Defined Benefit Pension Trust of FMCNA 5.45% 74,305
Bond Fund C/O the Free Methodist Foundation
Class A 8050 Spring Arbor Road
Spring Arbor, MI 49283
International Merrill Lynch Pierce 5.73% 76,991
Bond Fund Fenner & Smith
Class A 4800 Deer Lake Dr. East
Jacksonville, FL 32246
International NYLIFE Distributors Inc.(2) 36.68% 625,090
Equity Fund 260 Cherry Hill Road
Class A Parsippany, NJ 07054
International New York Life Trust Company 5.95% 101,533
Equity Fund Clients Accounts
Class A 51 Madison Avenue, Room 117A
New York, NY 10010
Strategic Income NYLIFE Distributors Inc.(2) 10.36% 549,397
Fund 300 Interpace Parkway
Class B Parsippany, NJ 07054
Strategic Income New York Life Insurance 33.92% 653,946
Fund Company General Account
Class A 51 Madison Avenue
New York, NY 10010
Value Fund New York Life Trust Company 22.23% 1,420,946
Class A Client Accounts
51 Madison Avenue, Rm 117A
New York, NY 10010-1603
Government New York Life Trust Company 18.12% 363,748
Fund Client Accounts
Class A 51 Madison Avenue, Rm 117A
New York, NY 10010-1603
Tax Free
Bond Fund Schmitt Family Trust 15.26% 202,393
Class A P.O. box 1566
Savannah, GA 31402
</TABLE>
B-185
<PAGE>
<TABLE>
<S> <C> <C> <C>
Value Fund Delaware Charter Guarantee 5.37% 343,465
Class A & Trust Co., Trustee
FBO Savings Incentive Plan for
Employees of LSB Industries Inc.
Holding Account 401K Plan
P.O. Box 8708
Wilimgton, DE 19899
Money Market New York Life Trust Company 6.89% 6,623,580
Fund Client Accounts
Class A 51 Madison Avenue, Room 117A
New York, NY 10010
Total Return New York Life Trust Company 49.57% 2,668,627
Fund Client Accounts
Class A 51 Madison Avenue, Room 117A
New York, NY 10010
Strategic Income Rodney A. Vanderaa 5.43% 104,752
Fund Joy Vanderaa
Class A 19140 Ada St.
Lansing, IL 60438
Strategic Income James C. Calano 5.76% 111,076
Fund 200 Boulder View Lane
Class A Boulder, CO 80304
Strategic Income Terry L. Vanderaa 5.07% 97,656
Fund Linda A. Vanderaa
Class A ATC Vancom
P.O. Box 7320
Oakbrook Terrace, IL 60181
Strategic Income Rodney A. Vanderaa 5.19% 100,040
Fund Wendy M. Vanderaa
Class A 18448 Holland Road
Lansing, IL 60436
Strategic Value New York Life Insurance 59.65% 914,161
Fund Company
Class A 51 Madison Avenue
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.
B-186
<PAGE>
(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.
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, Money Market Fund, Strategic Income Fund and Strategic Value Fund,
including the Portfolio of Investments as of December 31, 1997, the Statement of
Assets and Liabilities as of December 31, 1997, the Statement of Operations for
the year ended December 31, 1997, the Statement of Changes in Net Assets for the
years ended December 31, 1997 and 1996, the Notes to the Financial Statements
and the Reports of Independent Accountants, all of which are included in the
1997 Annual Reports to the Shareholders are hereby incorporated by reference
into this Statement of Additional Information.
An audited financial statement for NYLIFE Inc. as of December 31, 1997, is
included in this Statement of Additional Information.
B-187
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
(affiliates of
New York Life Insurance Company)
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
<PAGE>
April 8, 1998
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, 1997 and 1996, 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, 1997. 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 variance 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, 1997and 1996, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.
<PAGE>
To the Board of Directors and
Stockholder of NYLIFE Inc.
Page 2
April 8, 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, 1997 and 1996, and the results of their operations
and their cash flows for each of the three years in the period ended December
31,1997, on the basis of the accounting described in Note 2.
As described in Note 19, on March 15, 1998, New York Life Insurance Company
reached an agreement to sell 100% of the common stock of NYLCare Health Plans to
Aetna Inc.
/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,
---------------------------
1997 1996
---- ----
(in thousands)
ASSETS
<S> <C> <C>
Cash and cash equivalents $ 401,565 $ 310,232
Short-term investments 57,959 54,413
Premiums and accounts receivable less allowance for doubtful
accounts of $6,374 and $4,042, respectively 569,108 477,317
Interest and other receivables 36,805 59,414
Deferred distribution costs (net of accumulated amortization
of $296,341 and $229,711, respectively) 268,470 224,752
Investments:
Common stocks 26,130 7,042
Available for sale - bonds 241,697 200,442
Held to maturity - bonds 4,119 2,311
Insurance operations - bonds 50,253 32,411
Mortgage loans - 6,769
Real estate 11,359 100,374
MainStay funds at fair value 41,665 47,263
Security alarm monitoring contracts held for sale 34,180 38,455
Other investments and advances to affiliates 66,034 100,240
Statutory valuation of subsidiary in excess of GAAP net equity 200,247 99,527
Fixed assets (net of accumulated depreciation of $84,445 and
$76,014, respectively) 80,355 89,064
Income taxes receivable 10,961 12,565
Receivable from New York Life Insurance Company 500,686 -
Other assets 124,748 126,033
Net assets of dissolved subsidiaries (790) 65,763
------------ ------------
Total assets $ 2,725,551 $ 2,054,387
============ ============
LIABILITIES and STOCKHOLDER'S EQUITY
Accrued HMO claims payable $ 341,594 $ 229,802
Policy and claim reserves - accident and health 133,412 127,722
Policy and claim reserves - life 94,825 67,657
Participating policyholder liability 14,866 30,100
Payable to New York Life Insurance Company 48,204 47,737
Accrued expenses and other payables 202,642 152,373
Payable on reinsurance assumed 39,608 26,507
Medical group risk sharing and unearned premiums 71,424 54,270
Notes payable 577,930 183,196
Net deferred tax liability and other liabilities 148,907 147,224
------------ ------------
Total liabilities 1,673,412 1,066,588
------------ ------------
Minority interest 111,901 89,533
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 1,043,108 1,066,921
Accumulated deficit (306,938) (270,817)
Investment valuation account 200,247 99,527
Net unrealized gains (losses) on available for sale investments (net of
taxes of $886 and $(764), respectively) 1,383 (1,215)
Cumulative translation adjustment 2,438 3,850
------------ ------------
Total stockholder's equity 940,238 898,266
------------ ------------
Total liabilities and stockholder's equity $ 2,725,551 $ 2,054,387
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
For the Years ended December 31,
----------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Income:
Premium revenue - net of reinsurance $2,792,678 $2,363,286 $ 2,146,107
Premiums assumed on initial reinsurance settlement - 478,149 -
