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IAI Retirement Funds, Inc.
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Prospectus
May 1, 1995
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[LOGO]
Mutual Funds
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TABLE OF CONTENTS
Financial Highlights 3
Investment Performance 4
Investment Objectives and Policies 4
Regional Portfolio 4
Balanced Portfolio 5
Reserve Portfolio 6
Other Investment Techniques 6
Risk Factors 9
Management 10
Computation of Net Asset Value and Pricing 12
Purchase of Shares 12
Redemption of Shares 12
Dividends, Distributions and Tax Status 13
Description of Common Stock 13
Counsel and Auditors 14
Custodian, Transfer Agent and Dividend Disbursing Agent 14
Investment Advisers, Inc.
3700 First Bank Place, P.O. Box 357,
Minneapolis, Minnesota 55440-0357
800.945.3863
612.376.2700
Prospectus
May 1, 1995
IAI Retirement Funds, Inc.
IAI Retirement Funds, Inc. (the "Fund"), is a diversified, open-end management
investment company offering insurance companies a selection of investment
vehicles for variable annuity and variable life insurance contracts. This
Prospectus describes the three portfolios currently offered by the Fund (the
"Portfolios"). Each Portfolio has its own distinct investment objective. There
can be no assurance that any Portfolio will achieve its investment objective.
IAI Regional Portfolio ("Regional Portfolio") pursues its objective of capital
appreciation by investing at least 80% of its equity investments in companies
which have their headquarters in Minnesota, Wisconsin, Iowa, Illinois, Nebraska,
Montana, North Dakota or South Dakota.
IAI Balanced Portfolio's ("Balanced Portfolio") investment objective is to
maximize total return to investors. IAI Balanced Portfolio pursues its
objective by investing in a broadly diversified portfolio of stocks, bonds and
short-term instruments.
IAI Reserve Portfolio's ("Reserve Portfolio") investment objectives are to
provide its shareholders with high levels of capital stability and liquidity
and, to the extent consistent with these primary objectives, a high level of
current income. IAI Reserve Portfolio pursues its investment objectives by
investing primarily in a diversified portfolio of investment grade bonds and
other debt securities of similar quality. IAI Reserve Portfolio's dollar
weighted average maturity will not exceed twenty-five (25) months.
This Prospectus sets forth concisely the information which a prospective
investor should know about the Portfolios before investing and it should be
retained for future reference. A "Statement of Additional Information" dated
May 1, 1995, which provides a further discussion of certain areas in this
Prospectus and other matters which may be of interest to some investors, has
been filed with the Securities and Exchange Commission and is incorporated
herein by reference. For a free copy, call or write the Fund at the address or
telephone number shown below.
Shares of each Portfolio may be purchased only by the separate accounts of
insurance companies for the purpose of funding variable annuity and/or variable
life insurance contracts. Particular Portfolios may not be available in your
state due to various insurance regulations. Please check with your insurance
company. Inclusion of a Portfolio in this Prospectus is not to be considered a
solicitation if such Portfolio is not available in your state. This Prospectus
should be read in conjunction with the prospectus of the separate account of the
specific insurance product which accompanies this Prospectus.
These Securities have not been approved or disapproved by the securities and
exchange commission or any state securities commission nor has the securities
and exchange commission or any state securities commission passed upon the
accuracy or adequacy of this prospectus. Any Representation to the contrary is
a criminal offense.
2
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Financial Highlights
The following information has been audited by KPMG Peat Marwick LLP, independent
auditors, whose report is included in the Fund's Annual Report. The Annual
Report is incorporated by reference in (and is a part of) the Statement of
Additional Information. Such Annual Report may be obtained by shareholders on
request from the Fund at no charge.
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For the Period Ended December 31, 1994
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IAI IAI IAI
Regional Balanced Reserve
Portfolio (1) Portfolio (2) Portfolio (3)
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<S> <C> <C> <C>
Net Asset Value:
Beginning of period $ 10.00 $ 10.00 $ 10.00
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Operations:
Net investment income .03 .10 .20
Net realized and unrealized gains .59 .12 .02
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Total from operations .62 .22 .22
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Distributions to shareholders from:
Net investment income - - (.19)
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Total distributions - - (.19)
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Net Asset Value:
End of period $ 10.62 $ 10.22 $ 10.03
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Total investment return* 6.20% 2.20% 2.25%
Net assets at end of period $ 865,182 $ 205,668 $ 543,846
Ratios:
Expenses to average daily net assets** 1.13%*** 1.25%*** 0.85%***
Net investment income to average daily net assets** 0.81%*** 2.28%*** 3.56%***
Portfolio turnover rate
(excluding short-term securities) 127.6% 21.6% 0.00%
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* Total investment return is based on the change in net asset value of a
share during the period and assumes reinvestment of distributions at net
asset value.
** Annualized.
*** The Portfolios' adviser voluntarily waived $7,455, $7,756 and $6,930 in
expenses for Regional Portfolio, Balanced Portfolio and Reserve Portfolio,
respectively. If the Portfolios had been charged for these expenses, the
ratio of expenses to average daily net assets would have been 3.90%, 10.33%
and 4.62%, respectively, and the ratio of net investment income to average
daily net assets would have been (1.96%), (6.80%) and (0.21%),
respectively.
(1) Period from January 31, 1994 to December 31, 1994.
(2) Period from February 3, 1994 to December 31, 1994.
(3) Period from April 7, 1994 to December 31, 1994.
3
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Investment Performance
Each Portfolio's performance may be quoted in advertising in terms of yield and
total return. All such figures are based on historical earnings and performance
and are not intended to be indicative of future performance. The investment
return on and principal value of an investment in a Portfolio will fluctuate, so
that an investor's shares, when redeemed, may be worth more or less than their
original cost.
Total return is the change in value of an investment in a Portfolio over a given
period, assuming reinvestment of any dividends and capital gains. A cumulative
total return reflects actual performance over a stated period of time. An
average annual total return is a hypothetical rate of return that, if achieved
annually, would have produced the same cumulative total return if performance
had been constant over the entire period.
Yield refers to the income generated by an investment in a Portfolio over a
given period of time, expressed as an annual percentage rate. Yields are
calculated according to a standard that is required for all stock and bond
funds. Because this differs from other accounting methods, the quoted yield may
not equal the income actually paid to shareholders.
Total returns and yields include the effect of deducting a Portfolio's expenses,
but may not include charges and expenses attributable to any particular
insurance product. Since shares of the Portfolios may be purchased only through
a variable annuity or variable life contract, you should carefully review the
prospectus of the insurance product you have chosen for information on relevant
charges and expenses. Excluding these charges from quotations of a Portfolio's
performance has the effect of increasing the performance quoted. You should
bear in mind the effect of these charges when comparing a Portfolio's
performance to that of other mutual funds.
For additional information regarding the calculation of such total return and
yield figures, see "Investment Performance" in the Statement of Additional
Information. Further information about the performance of each Portfolio is
contained in the Fund's annual report to shareholders which may be obtained
without charge from the Fund.
Investment Objectives and Policies
The investment objectives and policies of each of the Portfolios are listed
below. There is no assurance that any Portfolio will achieve its investment
objectives. The value of shares when redeemed may be higher or lower than when
purchased.
Regional Portfolio
The investment objective of Regional Portfolio is capital appreciation. The
Portfolio does not expect to provide significant current income to investors.
The Portfolio pursues its objective by investing at least 80% of its equity
investments in companies which have their headquarters in Minnesota, Wisconsin,
Iowa, Illinois, Nebraska, Montana, North Dakota or South Dakota (the "Eight
State Region"). The Portfolio's investment objective may not be changed without
shareholder approval. There can be no assurance that the Portfolio will achieve
its investment objective.
The Portfolio invests primarily in common stocks but may also invest in
securities convertible into common stocks, nonconvertible preferred stocks, and
nonconvertible debt securities. In selecting investments for the Portfolio,
Investment Advisers, Inc. ("IAI"), the Portfolio's investment adviser and
manager, considers a number of factors, such as product development and demand,
operating ratios, utilization of earnings for expansion, management abilities,
analyses of intrinsic values, market action and overall economic and political
conditions. In unusual market conditions, when management believes a defensive
position is warranted, the Portfolio may temporarily invest all or a portion of
its assets in investment grade bonds, other fixed income securities, or short-
term money market securities (including repurchase agreements) without
geographic or percentage limitation. Such fixed income securities will only be
purchased if they are rated within the four highest grades assigned by Moody's
Investor's Service, Inc. ("Moody's") or Standard & Poor's Corporation ("S&P").
Short-term money market securities will only be purchased if they are of "high
quality," which means the instruments, if rated, must have been given one of the
top two ratings by a major rating service, or if unrated, are of comparable
quality as determined by IAI.
4 IAI Mutual Funds
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Along with investments in nationally recognized companies, the Portfolio invests
in companies which are not as well known because they are newer or have a small
capitalization, but which offer the potential for capital appreciation. The
prices of stocks of such companies are more volatile than prices of stocks of
mature companies. All investments are subject to the market risks inherent in
any investment in equity securities.
Regional Portfolio may employ certain other investment techniques, as described
in the section "Other Fund Investment Techniques." Please see the Prospectus
section "Fund Risk Factors" as well as the Statement of Additional Information
section "Investment Objectives and Policies" for a discussion of the risks
associated with investing in the Portfolio.
Balanced Portfolio
The investment objective of Balanced Portfolio is to maximize total return.