Fee income 1,392,649 925,671 723,494
Interest and dividend income 57,108 56,846 110,642
Commission income 113,590 95,858 50,378
Net realized and unrealized losses on investments (6,462) (2,869) (8,558)
Realized gain on sale of interest in subsidiaries 19,932 121,741 -
Equity in (loss) earnings of affiliates (2,551) (699) 155
Gain on issuance of additional shares by public subsidiary 2,411 27,835 -
Income (loss) from dissolved subsidiaries 16,066 1,836 (138,036)
Other income 22,275 10,035 12,082
----------- ----------- ------------
Total income 4,407,696 4,077,689 2,896,264
----------- ----------- ------------
Expenses:
HMO claims and capitation costs 1,738,512 1,350,743 1,155,269
Health, disability and death benefit costs 618,663 551,816 556,582
Cost of prescription sales 1,015,982 621,652 439,776
Administrative charge from New York Life Insurance Company 65,385 62,631 40,453
Employee compensation 368,939 339,974 286,811
Initial reserve transfer on reinsurance assumed - 478,149 -
Increase in policy reserves - life 21,829 11,746 14,237
Depreciation and amortization 120,238 112,642 103,621
Impairment of intangible asset 4,381 28,830 -
Interest 14,558 15,594 29,784
Professional fees 35,138 37,938 31,893
Selling expenses 166,632 123,413 118,637
Rent expense 36,575 34,943 32,848
Interest crediting expense - - -
Administrative and other expenses 184,442 152,272 202,129
----------- ----------- ------------
Total expenses 4,391,274 3,922,343 3,012,040
----------- ----------- ------------
Net income (loss) before income taxes,
and minority interest 16,422 155,346 (115,776)
Net income tax expense (benefit) 21,929 76,325 (24,441)
----------- ----------- ------------
Net (loss) income before minority interest (5,507) 79,021 (91,335)
Minority interest 18,288 14,188 4,598
----------- ----------- ------------
Net (loss) income $ (23,795) $ 64,833 $ (95,933)
=========== =========== ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
<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, 1997, 1996, and 1995
<TABLE>
<CAPTION>
Net
Common 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
------- ------- ------- ----------- ---------- ------
<S> <C> <C> <C> <C> <C> <C>
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 168,325 - - - - 168,325
Return of capital (47,950) - - - - (47,950)
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
Capital contributions 101,087 - - - - 101,087
Return of capital (124,900) - - - - (124,900)
Cumulative translation adjustment - - - - (1,412) (1,412)
Statutory valuation of subsidiary
in excess of GAAP net equity - - 100,720 - - 100,720
Other equity adjustments - (12,326) - - - (12,326)
Net unrealized gains on available
for sale investments - - - 2,598 - 2,598
Net loss - (23,795) - - - (23,795)
------------ ----------- --------- --------- -------- -----------
Balance at December 31, 1997 $ 1,043,108 $ (306,938) $ 200,247 $ 1,383 $ 2,438 $ 940,238
============ =========== ========= ========= ======== ===========
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
For the Years ended December 31,
------------------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Cash flow from operating activities:
Net (loss) income $ (23,795) $ 64,833 $ (95,933)
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 120,238 112,642 104,521
Impairment of intangible assets 4,381 28,830 --
Insurance reserves 21,829 11,748 24,370
Gain on sale of shares of subsidiaries (19,932) (121,741) --
Net realized and unrealized losses 6,462 2,869 8,558
Equity in loss (earnings) of affiliates 2,551 699 (155)
Provision for deferred income tax expense (benefit) 13,609 87,297 (41,968)
Minority interest 18,288 14,188 4,598
Gain on issuance of additional shares by public subsidiary (2,411) (27,835) --
Other 3,821 11,083 2,502
Change in assets and liabilities:
Bank overdrafts -- -- (53,538)
Premiums and accounts receivable (91,791) (206,586) (95,884)
Interest and other receivables 22,609 (67,897) 3,360
Deferred distribution costs and other assets (107,471) (141,565) (93,479)
Accrued expenses and other payables 171,002 170,509 10,948
Payable to New York Life Insurance Company 467 30,499 (19,266)
Policy and claim reserves 11,029 143,096 (6,194)
Income taxes payable 1,604 (58,597) 340
Other liabilities (13,285) 345 (3,596)
Net assets of dissolved subsidiaries 66,553 (192,223) 137,654
--------- --------- ---------
Cash provided by (used in) operating activities 205,758 (137,806) (113,162)
Cash flow from investing activities:
Capital expenditures (38,826) (51,446) (44,721)
Proceeds from sale of investments 214,642 209,383 857,479
Purchase of investments (165,089) (283,947) (534,531)
Sale of subsidiaries, net of cash sold 2,766 138,497 --
Acquisition of subsidiaries, net of cash acquired -- (14,843) (15,765)
Loan to New York Life (499,781) -- --
Payments received on investments 8,693 45,653 5,478
Other (1,045) 3,552 3,121
--------- --------- ---------
Net cash (used in) provided by investing activities $(478,640) $ 46,849 $ 271,061
--------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CASH FLOWS (continued)
<TABLE>
<CAPTION>
For the Years ended December 31,
--------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Cash flow from financing activities:
Capital contributions $ 95,471 $ 97,784 $ 160,752
Dividends paid - (35,250) (32,584)
Borrowings net of repayments under line of credit agreements (97,446) 53,378 20,342
Payments applied against capital leases (527) (779) (1,107)
Proceeds from issuance of debt 500,708 - 24,521
Principal repayment of debt (8,173) (12,536) (310,644)
Return of capital distribution (124,900) - -
Proceeds from issuance of shares by public subsidiary - 52,592 -
Other 2,124 (52,839) 21,309
---------- ---------- ----------
Net cash provided by (used in) financing activities 367,257 102,350 (117,411)
---------- ---------- ----------
Effect of exchange rates on cash (3,042) 3,158 (339)
---------- ---------- ----------
Net increase in cash and cash equivalents 91,333 14,551 40,149
Cash and cash equivalents at beginning of period 310,232 295,681 255,532
---------- ---------- ----------
Cash and cash equivalents at end of period $ 401,565 $ 310,232 $ 295,681
========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
December 31, 1997, 1996 and 1995
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")
Eagle Strategies Corp. ("Eagle")
Greystone Realty Corporation ("Greystone")
MacKay-Shields Financial Corporation ("MacKay-Shields")
Madison Square Advisors, Inc. ("MSA")
MainStay Management, Inc. ("MainStay Management")
MainStay Shareholder Services Inc. ("MSS")
Monitor Capital Advisors, Inc. ("Monitor Capital")
MSC Holding, Inc. ("MSC"), 85% owned
New York Life Benefit Services, Inc. ("Benefit Services")
New York Life Capital Corporation ("Capital Corp.")
New York Life International, Inc. ("International, Inc."), formerly
New York Life Worldwide Holding, Inc.
New York Life International Investment, Inc. ("NYL International")
NYL Management Limited
Monetary Research Limited ("MRL")
New York Life Irrevocable Trust of 1996 ("Trust")
New York Life Settlement Corporation ("NYLSET")
New York Life Trust Company ("NYL Trust")
NYLCO, Inc.
NYLIFE Administration Corp. ("NYLACOR")
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")
Express Scripts Inc. ("ESI"), 45% 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")
Auto Funding II, LP ("Auto Funding")
NYLIFE Structured Asset Management Company, Ltd. ("SAMCO")
NYLINK Insurance Agency Corporation ("NYLINK")
NYLTemps Inc. ("NYLTemps")
<PAGE>
-2-
NYLIFE Inc., through its subsidiaries, offers health insurance, managed care and
related products and services; life insurance in certain international markets;
investment management, mutual fund, securities brokerage and pension products
and services; and the ability to raise capital. 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 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. As described in Note 19, the Company entered
into an agreement on March 15, 1998 to sell NYLCare.
International operations are conducted through International, Inc., 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, mutual fund distribution and
administration services are conducted through NYLIFE Securities, NYLIFE
Distributors, MainStay Shareholder Services and MainStay Management. Pension and
401(k) products and related administrative and trust services are offered
through Benefit Services and NYL Trust.
Capital raising operations are conducted through Capital Corp. which issues
commercial paper and borrows from other sources for the purpose of making loans
to New York Life and its affiliates.
BUSINESS COMBINATIONS:
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 has assumed the risk on 90% of New York Life's group life and
health indemnity insurance business. Under the terms of the modified coinsurance
agreement, NYLHIC assumes the risk for group life and health policies issued by
New York Life; however, New York Life retains the reserves and related assets.
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 net income of $14,175,000 in 1995, and an increase in stockholder's
equity of $105,505,000 as of December 31, 1995.
<PAGE>
-3-
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
- -----------------------------------------
BASIS OF ACCOUNTING:
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").
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 its useful
life; (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 (subject to certain liquidity adjustments) as the carrying value
for its investment in Express Scripts Inc., a publicly traded 45% 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 $4,000,000,
$17,000,000 and $2,000,000 for the years ending December 31, 1997, 1996 and
1995, respectively, a decrease in total assets of $122,000,000 and an increase
in total assets of $4,000,000 at December 31, 1997 and 1996, respectively, and a
decrease in stockholder's equity of $123,000,000 and $4,000,000 as of December
31, 1997 and 1996, 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.
<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 ("CTA") account in stockholder's equity. The change in
the CTA 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 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, 1997 and 1996
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 consist of commercial paper and are carried at cost which
approximates fair value. Common stocks are stated at market value. At December
31, 1997 and 1996, 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 recorded at
fair value and is held by MacKay-Shields, an investment advisor and NYLIFE
Securities and NYLIFE Distributors, broker-dealers. In accordance with
specialized accounting practices for broker-dealers, unrealized gains and losses
are included in income.
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 direct 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 5). 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.
<PAGE>
-5-
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, real
estate and the investment in the MainStay Funds is reported in Note 8 and fair
value disclosure of notes payable is reported in Note 11. 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, net of reinsurance, for indemnity 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.
FEE INCOME:
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.
Fees and payments to these pharmacy providers are included as 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.
Through its subsidiaries, the Company receives fees for services provided under
agreements with its clients. The Company accrues fee income when earned.
Consulting and management fees are recognized in income as services are
rendered. Additionally, the Company derives monitoring revenues from customer
payments for alarm monitoring services. The Company recognizes revenue as the
monitoring services are provided.
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
<PAGE>
-6-
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 include 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.
PARTICIPATING POLICYHOLDER LIABILITY:
The liability for participating policyholders consists principally of dividends
accrued 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, 1997
and 1996 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.
NEW ACCOUNTING PRONOUNCEMENT:
During 1997 the FASB issued SFAS 130, "Reporting Comprehensive Income" which
establishes standards for the reporting and display of comprehensive income and
its components. Comprehensive income is composed of two items, "net income" and
"other comprehensive income". Other comprehensive income includes all changes in
equity from nonowner sources (e.g., unrealized holding gains and losses on
available for sale securities).
This Statement requires that the Company classify items of other comprehensive
income according to their nature and present each item separately in the
financial statement in which other comprehensive income is reported. This
Statement also requires that the accumulated balance of other comprehensive
income be reported as a separate item in the equity section of the balance
sheet. This Statement is effective for the 1998 financial statements of the
Company. Reclassification of financial statements for earlier periods provided
for comparative purposes is required.
RECLASSIFICATIONS:
Certain 1996 and 1995 amounts in the consolidated financial statements have been
reclassified to conform with the 1997 presentation. These reclassifications had
no effect on net earnings or stockholders' equity as previously reported.
<PAGE>
-7-
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.
During 1993, New York Life received authorization from the New York State
Insurance Department to adopt approximate market value (subject to certain
liquidity adjustments) as the carrying value for its investment in ESI.
Accordingly, the Company recorded adjustments of $200,247,000 and $99,527,000
for the statutory valuation of ESI in excess of its GAAP net equity at December
31, 1997 and 1996, respectively. These adjustments are included as a component
of stockholder's equity. Based upon the market value of ESI's common stock at
March 31, 1998, the amount of the statutory valuation of the subsidiary in
excess of GAAP net equity was approximately $321,205,000. A significant decline
in the value of this stock could have an adverse effect on the Company's
stockholder's equity.
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, expense 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 materially 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 International, Inc.'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.
See Note 16 for description of specific commitments and contingencies.
NOTE 4 - IMPAIRMENT OF LONG LIVED ASSETS
- ----------------------------------------
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
accordance with SFAS 121, the following NYLIFE Inc. subsidiaries established
impairment reserves:
<PAGE>
-8-
NYLIFE REFINERY
NYLIFE Refinery, Inc. determined that adverse market and operating conditions
and independent market value quotes were sufficient indicators of a potential
impairment for its investment in Refinery Holding Corporation. As a result,
NYLIFE Refinery recorded a $17,219,000 writedown on its investment in limited
partnerships in 1997.
NEW YORK LIFE BENEFIT SERVICES
Benefit Services determined that projected operating losses were indicators of
potential impairment. These operating losses indicated that a write-down of the
goodwill related to the purchase of this subsidiary was required. As a result,
the remaining $4,381,000 of goodwill that arose from the purchase of Benefit
Services was written off in 1997.
NYLCARE
In 1996, NYLCare determined that continuing operating losses of certain
subsidiaries which perform administrative services for physician groups, were
indicators of potential impairment. Based upon the estimated undiscounted cash
flows anticipated from these subsidiaries it was determined that a write-down of
the goodwill related to these subsidiaries was required. As a result of the
above, approximately $28,830,000 of goodwill and other intangibles was written
off in 1996.
SFD HOLDING
In 1997, Auto Funding II wrote down its investment in trusts by $4,600,000. In
addition, Funding II wrote-off approximately $2,600,000 of capitalized costs
associated with the investment.