The Portfolio will seek to achieve its objective by investing in a broadly
diversified portfolio of stocks, bonds and short-term instruments. The
Portfolio's investment objective may not be changed without shareholder
approval. There can be no assurance that the Portfolio will achieve its
investment objective.
In seeking to achieve its investment objective, IAI, the Portfolio's investment
adviser and manager, will allocate the Portfolio's assets among the three
classes of assets set forth above. Under normal market conditions, the
Portfolio will hold between 25% and 75% of its assets in stocks and other equity
securities, between 25% and 75% of its assets in bonds and other fixed income
securities, and up to 50% of its assets in short-term instruments. The
Portfolio may also make other investments that do not fall within these classes.
The stock class includes equity securities of all types and will consist
primarily of common stocks, securities convertible into common stocks, and non-
convertible preferred stocks. The bond class includes all varieties of fixed-
income instruments with maturities of more than one year and will consist
primarily of investment grade bonds and other comparable fixed income
securities.
The short-term class includes all types of short-term instruments with remaining
maturities of one year or less and will consist primarily of commercial paper,
bank certificates of deposit, bankers' acceptances, government securities,
repurchase agreements and other similar short-term instruments. Short-term
securities will only be purchased if given one of the top two ratings by a major
rating service or, if unrated, are of comparable quality as determined by IAI.
Within each of these classes, the Portfolio may invest in both domestic and
foreign securities.
Although the Portfolio may invest in below investment grade securities, the
Portfolio currently intends to limit such investments to 5% of its total net
assets and not to invest in securities rated lower than Ba by Moody's or BB by
S&P. Securities rated in the medium to lower rating categories of nationally
recognized statistical rating organizations and unrated securities of comparable
quality are predominantly speculative with respect to the capacity to pay
interest and repay principal in accordance with the terms of the security and
generally involve a greater volatility of price than securities in higher rating
categories. See "Investment Objectives and Policies" in the Statement of
Additional Information for additional information regarding ratings of debt
securities. In purchasing such securities, Bond Fund will rely on IAI's
judgment, analysis and experience in evaluating the creditworthiness of an
issuer of such securities. IAI will take into consideration, among other
things, the issuer's financial resources, its sensitivity to economic conditions
and trends, its operating history, the quality of the issuer's management and
regulatory matters.
IAI will regularly review its allocation of the Portfolio's assets among the
three classes and will gradually vary them over time to favor asset classes
that, in IAI's judgment, provide the most favorable total return outlook.
Because the Portfolio seeks to maximize total return over the long-term, it will
not try to pinpoint the precise moment when major reallocations are warranted.
Rather, such reallocations among asset classes will be made gradually over time
and, under normal conditions, a single reallocation decision will not involve
more than 10% of the Portfolio's total assets. The Portfolio may make
substantial temporary investments in cash or other high-quality short-term or
money market instruments when IAI believes a defensive position is warranted.
IAI Mutual Funds 5
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Balanced Portfolio may employ certain other investment techniques, as described
in the section "Other Fund Investment Techniques." Please see the Prospectus
section "Fund Risk Factors" as well as the Statement of Additional Information
section "Investment Objectives and Policies" for a discussion of the risks
associated with investing in the Portfolio.
Reserve Portfolio
Reserve Portfolio's investment objectives are to provide its shareholders with
high levels of capital stability and liquidity and, to the extent consistent
with these primary objectives, a high level of current income. Such objectives
may not be changed without shareholder approval. There can be no assurance that
the Portfolio's investment objectives will be attained.
The Portfolio pursues its objectives primarily through investment in a
diversified portfolio of investment grade bonds and other debt securities of
similar quality. Investment grade securities are those securities rated within
the four highest grades assigned by Moody's or S&P. Although the Portfolio may
invest in below investment grade securities, it currently has no intention of
doing so. The Portfolio will maintain a dollar weighted average maturity of its
investment portfolio of twenty-five (25) months or less. For purposes of such
determination, securities that provide for optional maturity dates, at the
holder's option, shall be deemed by the Portfolio to have been issued with the
shorter optional maturity dates.
Other debt securities in which the Portfolio may invest include securities of,
or guaranteed by, the U.S. Government, its agencies or instrumentalities,
corporate debt obligations, debt securities of foreign issuers, mortgage-related
securities, commercial paper rated at least Prime-2 by Moody's or A-2 by S&P or
otherwise issued by companies having an outstanding unsecured debt issue
currently rated A or better by Moody's or S&P, bank certificates of deposit and
other short-term instruments and repurchase agreements relating to such
securities. U.S. Government securities are issued or guaranteed by the U.S.
Treasury or by an agency or instrumentality of the U.S. Government. Not all
U.S. Government securities are backed by the full faith and credit of the United
States. Some are supported only by the credit of the agency that issued them.
Reserve Portfolio may employ certain other investment techniques, as described
in the section "Other Fund Investment Techniques." Please see the Prospectus
section "Fund Risk Factors" as well as the Statement of Additional Information
section "Investment Objectives and Policies" for a discussion of the risks
associated with investing in the Portfolio.
Other Investment Techniques
Repurchase Agreements
Each Portfolio may invest in repurchase agreements relating to the securities in
which it may invest. In a repurchase agreement, a Portfolio buys a security at
one price and simultaneously agrees to sell it back at a higher price. Delays
or losses could result if the other party to the agreement defaults or becomes
bankrupt.
Foreign Securities
Each Portfolio may invest in securities of foreign issuers in accordance with
its investment objectives and policies. In considering whether to purchase
securities of foreign issuers, IAI will consider the political and economic
conditions in a country, the prospect for changes in the value of its currency
and the liquidity of the investment in that country's securities markets. Each
of Regional and Balanced Portfolio intends to limit its investment in foreign
securities denominated in foreign currency and not publicly traded in the United
States to no more than 10% of its total assets. Reserve Portfolio intends to
invest no more than 15% of the value of its total assets in such securities.
Illiquid Securities
Each Portfolio may also invest up to 15% of its total assets in securities that
are considered illiquid because of the absence of a readily available market or
due to legal or contractual restrictions. However, certain restricted
securities that are not registered for sale to the general public but that can
be resold to institutional investors may be considered liquid pursuant to
guidelines adopted by the Board of Directors. The institutional trading market
is relatively new,
6 IAI Mutual Funds
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and the liquidity of each Portfolio's investments could be impaired if trading
does not develop or declines.
Venture capital
Regional and Balanced Portfolios may invest in venture capital limited
partnerships and funds which, in turn, invest principally in securities of early
stage, developing companies. Investments in venture capital limited partnerships
and funds present a number of risks not found in investing in established
enterprises including the facts that such a partnership's portfolio will be
composed almost entirely of early-stage companies which may lack depth of
management and sufficient resources, which may be marketing a new product for
which there is no established market, and which may be subject to intense
competition from larger companies. Any investment in a venture capital fund will
lack liquidity, will be difficult to value, and each such Portfolio will not be
entitled to participate in the management of the partnership or fund. If for any
reason the services of the general partners of a venture capital limited
partnership were to become unavailable, such limited partnership could be
adversely affected.
LBOs
Regional and Balanced Portfolios may invest in leveraged buyout limited
partnerships and funds which, in turn, invest in leveraged buyout transactions
("LBOs"). An LBO, generally, is an acquisition of an existing business by a
newly formed corporation financed largely with debt assumed by such newly formed
corporation to be later repaid with funds generated from the acquired company.
Since most LBOs are by nature highly leveraged (typically with debt to equity
ratios of approximately 9 to 1), equity investments in LBOs may appreciate
substantially in value given only modest growth in the earnings or cash flow of
the acquired business. Investments in LBOs, however, present a number of risks.
Investments in LBO limited partnerships and funds will normally lack liquidity
and may be subject to intense competition from other LBO limited partnerships
and funds. Additionally, if the cash flow of the acquired company is
insufficient to service the debt assumed in the LBO, the LBO limited partnership
or fund could lose all or part of its investment in such acquired company.
When-Issued/Delayed Delivery Transactions
Balanced and Reserve Portfolios may purchase securities on a "when-issued" or
delayed delivery basis and purchase or sell securities on a "forward commitment"
basis. When such transactions are negotiated, the price is fixed at the time the
commitment is made, but delivery and payment for the securities take place at a
later date. Normally, the settlement date occurs within two months after the
transaction, but delayed settlements beyond two months may be negotiated. At the
time a Portfolio enters into a transaction on a when-issued or forward
commitment basis, a segregated account consisting of cash, government securities
or liquid high-grade debt securities equal to the value of the when-issued or
forward commitment securities will be established and maintained with the
custodian and will be marked to the market daily. During the period between a
commitment and a settlement, no payment is made for the securities and, thus, no
interest accrues to the purchaser from the transaction. If a Portfolio disposes
of the right to acquire a when-issued security prior to its acquisition or
disposes of its right to deliver or receive against a forward commitment, it can
incur a gain or loss due to market fluctuation. The use of when-issued
transactions and forward commitments enables a Portfolio to hedge against
anticipated changes in interest rates and prices. A Portfolio may also enter
into such transactions to generate incremental income. In some instances, the
third-party seller of when-issued or forward commitment securities may determine
prior to the settlement date that it will be unable or unwilling to meet its
existing transaction commitments without borrowing securities. If advantageous
from a yield perspective, a Portfolio may, in that event, agree to resell its
purchase commitment to the third-party seller at the current market price on the
date of sale and concurrently enter into another purchase commitment for such
securities at a later date. As an inducement for a Portfolio to "roll over" its
purchase commitment, a Portfolio may receive a negotiated fee. No more than 20%
of a Portfolio's net assets may be invested in when-issued, delayed delivery or
forward commitment transactions, and of such 20%, no more than one-half (i.e.
10% of its net assets) may be invested in when-issued, delayed delivery or
forward commitment transactions without the intention of actually acquiring
securities (i.e.
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dollar rolls or "roll" transactions). For additional information on roll
transactions, see "Investment Objectives and Policies-Dollar Rolls" in the
Statement of Additional Information.
Zero Coupon Obligations
Balanced and Reserve Portfolios may also invest in zero coupon obligations of
the U.S. Government or its agencies, tax exempt issuers and corporate issuers,
including rights to stripped coupon and principal payments ("strips"). Zero
coupon bonds do not make regular interest payments; rather, they are sold at a
discount from face value. Principal and accreted discount (representing interest
accrued but not paid) are paid at maturity. Strips are debt securities that are
stripped of their interest after the securities are issued, but otherwise are
comparable to zero coupon bonds. The market values of strips and zero coupon
bonds generally fluctuate in response to changes in interest rates to a greater
degree than do interest-paying securities of comparable term and quality.
Lending
In order to generate additional income, each Portfolio may lend portfolio
securities up to one-third of the value of its total assets to broker-dealers,
banks or other financial borrowers of securities. This practice could cause each
Portfolio to experience either a loss or a delay in recovering its securities.
Adjusting Investment Exposure
Each Portfolio can use various techniques to increase or decrease its exposure
to changing security prices, interest rates, currency exchange rates, commodity
prices, or other factors that affect security values. These techniques include
buying and selling options and futures contracts, entering into currency
exchange contracts or swap agreements, purchasing indexed securities and selling
securities short. Further information regarding these techniques is contained in
the Statement of Additional Information. Because some assets of Regional and
Balanced Portfolios may not be associated with short-term movements in the
financial markets, a portion of such Portfolios may be subject to market
participation risk. Each such Portfolio may invest in futures contracts in
amounts corresponding to its investments in such assets in order to participate
fully in market movements.
Borrowing
Each Portfolio may borrow from banks for temporary or emergency purposes or
through reverse repurchase agreements. If a Portfolio borrows money, its share
price may be subject to greater fluctuation until the borrowing is paid off. If
a Portfolio makes additional investments while borrowings are outstanding, this
may be considered a form of leverage.
Portfolio Turnover
Each Portfolio will dispose of securities without regard to the time they have
been held when such action appears advisable to management either as a result of
securities having reached a price objective, or by reason of developments not
foreseen at the time of the investment decision. Since investment changes
usually will be made without reference to the length of time a security has been
held, a significant number of short-term transactions may result. Accordingly, a
Portfolio's annual portfolio turnover rate cannot be anticipated and may be
relatively high. High turnover rates increase transaction costs, and may
increase taxable capital gains. Each Portfolio's historical portfolio turnover
rates are set forth in the section "Financial Highlights."
Investment Restrictions
Each Portfolio also follows certain limitations imposed by the Internal Revenue
Service on separate accounts of insurance companies relating to the tax-deferred
status of variable contracts. More specific information may be contained in the
insurance company's separate account prospectus.
Each Portfolio is subject to certain other investment policies and restrictions
described in the Statement of Additional Information, some of which are
fundamental and may not be changed without the approval of the shareholders of
each Portfolio. Please refer to the Statement of Additional Information for a
further discussion of these policies and restrictions.
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Risk Factors
Duration
In managing Reserve Portfolio and the fixed income component of Balanced
Portfolio, IAI will adjust the duration of the investment portfolio in response
to economic and market conditions. Duration is a measure of the expected change
in value of a fixed income security (or portfolio) for a given change in
interest rates. For example, if interest rates rise by one percent, the market
value of a security (or portfolio) having a duration of two generally will fall
by approximately two percent. Duration is generally considered a better measure
of interest rate risk than is maturity. In some situations, the standard
duration calculation does not properly reflect the interest rate risk of a
security. In such situations, IAI will use more sophisticated analytical
techniques, such as modeling principal and interest payments based upon
historical experience or expected volatility, to arrive at an effective duration
that incorporates the additional variables into the determination of interest
rate risk. These techniques may involve estimates of future economic parameters
which may vary from actual future outcomes.
Foreign Investment Risk Factors
Investments in foreign securities involve risks that are different in some
respects from investments in securities of U.S. issuers, such as the risk of
fluctuations in the value of the currencies in which they are denominated, the
risk of adverse political and economic developments and, with respect to certain
countries, the possibility of expropriation, nationalization or confiscatory
taxation or limitations on the removal of funds or other assets of the
Portfolios. Securities of some foreign companies are less liquid and more
volatile than securities of comparable domestic companies. There also may be
less publicly available information about foreign issuers than domestic issuers,
and foreign issuers generally are not subject to the uniform accounting,
auditing and financial reporting standards, practices and requirements
applicable to domestic issuers. Because the Portfolios can invest in securities
denominated or quoted in currencies other than the U.S. dollar, changes in
foreign currency exchange rates may affect the value of securities in the
portfolio. Foreign currency exchange rates are determined by forces of supply
and demand in the foreign exchange markets and other economic and financial
conditions affecting the world economy. A decline in the value of any particular
currency against the U.S. dollar will cause a decline in the U.S. dollar value
of a Portfolio's holdings of securities denominated in such currency and,
therefore, will cause an overall decline in a Portfolio's net asset value and
net investment income and capital gains, if any, to be distributed in U.S.
dollars to shareholders by a Portfolio. Delays may be encountered in settling
securities transactions in certain foreign markets, and the Portfolios will
incur costs in converting foreign currencies into U.S dollars. Custody charges
are generally higher for foreign securities.
Risks of Transactions in Derivatives
IAI may use futures, options, swap and currency exchange agreements as well as
short sales to adjust the risk and return characteristics of each Portfolio's
portfolio of investments. If IAI judges market conditions incorrectly or employs
a strategy that does not correlate well with a Portfolio's investments, use of
these techniques could result in a loss, regardless of whether the intent was to
reduce risk or increase return. Use of these techniques may increase the
volatility of a Portfolio and may involve a small investment of cash relative to
the magnitude of risk assumed. In addition, these techniques could result in a
loss if the counterparty to the transaction is unable to perform as promised.
Moreover, a liquid secondary market for any futures or options contract may not
be available when a futures or options position is sought to be closed. Please
refer to the Statement of Additional Information which further describes these
risks.
Risks of Geographic Concentration
For the Regional Portfolio, the objective of capital appreciation along with the
policy of concentrating equity investments in the Eight State Region means that
the assets of the Portfolio will generally be subject to greater risk than may
be involved in investing in securities which do not have appreciation potential
or which have more geographic diversity. For example, the Portfolio's net asset
value could be adversely affected by economic, political, or other developments
having an unfavorable impact upon the Eight State Region; moreover, because of
the geographic limitation, the Portfolio may be less diversified by industry and
company than other funds with a similar investment objective and no such
geographic limitation.
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Risks of Lower-Rated Debt Securities
Balanced Portfolio may invest in debt securities commonly known as "junk" bonds.
Such securities are subject to higher risks and greater market fluctuations than
are lower-yielding, higher-rated securities. The price of junk bonds has been
found to be less sensitive to changes in prevailing interest rates than higher-
rated investments, but is likely to be more sensitive to adverse economic
changes or individual corporate developments. During an economic downturn or
substantial period of rising interest rates, highly leveraged issuers may
experience financial stress which would adversely affect their ability to
service their principal and interest payment obligations, to meet their
projected business goals or to obtain additional financing. If the issuers of a
fixed-income security owned by the Portfolio were to default, the Portfolio
might incur additional expenses to seek recovery. The risk of loss due to
default by issuers of junk bonds is significantly greater than that associated
with higher-rated securities because such securities generally are unsecured and
frequently are subordinated to the prior payment of senior indebtedness. In
addition, periods of economic uncertainty and change can be expected to result
in an increased volatility of market prices of junk bonds and a concomitant
volatility in the net asset value of a share of the Portfolio.
The secondary market for junk bonds is less liquid than the markets for higher
quality securities and, as such, may have an adverse effect on the market prices
of certain securities. The limited liquidity of the market may also adversely
affect the ability of the Portfolio to arrive at a fair value for certain junk
bonds at certain times and could make it difficult for the Portfolio to sell
certain securities. For a description of Moody's and S&P ratings, see Appendix A
to the Statement of Additional Information.
Management
Under Minnesota law, the Fund's Board of Directors is generally responsible for
the overall management and operation of the Fund. IAI serves as the investment
adviser and manager of the Portfolios pursuant to a written advisory agreement
(the "Advisory Agreement"). IAI also furnishes investment advice to other
concerns including other investment companies, pension and profit sharing plans,
portfolios of foundations, religious, educational and charitable institutions,
trusts, municipalities and individuals, having total assets in excess of $14
billion. IAI is an affiliate of Hill Samuel Group ("Hill Samuel"), an
international merchant banking and financial services group based in London,
England. Hill Samuel, in turn, is owned by TSB Group plc, a publicly-held
financial services organization headquartered in London, England. TSB Group plc
is one of the largest personal and corporate financial services groups in the
United Kingdom and is engaged in a wide range of activities including banking,
unit linked life assurance, unit trust management, investment management, credit
card and finance house business. The address of IAI is that of the Fund.