NOTE 5 - CHANGES IN ACCOUNTING PRINCIPLES
- -----------------------------------------
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. (See Note 19
for subsequent events related to this transaction.) 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.
NOTE 6 - ACCOUNTING FOR STOCK-BASED COMPENSATION
- ------------------------------------------------
NON EMPLOYEE AGREEMENTS:
On December 31, 1995, ESI entered into a ten-year corporate alliance with
Premier Purchasing Partners, L.P. (American Healthcare Systems Purchasing
Partners, L.P., the "Partnership"), an affiliate of Premier, Inc. ("Premier").
Under the terms of the transaction, ESI is Premier's preferred vendor of
pharmacy benefit management services to Premier's shareholder systems and their
managed care affiliates and will issue shares of its Class A Common Stock as an
administrative fee to the Partnership based on the attainment of certain
benchmarks, principally related to the number of members receiving ESI pharmacy
benefit management services under the arrangement, and to the
<PAGE>
-9-
achievement of certain joint purchasing goals. In accordance with the terms of
the agreement, ESI issued 227,273 shares of Class A Stock to Premier in May
1996, and may be required to issue up to an additional 2,250,000 shares to the
Partnership over a period up to the first five years of the agreement if the
Partnership exceeds all benchmarks. The shares issued were valued at $11,250,000
and are being amortized over the then remaining term of the agreement.
Amortization expense amounted to $1,164,000 in 1997 and $776,000 in 1996. Except
for certain exemptions from registration under the Securities Act of 1933, as
amended (the "1933 Act"), any shares issued to the Partnership cannot be traded
until they have been registered under the 1933 Act and any applicable state
securities laws. No stock was issued in 1997.
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 or to be issued under alliances based on fair
value at the date the agreement is consummated.
In November 1997, the Emerging Issues Task Force reached a consensus that the
value of equity instruments issued for consideration other than employee
services should be initially determined on the date on which a "firm commitment"
for performance first exists by the provider of goods or services. Firm
commitment is defined as a commitment pursuant to which performance by a
provider of goods or services is probable because of sufficiently large
disincentives for nonperformance. The consensus must be applied for all new
arrangements and modifications of existing arrangements entered into from
November 20, 1997. The consensus only addresses the date upon which fair value
is determined and does not change the accounting based upon fair value as
prescribed by SFAS 123. No such arrangements have been entered into by ESI
subsequent to November 20, 1997.
EMPLOYEE STOCK-OPTIONS:
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 7 - ACQUISITIONS AND DISPOSITIONS
- --------------------------------------
In 1995, New York Life, NYLIFE Inc., 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 Inc.
recorded a provision of $137,000,000 to reflect the
<PAGE>
-10-
estimated costs of dissolving 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. Final settlement
costs totaled $121,000,000 and, as a result, a corresponding $16,000,000 pre-tax
gain was recorded in 1997.
Pursuant to the Plan, NYLIFE Equity and NYLIFE Realty, as liquidators, have
finalized the process of winding up the partnership programs. All of the
property interests of the partnership programs were sold prior to September 30,
1997. As of September 30, 1997, pursuant to the Settlement Agreement, NYLIFE
Inc. has advanced $173,000,000 to the Investors and has paid $35,652,000 to
other unaffiliated entities for costs of the liquidation, primarily from the
proceeds from a $200,000,000 line of credit with New York Life. In addition,
NYLIFE Inc. has recovered $87,723,000 from the liquidation of the partnership
programs.
NYLIFE Equity and NYLIFE Realty were dissolved on September 30, 1997, whereby
each entity disbursed its remaining funds and transferred its net assets to
NYLIFE Inc. Closing returns of capital totaled $8,888,000 and $2,579,000 for
NYLIFE Equity and NYLIFE Realty, respectively.
For purposes of these financial statements, the results of the dissolved
subsidiaries have been reported as a one line adjustment and, accordingly,
financial statements presented for periods prior to September 30, 1997 have been
restated to include this one line adjustment on the consolidated statement of
financial position and consolidated statement of operations.
NYLIFE HEALTHCARE
On December 31, 1997, NYLCare sold its 100% stock interest in Avanti Health
Systems of Texas, Inc. ("Avanti"), its physician practice management company
located in Texas. An election was made to treat the sale as an asset sale for
federal tax purposes under Section 338(h) 10 of the internal Revenue Code.
NYLCare received approximately 1,402,000 shares of FPA Medical Management, Inc.
common stock with a market value of $26,115,000. NYLCare has recorded a gain of
$19,454,000 after adjusting for the costs related to the sale.
In 1997, NYLCare sold substantially all of the operating assets and certain
liabilities of Avanti of the District, Inc., its physician management practice
company located principally in Maryland. NYLCare received $2,766,000 in cash,
resulting in a gain on the sale of $478,000.
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%.
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 $27,835,000, 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%. Additional issuance of
shares in 1997 reduced NYLIFE HealthCare's ownership to 45% and its voting stock
to 89%. See Note 19 for description of ESI's subsequent purchase of Value Rx.
<PAGE>
-11-
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. As described in Note 19, the Company
entered into an agreement on March 15, 1998 to sell NYLCare.
MADISON SQUARE ADVISORS
On November 13, 1997, MSA was created to act as investment advisors over three
New York Life separate accounts. MSA was funded with a $25,000 subscription
receivable. A $25,000 cash contribution was made in January of 1998.
MAINSTAY MANAGEMENT, INC.
On August 22, 1997, MainStay Management was created to oversee the portfolio
management services provided by MacKay-Shields and Monitor Capital and for
managing the MainStay Funds business affairs. MainStay Management was funded
with a $1,000,000 cash contribution and $1,210,000 of furniture and equipment.
MAINSTAY SHAREHOLDER SERVICES INC.
On March 4, 1997, MSS was created to assume certain shareholder servicing
functions previously handled by NYLIFE Distributors. MSS was funded with a
$2,000,000 cash contribution and $912,000 of furniture and equipment.
MSC HOLDING, INC.
During 1995, the assets of the Health and Investment Divisions of MSC 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, 1997, $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 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. commenced operations in 1997 with the issuance of
commercial paper.
NYLINK INSURANCE AGENCY CORPORATION
NYLINK was incorporated in Delaware in November 1996. NYLINK's activities will
primarily consist of the facilitation of the sale of non-proprietary insurance
products by New York Life registered representatives. NYLINK has not yet
commenced operations.
<PAGE>
-12-
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 was 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 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.
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. Aegis is expected to be
formally dissolved in 1998.
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. 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
investment value was $2,173,000, resulting in a loss of $360,000.