Under the Advisory Agreement, IAI provides the Portfolios with investment
advice, statistical and research facilities, and certain equipment and services,
including, but not limited to, office space and necessary office facilities,
equipment, and the services of required personnel. Under the Advisory Agreement,
IAI has the sole authority and responsibility to make and execute investment
decisions for the Portfolios within the framework of each Portfolio's investment
policies, subject to review by the Board of Directors. As compensation for these
services, for the fiscal year ended December 31, 1994, Regional, Balanced and
Reserve Portfolios paid IAI an advisory fee at an annual rate of .65%, .65% and
.45%, respectively, of each Portfolio's average daily net assets.
Each Portfolio is managed by a team of IAI investment professionals which is
responsible for making the day-to-day investment decisions for such Portfolio.
The teams managing the Portfolios are as follows.
Julian ("Bing") Carlin and Mark Hoonsbeen have responsibility for the management
of Regional Portfolio. Mr. Carlin is Senior Vice President of IAI and has served
as an equity portfolio manager since joining IAI in 1974. Mr. Carlin has managed
Regional Portfolio since its inception. Mr. Hoonsbeen is a Vice President of IAI
and has managed Regional Portfolio since he joined IAI in 1994. Prior to joining
IAI, Mr. Hoonsbeen served as an equity portfolio manager for the St. Paul
Companies Inc. from 1986 to 1994.
10
IAI Mutual Funds
<PAGE>
John Twele, David McDonald and Mark Simenstad have responsibility for the
management of Balanced Portfolio. Mr. Twele has managed Balanced Portfolio's
equity securities since April 1994, when he joined IAI as a Vice President and
equity portfolio manager. Before joining IAI, Mr. Twele had been a Senior Equity
Analyst with IDS Financial Services since 1987. Mr. McDonald has managed
Balanced Portfolio's equity securities since September 1994, when he joined IAI
as a Vice President and equity portfolio manager. Before joining IAI, Mr.
McDonald had been a Managing Director of Wessels Arnold & Henderson since 1989
and an Associate Portfolio Manager with IDS Financial Services from 1986 to
1989. Mr. Simenstad has managed Balanced Portfolio's fixed income securities
since inception. Mr. Simenstad is a Vice President of IAI and has served as a
fixed income portfolio manager since joining IAI in 1993. Before joining IAI,
Mr. Simenstad served as a fixed income portfolio manager for Lutheran
Brotherhood from 1983 to 1993.
Timothy Palmer and Livingston Douglas have responsibility for the management of
Reserve Portfolio. Mr. Palmer is a Senior Vice President of IAI and has served
as a fixed income portfolio manager since joining IAI in 1990. Mr. Palmer has
managed Reserve Portfolio since its inception. Mr. Douglas is a Vice President
of IAI and has served as a fixed income portfolio manager since joining IAI in
1993. Prior to joining IAI, Mr. Douglas served as a fixed income portfolio
manager for Mackey-Shields Financial Corp. from 1987 to 1993. Mr. Douglas has
also managed Reserve Portfolio since its inception.
Pursuant to the terms of an Administrative Agreement, IAI also provides all
required administrative, stock transfer, redemption, dividend disbursing and
accounting services, including, for example, the maintenance of each Portfolio's
accounts, books and records, the daily calculation of each Portfolio's net asset
value, daily and periodic reports, all information necessary to complete tax
returns, questionnaires and other reports requested by the Portfolios, the
maintenance of stock registry records, the processing of requested account
registration changes and redemption requests, and the administration of payments
of dividends and distributions declared by the Portfolios. As compensation for
these services, for the fiscal year ended December 31, 1994, each Portfolio paid
IAI an administrative fee at the annual rate of .10% of such Portfolio's average
daily net assets.
In addition to the advisory fee and the administrative fee paid to IAI, each
Portfolio pays all its other costs and expenses, including, for example, costs
incurred in the purchase and sale of assets, interest, taxes, charges of the
custodian of each Portfolio's assets, costs of reports and proxy materials sent
to Portfolio shareholders, fees paid for independent accounting and legal
services, costs of printing prospectuses for Portfolio shareholders and
registering each Portfolio's shares, postage, fees to disinterested directors,
insurance premiums and costs of attending investment conferences. IAI, in its
discretion, may from time to time waive or reduce its management and/or
administrative fee or otherwise reimburse Fund operating expenses. For the
fiscal year ended December 31, 1994, IAI voluntarily agreed to reimburse total
Portfolio operating expenses which exceeded 1.13%, 1.25% and .85% of the average
daily net assets of Regional, Balanced and Reserve Portfolios, respectively.
IAI shall not be liable for any loss suffered by a Portfolio in the absence of
willful misfeasance, bad faith or gross negligence in the performance of its
duties and obligations.
Each Portfolio has an investment objective similar to that of an existing IAI
retail fund. IAI Regional Portfolio is similar to IAI Regional Fund, IAI
Balanced Portfolio to IAI Balanced Fund, and IAI Reserve Portfolio to IAI
Reserve Fund. Performance of each Portfolio is not expected to be the same as
the performance of the corresponding retail fund due in part to dissimilarities
in the investments and various insurance related costs at the insurance
company's separate account level.
Each Portfolio sells its shares to separate accounts of one or more insurance
companies unaffiliated with IAI. The Fund currently does not foresee any
disadvantages to policyowners arising out of the fact that Portfolio shares are
offered solely to separate accounts of various insurance companies to serve as
the investment medium for their variable products. Nevertheless, the Board of
Directors intends to monitor events in order to identify any material
irreconcilable conflicts which may possible arise, and to determine what action,
if any, should be taken in response to such conflicts. If such a conflict were
to occur, one or more insurance companies' separate accounts might be
11
IAI Mutual Funds
<PAGE>
required to withdraw its investments in one or more Portfolios and shares of
another Portfolio may be substituted. This might force a Portfolio to sell
securities at disadvantageous prices. In addition, the Board of Directors may
refuse to sell shares of any Portfolio to any separate account or may suspend or
terminate the offering of shares of any Portfolio if such action is required by
law or regulatory authority or is in the best interests of the shareholders of
the Portfolio.
Computation of Net Asset Value
and Pricing
Each Portfolio is open for business each day the New York Stock Exchange
("NYSE") is open. IAI normally calculates each Portfolio's net asset value
("NAV") as of the close of business of the NYSE, normally 3 p.m. Central time.
A Portfolio's NAV is the value of a single share. The NAV is computed by adding
up the value of a Portfolio's investments, cash, and other assets, subtracting
its liabilities, and then dividing the result by the number of shares
outstanding.
Each Portfolio's investments with remaining maturities of 60 days or less may be
valued on the basis of amortized cost. This method minimizes the effect of
changes in a security's market value. Other portfolio securities and assets are
valued primarily on the basis of market quotations or, if quotations are not
readily available, by a method that the Board of Directors believes accurately
reflects fair value. Foreign securities are valued on the basis of quotations
from the primary market in which they are traded, and are translated from the
local currency into U.S. dollars using current exchange rates.
The offering price (price to buy one share) and redemption price (price to sell
one share) of a Portfolio are a Portfolio's NAV next computed after receipt by a
Portfolio of a purchase or redemption order.
Purchase of Shares
Investments in the Fund may be made only by separate accounts established and
maintained by insurance companies for the purpose of funding variable annuity
contracts or variable life insurance contracts. Please refer to the prospectus
of your insurance company's separate account for information on how to invest in
each Portfolio. Investment by separate accounts in the Fund are expressed in
terms of full and fractional shares of each Portfolio. All investments in the
Portfolios are credited to an insurance company's separate account immediately
upon acceptance of the investment by a Portfolio. Investments will be processed
at the next NAV calculated after an order is received and accepted by a
Portfolio.
The offering of shares of any Portfolio may be suspended for a period of time
and each Portfolio reserves the right to reject any specific purchase order.
Purchase orders may be refused if, in IAI's opinion, they are of a size that
would disrupt the management of a Portfolio.
Because you may not purchase shares of a Portfolio directly, you should read the
prospectus of the insurance company's separate account to obtain instructions
for purchasing a variable annuity or variable life insurance contract.
Redemption of Shares
Shares of any Portfolio may be redeemed on any business day. Redemptions are
effected at the per share NAV next determined the redemption request has been
accepted by a Portfolio. Redemption proceeds will normally be wired to the
insurance company on the next business day after receipt of the redemption
instructions by a Portfolio but in no event later than seven days following
receipt of instruction. Each Portfolio may suspend redemptions or postpone
payment dates on days when the NYSE is closed (other than weekends or holidays),
when trading on the NYSE is restricted, or as permitted by the Securities and
Exchange Commission.
Please refer to the prospectus of your insurance company's separate account for
information on how to redeem from each Portfolio.
12 IAI MUTUAL FUNDS
<PAGE>
Dividends, Distributions and Tax Status
The policy of Reserve Portfolio is to pay dividends from net investment income
monthly, while Regional and Balanced Portfolios pay dividends semiannually. The
Portfolios make distributions of realized capital gains, if any, annually.
However, provisions in the Internal Revenue Code of 1986, as amended (the
"Code"), may result in additional net investment income and capital gains
distributions by the Portfolios. Such income and capital gains are automatically
reinvested in additional shares of the Portfolios.
The Fund intends to qualify for tax purposes as a regulated investment company
under the Code during the current taxable year. If so qualified, the Fund will
not be subject to federal income tax on income that it distributes to its
shareholders.
It is expected that Portfolio shares will be held under the terms of variable
annuity or variable life insurance contracts. Under current tax law, dividends
or capital gains distributions from the Portfolios are not currently taxable
when left to accumulate within a variable annuity or variable life insurance
contract. Depending on the variable contract, withdrawals from the contract may
be subject to ordinary tax and, in addition, to a 10% penalty tax on withdrawals
before age 59/1//2.