<PAGE>
-13-
NOTE 8 - INVESTMENTS
- --------------------
COMMON STOCK:
At December 31, 1997 and 1996, the distribution of unrealized gains on common
stock was as follows (in thousands):
Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
----------- ----------- ----------- ----------
1997 $26,126 $ 4 $ - $26,130
======== ========= ========== =======
1996 $ 5,975 $ 1,067 $ - $ 7,042
======= ======= ========== =======
BONDS:
At December 31, 1997, 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 $ 51,404 $ 51,431 $ - $ - $ 2,271 $ 2,284
Due in years two through five 108,983 109,869 - - 11,856 12,749
Due in years six through ten 60,789 62,137 - - 26,422 28,631
Due after ten years 15,905 15,874 4,119 4,614 9,704 10,429
-------- -------- --------- --------- -------- --------
Sub-total 237,081 239,311 4,119 4,614 50,253 54,093
Asset-backed securities 2,351 2,386 - - - -
-------- -------- --------- --------- -------- --------
Total $239,432 $241,697 $ 4,119 $ 4,614 $ 50,253 $ 54,093
======== ======== ========= ========= ======== ========
</TABLE>
At December 31, 1997 and 1996, the distribution of unrealized gains and losses
on bonds was as follows (in thousands):
DECEMBER 31, 1997
<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 $ 85,691 $ 785 $ 81 $ 86,395
Commercial paper and Corporate notes 149,456 1,819 258 151,017
Other 4,057 - - 4,057
Certificates of deposit 228 - - 228
-------- ------- -------- --------
Total $239,432 $ 2,604 $ 339 $241,697
======== ======= ======== ========
</TABLE>
<PAGE>
-14-
<TABLE>
<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 $4,119 $ 495 $ - $ 4,614
====== ======== ============ =======
<CAPTION>
Statement Unrealized Unrealized Estimated
Insurance Operations: Value Gains Losses Fair Value
- --------------------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Foreign Governments $ 16,520 $ 1,809 $ 12 $18,317
Corporate 19,738 2,000 231 21,507
Other 13,995 289 15 14,269
-------- ---------- -------- -------
Total $ 50,253 $ 4,098 $ 258 $54,093
======== ========== ======== =======
DECEMBER 31, 1996
<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
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
====== ======== =========== ======
<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
======== ========== ======== =========
</TABLE>
Proceeds from investments in bonds sold, matured, or repaid were $82,038,000,
$182,786,000, and $624,801,000, for 1997, 1996 and 1995, respectively. Realized
gains from investments in bonds sold, matured, or repaid were $0, $705,000, and
$10,164,000 for 1997, 1996 and 1995, respectively, and realized losses were
$89,000, $12,000, and $3,844,000 for 1997, 1996 and 1995, respectively.
Investment in bonds include $83,401,000 and $65,610,000 of restricted securities
on deposit to meet solvency requirements of various insurance departments, for
1997 and 1996, respectively.
<PAGE>
-15-
REAL ESTATE:
At December 31, 1997 and 1996, real estate totaled $11,359,000 and $100,374,000
respectively, and represented the following (in thousands):
Carrying Value
--------------
1997 1996
---- ----
Acquired through foreclosure $ - $ 98,100
International Operations 11,359 2,274
------- --------
Total $11,359 $100,374
======= ========
During 1997 NYLIFE Funding sold its remaining three properties and recorded a
realized loss of $9,526,000. During 1996, NYLIFE Funding foreclosed on two
delinquent mortgage loans and transferred them at their appraisal value to real
estate recording a realized gain of $773,000.
MAINSTAY FUNDS:
At December 31, 1997 the total investment in the MainStay Funds includes
investments in individual funds as follows (in thousands):
Fund Cost Fair Value
- ------------------------ ------- ----------
California Tax Free $ 2,834 $ 2,792
Capital Appreciation 61 170
Convertible 97 128
Corporate Bond 263 260
Equity Index 129 309
Institutional Growth 837 946
International Equity 6,450 6,638
International Bond 7,814 7,859
High Yield Corporate Bond 106 125
Short-Term Bond 10,897 10,353
New York Tax Free 5,200 5,141
Strategic Income/Value 5,352 5,301
Total Return 65 106
Value 1,452 1,537
-------- --------
Total 1997 $41,557 $41,665
======= =======
Total 1996 $46,862 $47,263
======= =======
SECURITY ALARM CONTRACTS:
At December 31, 1997, the carrying amount of security alarm monitoring contracts
held for sale includes Contracts collateralizing Series A, B and C Notes (see
Note 11) as follows (in thousands):
1997 1996
---- ----
Series A $ 7,821 $ 9,112
Series B 3,374 3,711
Series C 22,985 25,632
------- -------
Total $34,180 $38,455
======= =======
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.
<PAGE>
-16-
TIME DEPOSITS:
Time deposits, included in cash and cash equivalents, at December 31, 1997 and
1996, amounted to $5,625,000 and $11,889,000, 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
$13,117,000 and $32,403,000 at December 31, 1997 and 1996, respectively. The
1997 value includes a pre-tax impairment loss of $17,219,000 in accordance with
SFAS 121 (see Note 4).
As described in Note 7, 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. All of the property interests of
these partnership programs have been sold prior to September 30, 1997.
NOTE 9 - FIXED ASSETS
- ---------------------
At December 31, 1997 and 1996, fixed assets, at cost, are comprised of the
following (in thousands):
1997 1996
-------- --------
Furniture $ 29,571 $ 26,865
Equipment 51,124 44,447
Computer hardware 44,260 38,467
Computer software 18,326 15,590
Leasehold improvements 17,901 24,100
Other 3,618 15,609
-------- --------
164,800 165,078
Less accumulated depreciation and amortization 84,445 76,014
-------- ---------
Total $ 80,355 $ 89,064
======== ========
NOTE 10 - POLICY AND CLAIM RESERVES
- -----------------------------------
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 reserves on the initial settlement of $478,149,000 in the statement
of operations.
The modified coinsurance reserve retained by New York Life related to the
reinsured group life and health indemnity business is $568,105,000 and
$498,255,000 at December 31, 1997 and 1996, respectively. The liability for
unpaid group health indemnity claims incurred in the years ended December 31,
1997 and 1996 related to prior years is immaterial.
<PAGE>
-17-
NOTE 11 - NOTES PAYABLE
- -----------------------
Notes payable, generally carried at the unpaid principal balance, consisted of
the following at December 31, 1997 and 1996 (in thousands):
<TABLE>
<CAPTION>
1997 1996
---------- --------
<S> <C> <C>
Short-term notes payable $500,708 $ -
International-Loan from Windsor Life 5,075 6,103
Series A and B, Floating Rate Secured Five Year Notes 16,216 17,146
Series C 9% Fixed Rate Secured Five Year Notes 24,548 26,596
Loans payable to New York Life 29,474 113,220
Bank borrowings and revolving line of credit with financial institutions - 14,222
Other (including current portion) 1,909 5,909
--------- --------
Total $ 577,930 $183,196
========= ========
</TABLE>
The carrying value of notes payable approximates fair value.
Short-term notes payable consist of Capital Corp's debt balance at December 31,
1997. The weighted average cost of short-term notes payable was approximately
5.75% at December 31, 1997.
The $16,216,000 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. This balance is payable during 1998
(see Note 19).
The $24,548,000 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 1998.