For a discussion of the tax status of your variable contract, see the prospectus
of your insurance company's separate account. See "Tax Status" in the Statement
of Additional Information for further information. It is suggested you keep all
statements you receive to assist in your personal recordkeeping.
Description of Common Stock
Each Portfolio is a separate portfolio represented by a separate class of common
stock of IAI Retirement Funds, Inc., a Minnesota corporation. All shares of the
Portfolios have equal rights as to redemption, dividends and liquidation, and
will be fully paid and nonassessable when issued and will have no preemptive or
conversion rights.
The shares of the Portfolios have noncumulative voting rights, which means that
the holders of more than 50% of the shares voting for the election of directors
can elect 100% of the directors if they choose to do so. On some issues, such as
the election of directors, all shares of IAI Retirement Funds, Inc., vote
together as one series. On an issue affecting only a particular Portfolio, such
as voting on an Advisory Agreement, only the approval of that Portfolio's
shareholders is required to make the agreement effective with respect to such
Portfolio. An insurance company issuing a variable contract that participates in
the Fund will vote shares in the separate account as required by law and
interpretations thereof, as may be amended or changed from time to time. In
accordance with current law and interpretations thereof, a participating
insurance company is required to request voting instructions from policyowners
and, with certain exceptions, must vote shares in the separate account in
proportion to the voting instructions received. For a further discussion, please
refer to your insurance company's separate account prospectus.
Annual or periodically scheduled regular meetings of shareholders will not be
held except as required by law. Minnesota corporation law does not require an
annual meeting; instead, it provides for the Board of Directors to convene
shareholder meetings when it deems appropriate. In addition, if a regular
meeting of shareholders has not been held during the immediately preceding
fifteen months, shareholders holding three percent or more of the voting shares
of the Fund may demand a regular meeting of shareholders of the Fund by written
notice of demand given to the chief executive officer or the chief financial
officer of the Fund. Within thirty days after receipt of the demand by one of
those officers, the Board of Directors shall cause a regular meeting of
shareholders to be called and held no later than ninety days after receipt of
the demand, all at the expense of the Fund. An annual meeting will be held on
the removal of a director or directors of the Fund if requested in writing by
holders of not less than 10% of the outstanding shares of the Fund.
IAI MUTUAL FUNDS 13
<PAGE>
Counsel and Auditors
The firm of Dorsey & Whitney P.L.L.P., 220 South Sixth Street, Minneapolis,
Minnesota 55402, provides legal counsel for the Fund. KPMG Peat Marwick L.L.P.,
4200 Norwest Center, Minneapolis, Minnesota 55402, serves as the independent
auditors for the Fund.
Custodian, Transfer Agent and Dividend Disbursing Agent
The Custodian for the Fund is Norwest Bank Minnesota, N.A., Norwest Center,
Sixth and Marquette, Minneapolis, Minnesota 55479. Norwest employs foreign
subcustodians and depositories, which were approved by the Fund's Board of
Directors in accordance with the rules and regulations of the Securities and
Exchange Commission, for the purpose of providing custodial services for the
Fund's assets held outside the United States. The directors of the Fund monitor
the activities of the Custodian and subcustodians as well as the economic
conditions and applicable laws of the foreign countries in which the Fund's
assets are held. For a listing of the subcustodians and depositories currently
employed by the Fund, see the Statement of Additional Information. IAI acts as
the Fund's transfer agent and dividend disbursing agent, at P.O. Box 357,
Minneapolis, Minnesota 55440.
14 [LOGO]
Mutual Funds
<PAGE>
[LOGO]
Mutual Funds
Investment Advisers, Inc.
3700 First Bank Place, P.O. Box 357, Minneapolis, Minnesota 55440-0357 USA
800.945.3863
612.376.2700
<PAGE>
IAI RETIREMENT FUNDS, INC.
STATEMENT OF ADDITIONAL INFORMATION
DATED MAY 1, 1995
THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT A PROSPECTUS. THIS
STATEMENT OF ADDITIONAL INFORMATION RELATES TO A PROSPECTUS DATED MAY 1, 1995
AND SHOULD BE READ IN CONJUNCTION THEREWITH. COPIES OF THE PROSPECTUS MAY BE
OBTAINED FROM THE INSURANCE COMPANIES WHOSE SEPARATE ACCOUNTS MAY PURCHASE
SHARES OF THE FUND.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
<S> <C>
Investment Objectives And Policies....................... 3
Repurchase Agreements............................... 3
Reverse Repurchase Agreements....................... 3
Securities of Foreign Issuers....................... 3
Lending Portfolio Securities........................ 4
Extendible Notes.................................... 4
Variable or Floating Rate Instruments............... 5
Delayed-Delivery Transactions....................... 5
Mortgage-Backed Securities.......................... 5
Stripped Mortgage-Backed Securities................. 6
Asset-Backed Securities............................. 6
Zero Coupon Bonds................................... 6
Lower-Rated Debt Securities......................... 6
Illiquid Securities................................. 7
Dollar Rolls........................................ 7
Swap Agreements..................................... 7
Indexed Securities.................................. 8
Foreign Currency Transactions....................... 8
Limitations on Futures and Options Transactions..... 9
Futures Contracts................................... 10
Futures Margin Payments............................. 10
Purchasing Put and Call Options..................... 10
Writing Put and Call Options........................ 11
Combined Positions.................................. 11
Correlation of Price Changes........................ 11
Liquidity of Options and Futures Contracts.......... 12
OTC Options......................................... 12
Options and Futures Relating to Foreign Currencies.. 12
Asset Coverage for Futures and Options Positions.... 13
Investment Restrictions.................................. 13
Portfolio Turnover.................................. 14
Investment Performance................................... 14
Management............................................... 16
Investment Advisory Agreement....................... 19
Administrative Agreement............................ 20
Allocation of Expenses.............................. 20
Duration of Agreements.............................. 20
Custodial Service........................................ 21
Portfolio Transactions And Allocation Of Brokerage....... 24
Capital Stock............................................ 25
Net Asset Value And Public Offering Price................ 27
Tax Status............................................... 27
Limitation Of Director Liability......................... 27
Financial Statements..................................... 28
Appendix A -- Ratings of Debt Securities................. A-1
</TABLE>
2
<PAGE>
INVESTMENT OBJECTIVES AND POLICIES
IAI Retirement Funds, Inc. (the "Fund") is designed to provide investment
vehicles for variable annuity and/or variable life insurance contracts of
various insurance companies.
The investment objectives and policies of IAI Reserve Portfolio ("Reserve
Portfolio"), IAI Balanced Portfolio ("Balanced Portfolio") and IAI Regional
Portfolio ("Regional Portfolio") (individually, "Portfolio" and collectively,
the "Portfolios") are summarized on the front page of the Prospectus and in the
text of the Prospectus under "Investment Objectives and Policies." Investors
should understand that all investments have a risk factor. There can be no
guarantee against loss resulting from an investment in any Portfolio, and there
can be no assurance that a Portfolio's investment policies will be successful,
or that its investment objectives will be attained. Certain of the Portfolios'
investment practices are further explained below.
REPURCHASE AGREEMENTS
Each Portfolio may invest in repurchase agreements relating to the
securities in which it may invest. A repurchase agreement involves the purchase
of securities with the condition that, after a stated period of time, the
original seller will buy back the securities at a predetermined price or yield.
Each Portfolio's custodian will have custody of, and will hold in a segregated
account, securities acquired by the Portfolio under a repurchase agreement or
other securities as collateral. In the case of a security registered on a book
entry system, the book entry will be maintained in the Portfolio's name or that
of its custodian. Repurchase agreements involve certain risks not associated
with direct investments in securities. For example, if the seller of the
agreement defaults on its obligation to repurchase the underlying securities at
a time when the value of the securities has declined, a Portfolio may incur a
loss upon disposition of such securities. In the event that bankruptcy
proceedings are commenced with respect to the seller of the agreement, a
Portfolio's ability to dispose of the collateral to recover its investment may
be restricted or delayed. While collateral will at all times be maintained in
an amount equal to the repurchase price under the agreement (including accrued
interest due thereunder), to the extent proceeds from the sale of collateral
were less than the repurchase price, a Portfolio could suffer a loss.
REVERSE REPURCHASE AGREEMENTS
In a reverse repurchase agreement, a Portfolio sells an instrument to
another party, such as a bank or broker-dealer, in return for cash and agrees to
repurchase the instrument at a particular price and time. While a reverse
repurchase agreement is outstanding, each Portfolio will comply with guidelines
established by the Securities and Exchange Commission regarding the segregation
of assets. Each Portfolio will enter into reverse repurchase agreements only
with parties whose creditworthiness has been found satisfactory by Investment
Advisers, Inc. ("IAI"), the Portfolios' investment adviser and manager. Such
transactions may increase fluctuations in the market value of the Portfolios'
assets and may be viewed as a form of leverage.
SECURITIES OF FOREIGN ISSUERS
Each Portfolio may invest in securities of foreign issuers in accordance
with its investment objectives and policies. Investing in foreign securities
may result in greater risk than that incurred by investing in domestic
securities. There is generally less publicly available information about
foreign issuers comparable to reports and ratings that are published about
companies in the United States. Also, foreign issuers are not subject to
uniform accounting and auditing and financial reporting standards, practices and
requirements comparable to those applicable to United States companies.
It is contemplated that most foreign securities will be purchased in over-
the-counter markets or on stock exchanges located in the countries in which the
respective principal offices of the issuers of the various securities are
located, if that is the best available market. Foreign stock markets are
generally not as developed or efficient as those in the United States. While
growing in volume, they usually have substantially less volume than the New York
Stock Exchange, and securities of some foreign companies are less liquid and
more volatile than securities of comparable United States companies. Similarly,
volume and liquidity in most foreign bond markets is less than in the United
States and at times volatility of price can be greater than in the United
States. Commissions on foreign stock exchanges are generally higher than
commissions on United States exchanges, although each
3
<PAGE>
Portfolio will endeavor to achieve the most favorable net results on its
portfolio transactions. There is generally less government supervision and
regulation of foreign stock exchanges, brokers and listed companies than in the
United States.
With respect to certain foreign countries, there is the possibility of
adverse changes in investment or exchange control regulations, expropriation or
confiscatory taxation, limitations on the removal of funds or other assets of
the Portfolio, political or social instability, or diplomatic developments which
could affect United States investments in those countries. Moreover, individual
foreign economies may differ favorably or unfavorably from the United States'
economy in such respects as growth of gross national product, rate of inflation,
capital reinvestment, resource self-sufficiency and balance of payments
position.
Each Portfolio is not aware at this time of the existence of any investment
or exchange control regulations which might substantially impair the operations
of the Portfolio as described in the Prospectus and this Statement of Additional
Information. It should be noted, however, that this situation could change at
any time.
The dividends and interest payable on certain of the Portfolios' foreign
securities may be subject to foreign withholding taxes, thus reducing the net
amount of income available for distribution to the Portfolios' shareholders.
The expense ratio of each Portfolio should not be materially affected by such
Portfolio's investment in foreign securities.
LENDING PORTFOLIO SECURITIES
In order to generate additional income, each Portfolio may lend portfolio
securities to broker-dealers, banks or other financial borrowers of securities.
As with other extensions of credit, there are risks of delay in recovery or even
loss of rights in the collateral should the borrower of the securities fail
financially. However, the Portfolios will only enter into loan arrangements
with broker-dealers, banks or other institutions which IAI has determined are
creditworthy under guidelines established by the Portfolios' Board of Directors.
The Portfolios may also experience a loss if, upon the failure of a borrower to
return loaned securities, the collateral is not sufficient in value or liquidity
to cover the value of such loaned securities (including accrued interest
thereon). However, the Portfolios will receive collateral in the form of cash,
United States Government securities, certificates of deposit or other high-
grade, short-term obligations or interest-bearing cash equivalents equal to at
least 102% of the value of the securities loaned. The value of the collateral
and of the securities loaned will be marked to market on a daily basis. During
the time portfolio securities are on loan, the borrower pays a Portfolio an
amount equivalent to any dividends or interest paid on the securities and a
Portfolio may invest the cash collateral and earn additional income or may
receive an agreed upon amount of interest income from the borrower. However,
the amounts received by a Portfolio may be reduced by finders' fees paid to
broker-dealers and related expenses.
EXTENDIBLE NOTES
Reserve Portfolio is permitted to invest up to 25% of the value of its
total assets in extendible notes. An extendible note is a debt arrangement
under which the holder, at its option, may require the issuer to repurchase the
note for a predetermined fixed price at one or more times prior to the ultimate
maturity date of the note. Typically, an extendible note is issued at an
interest rate that can be adjusted at fixed times throughout its term. At the
same times as the interest rate is adjusted by the issuer, the holder of the
note is typically given the option to "put" the note back to the issuer at a
predetermined price (e.g., at 100% of the outstanding principal amount plus
unpaid accrued interest) if the extended interest rate is undesirable to the
holder. This option to put the note back to the issuer (i.e., to require the
issuer to repurchase the note) provides the holder with an optional maturity
date that is shorter than the actual maturity date of the note.
If such extendible notes provide for an optional maturity date, then such
notes are deemed by such Portfolio to have been issued for the shorter optional
maturity date, for purposes of complying with the Portfolio's policy on maturity
of portfolio instruments. Investment in extendible notes is not expected to
have a material impact on the effective portfolio maturities of the Portfolio.
4
<PAGE>
An investment in an extendible note is liquid, and the note may be resold
to another investor prior to its optional maturity date at its market value.
The market value of an extendible note with a given optional maturity date is
determined and fluctuates in a similar manner as the market value of a fixed
maturity note with a maturity equivalent to the optional maturity of the
extendible note. Compared to fixed term notes of the same issuer, however,
extendible notes with equivalent optional maturities generally yield higher
returns without a material increase in risk to the Fund.
The creditworthiness of the issuers of extendible notes is monitored and
rated by Moody's and by S&P, and investments by the Reserve Portfolio in such
extendible notes are restricted to notes with the same investment ratings as are
acceptable to the Portfolio with respect to other forms of investment. The
creditworthiness of such issuers is also monitored by IAI.
VARIABLE OR FLOATING RATE INSTRUMENTS
Balanced and Reserve Portfolios may purchase instruments with variable or
floating rates. Such instruments (including notes purchased directly from
issuers) bear variable or floating interest rates and carry rights that permit
holders to demand payment of the unpaid principal balance plus accrued interest
from the issuers or certain financial intermediaries. Floating rate securities
have interest rates that change whenever there is a change in a designated base
rate while variable rate instruments provide for a specified periodic adjustment
in the interest rate. These formulas are designed to result in a market value
for the instrument that approximates its par value.
DELAYED-DELIVERY TRANSACTIONS
Reserve and Balanced Portfolios may buy and sell securities on a delayed-
delivery or when-issued basis. These transactions involve a commitment by a
Portfolio to purchase or sell specific securities at a predetermined price or
yield, with payment and delivery taking place after the customary settlement
period for that type of security (and more than seven days in the future).
Typically, no interest accrues to the purchaser until the security is delivered.
Each Portfolio may receive fees for entering into delayed-delivery transactions.
When purchasing securities on a delayed-delivery basis, a Portfolio assumes
the rights and risks of ownership, including the risk of price and yield
fluctuations. Because a Portfolio is not required to pay for securities until
the delivery date, these risks are in addition to the risks associated with such
Portfolio's other investments. If a Portfolio remains substantially fully
invested at a time when delayed delivery purchases are outstanding, delayed-
delivery purchases may result in a form of leverage. When delayed-delivery
purchases are outstanding, a Portfolio will set aside appropriate liquid assets
in a segregated custodial account to cover its purchase obligations. When a
Portfolio has sold a security on a delayed-delivery basis, such Portfolio does
not participate in further gains or losses with respect to the security. If the
other party to a delayed-delivery transaction fails to deliver or pay for the
securities, a Portfolio could miss a favorable price or yield opportunity, or
could suffer a loss.
Such Portfolios may renegotiate delayed-delivery transactions after they
are entered into, and may sell underlying securities before they are delivered,
which may result in capital gains or losses.
MORTGAGE-BACKED SECURITIES
Reserve and Balanced Portfolios may purchase mortgage-backed securities
issued by government and non-government entities such as banks, mortgage
lenders, or other financial institutions. A mortgage-backed security may be an
obligation of the issuer backed by a mortgage or pool of mortgages or a direct
interest in an underlying pool of mortgages. Some mortgage-backed securities,
such as collateralized mortgage obligations or CMOs, make payments of both
principal and interest at a variety of intervals; others make semiannual
interest payments at a predetermined rate and repay principal at maturity (like
a typical bond). Mortgage-backed securities are based on different types of
mortgages including those on commercial real estate or residential properties.
Other types of mortgage-backed securities will likely be developed in the
future, and each Portfolio may invest in them if IAI determines they are
consistent with such Portfolio's investment objectives and policies.
5
<PAGE>
The value of mortgage-backed securities may change due to shifts in the
market's perception of issuers. In addition, regulatory or tax changes may
adversely affect the mortgage securities market as a whole. Non-government
mortgage-backed securities may offer higher yields than those issued by
government entities, but also may be subject to greater price changes than
government issues. Mortgage-backed securities are subject to prepayment risk.
Prepayment, which occurs when unscheduled or early payments are made on the
underlying mortgages, may shorten the effective maturities of these securities
and may lower their total returns.
STRIPPED MORTGAGE-BACKED SECURITIES
Reserve Portfolio may purchase stripped mortgage-back securities. Such
securities are created when a U.S. government agency or a financial institution
separates the interest and principal components of a mortgage-backed security
and sells them as individual securities. The holder of the "principal-only"
security (PO) receives the principal payments made by the underlying mortgage-
backed security, while the holder of the "interest-only" security (IO) receives
interest payments from the same underlying security. The prices of stripped
mortgage-backed securities may be particularly affected by changes in interest
rates. As interest rates fall, prepayment rates tend to increase, which tends to
reduce prices of IOs and increase prices of POs. Rising interest rates can have
the opposite effect.
ASSET-BACKED SECURITIES
Reserve and Balanced Portfolios may purchase asset-backed securities, which
represent interests in pools of consumer loans (generally unrelated to mortgage
loans) and often are structured as pass-through securities. Interest and
principal payments alternately depend upon payment of the underlying loans by
individuals, although the securities may be supported by letters of credit or
other credit enhancements. The value of asset-backed securities may also depend
on the creditworthiness of the servicing agent for the loan pool, the originator
of the loans, or the financial institution providing the credit enhancement.