In January 1995, NYLIFE entered into a credit agreement, expiring January 1,
1998, 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 to terminate the agreement. At
December 31, 1997 and 1996 the total principal borrowed under this agreement was
$0 and $91,131,000, respectively. Interest expense amounted to $1,847,000 and
$2,598,000 in 1997 and 1996, respectively.
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 borrowing
accrues at the rate which is the annual simple interest equivalent (computed on
the actual daily principal balance based on a 360 day year or twelve 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 loan acquisitions, and (iii) a change
in the monthly interest payment date to the 20th of each month.
<PAGE>
-18-
During 1997, 1996 and 1995, SFD Holding made interest payments totaling
$2,396,000, $2,805,000 and $2,636,000, respectively, to New York Life pursuant
to the Master Notes. At December 31, 1997 and 1996, the amounts outstanding
under the Master Note are $29,474,000 and $22,089,000, respectively. Accrued
interest at December 31, 1997 and 1996 is $203,000 and $145,000, 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 be 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%. SFD Holding
made interest payments totaling $119,000, $981,000 and $138,000 to Barclays
pursuant to the Credit Agreement during 1997, 1996 and 1995, respectively. On
February 20, 1997, SFD Holding borrowed $12,833,000 under the Master Note
Agreement. Those funds were used to repay all amounts then outstanding under the
Credit Agreement. Concurrent with the repayment, the Credit Agreement was
terminated. At December 31, 1997 and 1996, borrowings under the Credit Agreement
were $0 and $13,700,000, respectively. Accrued interest at December 31, 1997 and
1996 was $0 and $70,000, respectively. All borrowings under the Credit Agreement
were guaranteed by NYLIFE Inc.
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 the Company.
Neither the Company nor New York Life have utilized the credit facility to date.
ESI maintains a $25,000,000 unsecured line of credit with the Mercantile Bank
National Association which was renewed for one year on May 29, 1997. ESI has
allowed a line of credit in the amount of $25,000,000 to lapse as of October 31,
1997. Terms of the agreement 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 this agreement on any unused portion are
charged at ten hundredths of one percent per year. At December 31, 1997 and
1996, ESI had no outstanding borrowings under this agreement, nor did it borrow
any amounts under these agreements during 1997.
<PAGE>
-19-
NOTE 12 - REINSURANCE
- ---------------------
MODIFIED COINSURANCE:
In 1996, NYLHIC entered into a modified coinsurance agreement with New York
Life, whereby 90% of New York Life's group life and health indemnity insurance
business was reinsured with NYLHIC. For the two years ended December 31, 1997
and 1996, NYLHIC recorded the following activity under the reinsurance agreement
(in thousands):
1997 1996
---- ----
Premiums and fees assumed $739,854 $613,632
Benefits 603,814 507,055
Commission and expense allowance 140,022 142,725
Modco reserve adjustment 35,602 (13,135)
Settlement on the net amount due is made 90 days after the end of each quarter.
Accordingly, at December 31, 1997 and 1996, NYLHIC recorded the following
amounts representing fourth quarter activity under the reinsurance agreement (in
thousands):
1997 1996
---- ----
Deferred and uncollected premiums and fees $183,970 $191,922
Claims payable (143,206) (143,096)
Commission and expense allowances
payable (34,762) (34,191)
Dividends due and unpaid (11,613) (27,777)
Payable on reinsurance assumed (39,608) (26,507)
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, 1997, 1996 and 1995
in connection with reinsurance agreements totaled $28,616,000, $29,434,000 and
$3,201,000, respectively. Policy reserves are recorded net of reinsurance
receivables of $8,434,000 and $7,709,000 at December 31, 1997 and 1996,
respectively.
NOTE 13 - 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.
<PAGE>
-20-
Investment management fees of $54,017,000, $40,864,000, and $35,089,000, were
received from New York Life and certain of its affiliates during the years ended
December 31, 1997, 1996 and 1995, respectively.
Certain subsidiaries earned premiums and fees related to health care services
provided to New York Life of $15,526,000, $14,447,000, and $14,301,000 in 1997,
1996 and 1995, respectively.
During 1995, one of NYLCare's HMO subsidiaries paid hospital service claims of
approximately $7,000,000 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 $6,200,000, $5,859,000 and $3,266,000, respectively, for the years ended
December 31, 1997, 1996 and 1995.
As a distributor of mutual funds, 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 1997 and
1996, was $49,248,000 and $36,826,000, respectively. At December 31, 1997 and
1996, receivables from the MainStay Funds approximated $10,153,000 and
$8,539,000, respectively for distribution, services and administration fees.
NYLIFE Securities earned commission revenue of approximately $85,690,000,
$61,438,000 and $29,910,000 on transactions with affiliates during 1997, 1996
and 1995, respectively.
At December 31, 1997, Greystone has an intercompany payable to New York Life of
$1,538,000 which requires minimum annual installments of $250,000 until the
balance of the account is liquidated. Greystone paid a total of $1,750,000 and
$750,000 in 1997 and 1996, respectively. Such liability is non-interest bearing.
During 1997, NYLIFE Funding received cash of $6,701,000 for transferring a
mortgage loan (with the same statement value) to New York Life Insurance and
Annuity Corporation, a wholly-owned subsidiary of New York Life. The cash in
this transaction was used to return capital of $6,700,000 to New York Life.
On October 1, 1997, Capital Corp. entered into a credit agreement with New York
Life whereby Capital Corp. has agreed to make loans to New York Life in an
aggregate principal amount at any time outstanding of up to but not exceeding
$500,000,000. This agreement and any loans made shall be automatically extended
and renewed for additional one year periods, unless either Capital Corp. or New
York Life notifies the other to terminate the Agreement. At December 31, 1997,
$499,781,000 was loaned to New York Life. During 1997, New York Life made
interest payments totaling $1,443,000. Interest receivable at December 31, 1997
totaled $2,422,000.
<PAGE>
-21-
As of October 27, 1997, MainStay Management began to serve as Manager to each of
the MainStay Retail Funds and, as of November 22, 1997, as Manager to each of
the Institutional Funds (collectively, the "Funds") pursuant to a Management
Agreement with the Funds. MainStay Management assumed responsibility for
oversight of the portfolio management services provided by the Sub-Advisers
(MacKay-Shields, Monitor Capital. and New York Life) and for managing the Funds'
business affairs, which includes furnishing the Funds with office facilities and
providing ordinary clerical, recordkeeping and bookkeeping services. As Manager
of the Funds, MainStay Management receives a fee which ranges between .50% and
1.00% of the average daily net assets of affiliated funds. As the Accounting
Service Agent, MainStay Management receives a separate fee which generally is
less than .05% per Fund on an annual basis. Such fees for 1997 were $14,109,000
and $249,000, respectively.