ZERO COUPON BONDS
Reserve and Balanced Portfolios may purchase zero coupon bonds, which do
not make interest payments; instead, they are sold at a deep discount from their
face value and are redeemed at face value when they mature. Because zero coupon
bonds do not pay current income, their prices can be very volatile when interest
rates change. In calculating its dividends, a Portfolio takes into account as
income a portion of the difference between a zero coupon bond's purchase price
and its face value.
A broker-dealer creates a derivative zero by separating the interest and
principal components of a U.S. Treasury security and selling them as two
individual securities. CATS (Certificates of Accrual on Treasury Securities),
TIGRs (Treasury Investment Growth Receipts), and TRs (Treasury Receipts) are
examples of derivative zeros.
The Federal Reserve Bank creates STRIPS (Separate Trading of Registered
Interest and Principal of Securities) by separating the interest and principal
components of an outstanding U.S. Treasury bond and selling them as individual
securities. Bonds issued by the Resolution Funding Corporation (REFCORP) and
the Financing Corporation (FICO) can also be separated in this fashion.
Original issue zeroes are zero coupon securities originally issued by the U.S.
government, a government agency, or a corporation in zero coupon form.
LOWER-RATED DEBT SECURITIES
Reserve and Balanced Portfolios may invest in lower-rated debt securities.
Issuers of high yield securities may be highly leveraged and may not have
available to them more traditional methods of financing. Therefore, the risks
associated with acquiring the securities of such issuers generally are greater
than is the case with higher rated securities. For example, during an economic
downturn or a sustained period of rising interest rates, issuers of high yield
securities may be more likely to experience financial stress, especially if such
issuers are highly leveraged. During such periods, such issuers may not have
sufficient revenues to meet their interest payment obligations. The issuer's
ability to service its debt obligations also may be adversely affected by
specific issuer developments or the issuer's inability to meet specific
projected business forecasts or the unavailability of additional financing. The
risk
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of loss due to default by the issuer is significantly greater for the holders of
high yield securities because such securities may be unsecured and may be
subordinated to other creditors of the issuer.
High yield securities frequently have call or redemption features which
would permit an issuer to repurchase the security from a Portfolio. If a call
were exercised by the issuer during a period of declining interest rates, a
Portfolio likely would have to replace such called security with a lower
yielding security, thus decreasing the net investment income to a Portfolio and
dividends to shareholders.
A Portfolio may have difficulty disposing of certain high yield securities
because there may be a thin trading market for such securities. The secondary
trading market for high yield securities is generally not as liquid as the
secondary market for higher rated securities. Reduced secondary market
liquidity may have an adverse impact on market price and a Portfolio's ability
to dispose of particular issues when necessary to meet such Portfolio's
liquidity needs or in response to a specific economic event such as a
deterioration in the creditworthiness of the issuer.
Adverse publicity and investor perceptions, which may not be based on
fundamental analysis, also may decrease the value and liquidity of high yield
securities, particularly in a thinly traded market. Factors adversely affecting
the market value of high yield securities are likely to adversely affect a
Portfolio's net asset value. In addition, a Portfolio may incur additional
expenses to the extent it is required to seek recovery upon a default on a
portfolio holding or participate in the restructuring of the obligation.
ILLIQUID SECURITIES
Each Portfolio may also invest up to 15% of its total assets in securities
that are considered illiquid because of the absence of a readily available
market or due to legal or contractual restrictions. However, certain restricted
securities that are not registered for sale to the general public but that can
be resold to institutional investors may be considered liquid pursuant to
guidelines adopted by the Board of Directors. It is not possible to predict
with assurance the maintenance of an institutional trading market for such
securities and the liquidity of a Portfolio's investments could be impaired if
trading declines.
DOLLAR ROLLS
In connection with its ability to purchase securities on a when-issued or
forward commitment basis, a Portfolio may enter into "dollar rolls" in which
such Portfolio sells securities for delivery in the current month and
simultaneously contracts with the same counterparty to repurchase similar (same
type, coupon and maturity) but not identical securities on a specified future
date. A Portfolio gives up the right to receive principal and interest paid on
the securities sold. However, a Portfolio would benefit to the extent of any
difference between the price received for the securities sold and lower forward
price for the futures purchase plus any fee income received. Unless such
benefits exceed the income and capital appreciation that would have been
realized on the securities sold as part of the dollar roll, the use of this
technique will diminish the investment performance of a Portfolio compared with
what such performance would have been without the use of dollar rolls. Each
Portfolio will hold and maintain in a segregated account until the settlement
date cash, government securities, or liquid high-grade debt securities in an
amount equal to the value of the when-issued or forward commitment securities.
The benefits derived from the use of dollar rolls may depend, among other
things, upon IAI's ability to predict interest rates correctly. There is no
assurance that dollar rolls can be successfully employed. In addition, the use
of dollar rolls by a Portfolio while remaining substantially fully invested
increases the amount of a Portfolio's assets that are subject to market risk to
an amount that is greater than such Portfolio's net asset value, which could
result in increased volatility of the price of such Portfolio's shares.
SWAP AGREEMENTS
Regional and Balanced Portfolios may engage in swap agreements. Swap
agreements can be individually negotiated and structured to include exposure to
a variety of different types of investments or market factors. Depending on
their structure, swap agreements may increase or decrease the Fund's exposure to
long- or short-term interest rates (in the U.S. or abroad), foreign currency
values, mortgage securities, corporate borrowing rates, or other factors such as
security prices or inflation rates. Swap agreements can take many
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different forms and are known by a variety of names. Each Portfolio is not
limited to any particular form of swap agreement if IAI determines it is
consistent with such Portfolio's investment objectives and policies.
Swap agreements will tend to shift a Portfolio's investment exposure from
one type of investment to another. For example, if a Portfolio agrees to
exchange payments in dollars for payments in foreign currency, the swap
agreement would tend to decrease such Portfolio's exposure to U.S. interest
rates and increase its exposure to foreign currency and interest rates.
Depending on how they are used, swap agreements may increase or decrease the
overall volatility of a Portfolio's investments and its share price.
The most significant factor in the performance of swap agreements is the
change in the specific interest rate, currency, or other factors that determine
the amounts of payments due to and from a Portfolio. If a swap agreement calls
for payments by a Portfolio, such Portfolio must be prepared to make such
payments when due. In addition, if the counterparty's creditworthiness
declined, the value of a swap agreement would be likely to decline, potentially
resulting in losses. Each Portfolio expects to be able to eliminate its
exposure under swap agreements either by assignment or other disposition, or by
entering into an offsetting swap agreement with the same party or a similarly
creditworthy party.
Each Portfolio will maintain appropriate liquid assets in a segregated
custodial account to cover its current obligations under swap agreements. If a
Portfolio enters into a swap agreement on a net basis, it will segregate assets
with a daily value at least equal to the excess, if any, of such Portfolio's
accrued obligations under the swap agreement over the accrued amount the
Portfolio is entitled to receive under the agreement. If a Portfolio enters
into a swap agreement on other than a net basis, it will segregate assets with a
value equal to the full amount of a Portfolio's accrued obligations under the
agreement.
INDEXED SECURITIES
Each Portfolio may purchase securities whose prices are indexed to the
prices of other securities, securities indexes, currencies, precious metals or
other commodities, or other financial indicators. Indexed securities typically,
but not always, are debt securities or deposits whose value at maturity or
coupon rate is determined by reference to a specific instrument or statistic.
Gold-indexed securities, for example, typically provide for a maturity value
that depends on the price of gold, resulting in a security whose price tends to
rise and fall together with gold prices. Currency-indexed securities typically
are short-term to intermediate-term debt securities whose maturity values or
interest rates are determined by reference to the values of one or more
specified foreign currencies, and may offer higher yields than U.S. dollar-
denominated securities of equivalent issuers. Currency-indexed securities may be
positively or negatively indexed; that is, their maturity value may increase
when the specified currency value increases, resulting in a security that
performs similarly to a foreign-denominated instrument, or their maturity value
may decline when foreign currencies increase, resulting in a security whose
price characteristics are similar to a put on the underlying currency.
Currency-indexed securities may also have prices that depend on the values of a
number of different foreign currencies relative to each other.
The performance of indexed securities depends to a great extent on the
performance of the security, currency, or other instrument to which they are
indexed, and may also be influenced by interest rate changes in the U.S. and
abroad. At the same time, indexed securities are subject to the credit risks
associated with the issuer of the security, and their values may decline
substantially if the issuer's creditworthiness deteriorates. Recent issuers of
indexed securities have included banks, corporations, and certain U.S.
government agencies. IAI will use its judgment in determining whether indexed
securities should be treated as short-term instruments, bonds, stocks, or as a
separate asset class for purposes of each Portfolio's investment policies,
depending on the individual characteristics of the securities. Indexed
securities may be more volatile than the underlying instruments.
FOREIGN CURRENCY TRANSACTIONS
Each Portfolio may hold foreign currency deposits from time to time and may
convert dollars and foreign currencies in the foreign exchange markets.
Currency conversion involves dealer spreads and other costs, although
commissions usually are not charged. Currencies may be exchanged on a spot
(i.e., cash) basis, or by
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entering into forward contracts to purchase or sell foreign currencies at a
future date and price. Forward contracts generally are traded in an interbank
market conducted directly between currency traders (usually large commercial
banks) and their customers. The parties to a forward contract may agree to
offset or terminate the contract before its maturity, or may hold the contract
to maturity and complete the contemplated currency exchange.
Each Portfolio may use currency forward contracts to manage currency risks
and to facilitate transactions in foreign securities. The following discussion
summarizes the principal currency management strategies involving forward
contracts that could be used by the Portfolios.