MainStay Shareholder Services is the Transfer Agent and Shareholder Servicing
Agent for The MainStay Funds. MSS provides shareholder services and acts as the
transfer agent for the Fund's authorized and issued shares of beneficial
interest, dividend disbursing agent and agent in connection with any
accumulation, letter of intent or similar purchase plans provided to
shareholders of record to the Fund and set out in the Prospectus and Statement
of Additional Information. For performance of transfer agent and servicing
duties, the Fund agrees to pay MSS an annual maintenance fee for each
shareholder account.
NOTE 14 - 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, 1997 and 1996 and for the years then ended are as follows (in
thousands):
CONSOLIDATED SUBSIDIARIES:
--------------------------
1997 1996
---- ----
Assets $151,690 $128,526
Liabilities 128,442 98,180
Revenue 39,639 43,760
Net Loss (20,225) (20,735)
NON-CONSOLIDATED SUBSIDIARIES
-----------------------------
1997 1996
---- ----
Assets $4,165,310 $3,961,499
Liabilities 4,000,338 3,807,416
Revenue 371,226 330,529
Net (Loss) Income (2,816) 25,852
The cumulative translation adjustments for 1997 and 1996, respectively, are
$2,438,000 and $3,850,000.
Dividend income earned by New York Life UK Limited ("NYLUK"), a wholly owned
subsidiary of International, Inc. on its investment in Life Assurance Holding
Corporation ("LAHC") was $5,136,000 and $3,673,000 for the years ended December
31, 1997 and 1996, respectively.
<PAGE>
-22-
NOTE 15 - 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 $5,983,000 and $14,481,000 due from New York Life as of
December 31, 1997 and 1996, respectively, pursuant to the tax allocation
agreement.
The components of income tax expense (benefit) for each year are as follows (in
thousands):
1997 1996 1995
---- ------ ----
Current
Federal $(4,621) $ (20,135) $ 9,119
State 12,471 8,973 8,771
Foreign 470 190 (363)
---------- ---------- ----------
Total Current 8,320 (10,972) 17,527
--------- -------- ----------
Deferred
Federal 13,230 86,686 (41,370)
State 379 611 (598)
---------- -------- ----------
Total Deferred $13,609 87,297 (41,968)
------- ------- --------
Total $21,929 $76,325 $(24,441)
======= ======= ========
Total income tax expense (benefit) is different from the amount computed using
the statutory federal tax rate of 35% in 1997, 1996 and 1995 for the following
reasons (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
------ ------ ------
<S> <C> <C> <C>
Income tax expense (benefit) at statutory rate $5,748 $54,371 $(40,522)
Tax exempt investment income and capital gains (174) (216) (231)
State and local taxes, net of federal income tax benefit 8,353 6,256 5,288
Amortization of goodwill 4,055 6,155 6,219
Net foreign taxes 470 183 (1,904)
Equity in non-consolidated affiliates 6,081 6,447 4,518
Non-deductible losses with respect to foreign operations 178 349 1,378
Undistributed earnings of subsidiaries 1,596 1,237 896
Issuance of additional shares by public subsidiary - 2,689 -
Subsidiary loan write-off (4,598) - -
Provision to return reconciliation 1,323 217 (1,126)
Other (1,103) (1,363) 1,043
-------- -------- ---------
Total income tax expense (benefit) $21,929 $76,325 $(24,441)
======= ======= ========
</TABLE>
<PAGE>
-23-
The net deferred tax liability at December 31, 1997 and 1996, respectively is
attributable to the following temporary differences (in thousands):
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Deferred tax asset:
Non-deductible reserves $ 11,879 $ 14,389
Net operating losses 4,445 4,448
Deferred compensation 12,122 13,417
Impairments - 2,133
Investments in affiliates and partnerships 2,087 652
Leasehold improvements 1,182 2,607
Deferred rent 2,190 2,365
Depreciation 819 912
Unrealized investment losses 84 764
Employee benefits 5,418 4,867
Modified coinsurance reserves 1,215 -
Deferred tax on sale of shares of subsidiary stock 2,614 2,614
Other 1,958 2,212
------ ---------
Gross deferred tax asset 46,013 51,380
Deferred tax liability:
Deferred distribution costs (93,965) (78,663)
Unrealized appreciation of subsidiary (12,299) (11,456)
Investments in affiliates and partnerships (98) (5,204)
Depreciation (1,715) (1,729)
Unrealized net appreciation (10,484) (9,102)
Unrealized investment gains (802) -
Forgiveness of subsidiary loan - (4,340)
Other (636) (492)
--------- ----------
Gross deferred tax liability (119,999) (110,986)
Valuation allowance (5,033) (4,445)
--------- ----------
Net deferred tax liability $ (79,019) $ (64,051)
========= ==========
</TABLE>
The December 31, 1997 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 16 - 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>
-24-
Future minimum lease payments under capital and noncancelable operating leases
with original or remaining lease terms in excess of one year at December 31,
1997, are as follows (in thousands):
<TABLE>
<CAPTION>
Capital Leases Operating Leases
-------------- ----------------
<S> <C> <C>
1998 $ 1,069 $ 32,661
1999 1,144 30,701
2000 1,223 28,084
2001 1,309 24,876
2002 1,398 30,816
2003 & thereafter - 95,102
----------- ---------
Total 6,143 242,240
----------- ---------
Less future sublease rental receipts - 12,614
----------- ---------
Present value of future minimum lease payments 6,143 -
----------- ---------
Less amount due in one year 1,069 -
----------- ---------
Total $ 5,074 $ 229,626
=========== =========
</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):
<TABLE>
<CAPTION>
December 31,
----------------------------
1997 1996
------ ------
<S> <C> <C>
Assets recorded under leases $ 14,091 $14,854
Accumulated depreciation (2,223) (2,048)
-------- -------
Total $ 11,868 $12,806
========= =======
</TABLE>
Rent expense for the years ended December 31, 1997, 1996 and 1995 was
approximately $36,575,000 $34,943,000 and $32,848,000, 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 began on January 8, 1998, 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 $15,000,000.
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.
<PAGE>
-25-
The Company and its subsidiaries are defendants in various legal 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.
NYLIFE Inc. along with NYLIFE Securities and NYLIFE Distributors have a support
agreement whereby NYLIFE Inc. has agreed to absorb any liability which may be
allocated to NYLIFE Securities and NYLIFE Distributors as a result of a lawsuit
alleging misappropriation of funds by a New York Life agent. At December 31,
1997 plaintiffs were seeking $98,000,000 in compensatory and punitive damages.
Plaintiffs recently moved to add 12 additional plaintiffs to the lawsuit who are
asserting similar claims and seek an additional $24,500,000 in damages. At this
time, neither the probability of loss nor the amount of the plaintiffs recovery,
if any, can be estimated.
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, 1997 and 1996, the net worth of these
subsidiaries exceeded the related requirements.
For the year ended December 31, 1997, approximately 66% of ESI's pharmaceutical
purchases were through one wholesaler. ESI believes that other alternative
sources are readily available.
On May 22, 1997, SAMCO received a letter of credit ("LC") in the aggregate
amount of $85,000,000 from The Chase Manhattan Bank. The LC was provided to
SAMCO in accordance with the provisions of the Consent Agreement. The LC secures
certain obligations owed to SAMCO under the Consent Agreement and the
Operational Services Agreement. In addition, SAMCO and WestSec entered into a
letter agreement dated May 21, 1997 memorializing certain collateral agreements
and understandings related to the LC. During 1997, the LC was reduced to
$75,994,000 in accordance with its terms.
NOTE 17 - EMPLOYEE BENEFIT PLANS
- --------------------------------
Long Term Performance Plan:
MacKay-Shields adopted Long-Term Performance Plans ("the Plans") in 1988 and
1995. These Plans associated with the grant awards are 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 1997 and
1996, respectively, MacKay-Shields recorded dividend and interest income in the
amount of $1,018,000 and $1,678,000 on the cash and investments segregated to
fund the Plan obligation.
<PAGE>
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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 of $3,903,000 was recorded as a liability based on results for the
three year period 1995 to 1997.
The Plans are 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 1997, 1996 and
1995, totaled $9,294,000, $9,011,000 and $1,794,000, respectively.
NOTE 18 - SUPPLEMENTAL CASH FLOW INFORMATION
- --------------------------------------------
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. The impact
on the Company's 1996 cash flows was 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 $5,613,000 and
$22,598,000, respectively, during 1997 and 1996.
Net cash received (paid) for income tax expense was $11,776,000, ($50,245,000)
and ($16,234,000) during 1997, 1996 and 1995, respectively.
Interest paid during 1997, 1996 and 1995 was $10,998,000, $15,075,000, and
$18,931,000, respectively.
NOTE 19 - SUBSEQUENT EVENTS
- ---------------------------
NYLCare Sale:
On March 15, 1998 New York Life reached an agreement to sell 100% of the
outstanding common stock of NYLCare to Aetna Inc. ("Aetna") and entered into a
coinsurance agreement with Aetna to reinsure 100% of New York Life's group life
and health indemnity insurance business currently reinsured by NYLHIC. The
reinsurance agreement between New York Life and NYLHIC will be terminated prior
to closing. Management expects the transaction to close in 1998.
New York Life will receive approximately $1.05 billion as consideration for the
sale of NYLCare, which will generate a pre-tax gain of approximately $700
million.
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The following is a condensed NYLCare Statement of Financial Position at December
31, 1997 and Statement of Operations for the year ended December 31, 1997 (in
millions):
STATEMENT OF FINANCIAL POSITION
ASSETS
- ------
Cash and cash equivalents $ 195
Premiums and accounts receivable 301
Investments 264
Fixed assets 47
Other assets 171
-----
Total assets $ 978
=====
LIABILITIES and STOCKHOLDER'S EQUITY
- ------------------------------------
Accrued HMO claims payable $ 211
Policy and claim reserves 154
Accrued expenses & other payables 111
Other liabilities 157
-------
Total liabilities $ 633
-----
Stockholder's equity: 345
-----
Total liabilities and stockholder's equity $ 978
=====
STATEMENT OF OPERATIONS
Total income $2,904
------
Expenses:
HMO Claims and capitation costs 1,820
Health, disability and death benefit costs 631
Employee compensation 258
Selling, administrative and other expenses 232
------
Total expenses 2,941
------
Loss before income taxes (37)
Income tax benefit (9)
------
Net loss $ (28)
=========
ESI Acquisition:
On April 1, 1998, ESI purchased Value Rx, the Pharmacy Benefit Management
("PBM") subsidiary of Columbia/HCA Healthcare Corporation ("Columbia"). Under
the terms of the agreement, ESI paid cash of $445,000,000 for the stock of Value
Health, Inc. and Managed Prescription Network, Inc. ESI used approximately
$100,000,000 of its own cash and financed the remainder of the purchase price
through a five year bank facility. In 1997, the unaudited revenue of Value Rx
was approximately $1,500,000,000. The acquisition will be accounted for as a
purchase.
<PAGE>
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Greystone:
In January 1998, management of NYLIFE, Greystone Realty's parent, formally
decided to transfer the asset and property management functions currently being
performed by Greystone to New York Life and to liquidate Greystone, if possible,
on or before June 1, 1998. It is anticipated that Greystone will incur certain
expenses related to this plan including employee severance and office closure
expenses. Further, it is not anticipated that the liquidation will provide
sufficient proceeds to repay all outstanding amounts due to NYLIFE. These
financial statements do not include any adjustments as a result of these
uncertainties.
SFD Holding:
On February 17, 1998, SAMCO sold to WestSec for $15,107,000, the security alarm
monitoring contracts and related assets which constituted the collateral
securing SAMCO's Series A Notes. The transaction was consummated pursuant to the
Operational Services Agreement dated November 15, 1991 between SAMCO and
Westinghouse Electric Corporation, as amended, and the Indenture dated as of
July 15, 1992, as supplemented, between SAMCO and United States Trust Company of
New York, as trustee. A portion of the proceeds of the sale were used to pay all
outstanding principal and accrued interest on the Series A Notes on February 17,
1998, the maturity date of such Notes. On February 17, 1998 SAMCO distributed
$1,640,000 to the Series C note holders, which included interest, quarterly
principal repayment and additional principal repayment.
Concurrent with the sale, SAMCO and WestSec instructed The Chase Manhattan Bank
to reduce the letter of credit to $54,338,000 in accordance with its terms.
On March 2, 1998, WestSec, Inc. filed a Declaratory Judgment action against
SAMCO. The Declaratory Judgement action brought by WestSec in the Texas state
court seeks a judgment by the court declaring that the "person reassignment"
Contracts are not included within the Contracts constituting the collateral
securing the Series A Notes and, therefore, are not included among the Contracts
WestSec was obligated to purchase. WestSec also requests that the Court
determine the number of Contracts which allegedly constitute "person
reassignment" Contracts. WestSec further requests the court to award it costs
and attorney's fees. SAMCO intends to vigorously defend against the claims made
by WestSec and may assert counterclaims as well.
NYLUK:
On March 12, 1998, the Financial Services Authority and the Personal Investment
Authority issued a consultation paper, for comment by May 18, 1998, on the next
phase of the pension sales practices review and redress program launched in
1994. The extension of this review and redress program will lead to claims
against NYLUK, for the expenses incurred in connection with the extension of
this program. NYLUK's loss in connection with the extension of this program,
which will most likely be material, cannot yet be reasonably estimated.
In March of 1998, NYLUK contributed approximately $10,000,000 to LAHC, to fund
the acquisition of GAN Life Holdings (LAHC is a UK holding company which NYLUK
had a 31.25% equity investment in at December 31, 1997). This transaction
resulted in a reduction of NYLUK's investment in LAHC to 22.8%.
Other:
On February 20, 1998, the Board of Directors of NYLIFE Funding and NYLIFE
Resources Inc. approved plans to voluntarily dissolve the Companies. NYLIFE
Funding and NYLIFE Resources Inc. have no present operations and are expected to
be formally dissolved in 1998.