In connection with purchases and sales of securities denominated in foreign
currencies, each Portfolio may enter into currency forward contracts to fix a
definite price for the purchase or sale in advance of the trade's settlement
date. This technique is sometimes referred to as a "settlement hedge" or
"transaction hedge." IAI expects to enter into settlement hedges in the normal
course of managing each Portfolio's foreign investments. Each Portfolio could
also enter into forward contracts to purchase or sell a foreign currency in
anticipation of future purchases or sales of securities denominated in foreign
currency, even if the specific investments have not yet been selected by IAI.
Each Portfolio may also use forward contracts to hedge against a decline in
the value of existing investments denominated in foreign currency. For example,
if a Portfolio owned securities denominated in pounds sterling, it could enter
into a forward contract to sell pounds sterling in return for U.S. dollars to
hedge against possible declines in the pound's value. Such a hedge, sometimes
referred to as a "position hedge," would tend to offset both positive and
negative currency fluctuations but would not offset changes in security values
caused by other factors. Each Portfolio could also hedge the position by
selling another currency expected to perform similarly to the pound sterling --
for example, by entering into a forward contract to sell Deutschmarks or
European Currency Units in return for U.S. dollars. This type of hedge,
sometimes referred to as a "proxy hedge," could offer advantages in terms of
cost, yield, or efficiency, but generally would not hedge currency exposure as
effectively as a simple hedge into U.S. dollars. Proxy hedges may result in
losses if the currency used to hedge does not perform similarly to the currency
in which the hedged securities are denominated.
Under certain conditions, SEC guidelines require mutual funds to set aside
appropriate liquid assets in a segregated custodial account to cover currency
forward contracts. As required by SEC guidelines, the Portfolios will segregate
assets to cover currency forward contracts, if any, whose purpose is essentially
speculative. Each Portfolio will not segregate assets to cover forward
contracts entered into for hedging purposes, including settlement hedges,
position hedges, and proxy hedges.
Successful use of forward currency contracts will depend on IAI's skill in
analyzing and predicting currency values. Forward contracts may substantially
change the Portfolios' investment exposure to changes in currency exchange
rates, and could result in losses to the Portfolios if currencies do not perform
as IAI anticipates. For example, if a currency's value rose at a time when IAI
had hedged a Portfolio by selling that currency in exchange for dollars, such
Portfolio would be unable to participate in the currency's appreciation. If IAI
hedges currency exposure through proxy hedges, a Portfolio could realize
currency losses from the hedge and the security position at the same time if the
two currencies do not move in tandem. Similarly, if IAI increases a Portfolio's
exposure to a foreign currency, and that currency's value declines, such
Portfolio will realize a loss. There is no assurance that IAI's use of forward
currency contracts will be advantageous to the Portfolios or that it will hedge
at an appropriate time. The policies described in this section are non-
fundamental policies of the Portfolios.
LIMITATIONS ON FUTURES AND OPTIONS TRANSACTIONS
Each Portfolio has filed a notice of eligibility for exclusion from the
definition of the term "commodity pool operator" with the Commodity Futures
Trading Commission (CFTC) and the National Futures Association, which regulate
trading in the futures markets, before engaging in any purchases or sales of
futures contracts or options on futures contracts. Each Portfolio intends to
comply with Section 4.5 of the regulations under the Commodity Exchange Act,
which limits the extent to which the Portfolios can commit assets to initial
margin deposits and option premiums.
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In addition, each Portfolio will not: (a) sell futures contracts, purchase
put options, or write call options if, as a result, more than 25% of each
Portfolio's total assets would be hedged with futures and options under normal
conditions; (b) purchase futures contracts or write put options if, as a result,
a Portfolio's total obligations upon settlement or exercise of purchased futures
contracts and written put options would exceed 25% of its total assets; or (c)
purchase call options if, as a result, the current value of option premiums for
call options purchased by a Portfolio would exceed 5% of the Portfolio's total
assets. These limitations do not apply to options attached to or acquired or
traded together with their underlying securities, and do not apply to securities
that incorporate features similar to options.
The above limitations on the Portfolios' investments in futures contracts
and options, and the Portfolios' policies regarding futures contracts and
options discussed elsewhere in this Statement of Additional Information may be
changed as regulatory agencies permit.
FUTURES CONTRACTS
When a Portfolio purchases a futures contract, it agrees to purchase a
specified underlying instrument at a specified future date. When a Portfolio
sells a futures contract, it agrees to sell the underlying instrument at a
specified future date. The price at which the purchase and sale will take place
is fixed when a Portfolio enters into the contract. Some currently available
futures contracts are based on specific securities, such as U.S. Treasury bonds
or notes, and some are based on indexes of securities prices, such as the
Standard & Poor's 500 Composite Stock Price Index (S&P 500). Futures can be
held until their delivery dates, or can be closed out before then if a liquid
secondary market is available.
The value of a futures contract tends to increase and decrease in tandem
with the value of its underlying instrument. Therefore, purchasing futures
contracts will tend to increase a Portfolio's exposure to positive and negative
price fluctuations in the underlying instrument, much as if it had purchased the
underlying instrument directly. When a Portfolio sells a futures contract, by
contrast, the value of its futures position will tend to move in a direction
contrary to the market. Selling futures contracts, therefore, will tend to
offset both positive and negative market price changes, much as if the
underlying instrument had been sold.
FUTURES MARGIN PAYMENTS
The purchaser or seller of a futures contract is not required to deliver or
pay for the underlying instrument unless the contract is held until the delivery
date. However, both the purchaser and seller are required to deposit "initial
margin" with a futures broker, known as a futures commission merchant (FCM),
when the contract is entered into. Initial margin deposits are typically equal
to a percentage of the contract's value. If the value of either party's
position declines, that party will be required to make additional "variation
margin" payments to settle the change in value on a daily basis. The party that
has a gain may be entitled to receive all or a portion of this amount. Initial
and variation margin payments do not constitute purchasing securities on margin
for purposes of the Portfolios' investment limitations. In the event of the
bankruptcy of an FCM that holds margin on behalf of a Portfolio, such Portfolio
may be entitled to return of margin owed to it only in proportion to the amount
received by the FMC's other customers, potentially resulting in losses to such
Portfolio.
PURCHASING PUT AND CALL OPTIONS
By purchasing a put option, a Portfolio obtains the right (but not the
obligation) to sell the option's underlying instrument at a fixed strike price.
In return for this right, a Portfolio pays the current market price for the
option (known as the option premium). Options have various types of underlying
instruments, including specific securities, indexes of securities prices, and
futures contracts. A Portfolio may terminate its position in a put option it
has purchased by allowing it to expire or by exercising the option. If the
option is allowed to expire, a Portfolio will lose the entire premium it paid.
If a Portfolio exercises the option, it completes the sale of the underlying
instrument at the strike price. A Portfolio may also terminate a put option
position by closing it out in the secondary market at its current price, if a
liquid secondary market exists.
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The buyer of a typical put option can expect to realize a gain if security
prices fall substantially. However, if the underlying instrument's price does
not fall enough to offset the cost of purchasing the option, a put buyer can
expect to suffer a loss (limited to the amount of the premium paid, plus related
transaction costs).
The features of call options are essentially the same as those of put
options, except that the purchaser of a call option obtains the right to
purchase, rather than sell, the underlying instrument at the option's strike
price. A call buyer typically attempts to participate in potential price
increases of the underlying instrument with risk limited to the cost of the
option if security prices fall. At the same time, the buyer can expect to
suffer a loss if security prices do not rise sufficiently to offset the cost of
the option.
WRITING PUT AND CALL OPTIONS
When a Portfolio writes a put option, it takes the opposite side of the
transaction from the option's purchaser. In return for receipt of the premium,
a Portfolio assumes the obligation to pay the strike price for the option's
underlying instrument if the other party to the option chooses to exercise it.
When writing an option on a futures contract a Portfolio would be required to
make margin payments to an FCM as described above for futures contracts. Each
Portfolio may seek to terminate its position in a put option it writes before
exercise by closing out the option in the secondary market at its current price.
If the secondary market is not liquid for a put option a Portfolio has written,
however, such Portfolio must continue to be prepared to pay the strike price
while the option is outstanding, regardless of price changes, and must continue
to set aside assets to cover its position. If security prices rise, a put
writer would generally expect to profit, although its gain would be limited to
the amount of the premium it received.
If security prices remain the same over time, it is likely that the writer
will also profit, because it should be able to close out the option at a lower
price. If security prices fall, the put writer would expect to suffer a loss.
This loss should be less than the loss from purchasing the underlying instrument
directly, however, because the premium received for writing the option should
mitigate the effects of the decline.
Writing a call option obligates a Portfolio to sell or deliver the option's
underlying instrument, in return for the strike price, upon exercise of the
option. The characteristics of writing call options are similar to those of
writing put options, except that writing calls generally is a profitable
strategy if prices remain the same or fall. Through receipt of the option
premium, a call writer mitigates the effects of a price decline. At the same
time, because a call writer must be prepared to deliver the underlying
instrument in return for the strike price, even if its current value is greater,
a call writer gives up some ability to participate in security price increases.
COMBINED POSITIONS
Each Portfolio may purchase and write options in combination with each
other, or in combination with futures or forward contracts, to adjust the risk
and return characteristics of the overall position. For example, each Portfolio
may purchase a put option and write a call option on the same underlying
instrument, in order to construct a combined position whose risk and return
characteristics are similar to selling a futures contract. Another possible
combined position would involve writing a call option at one strike price and
buying a call option at a lower price, in order to reduce the risk of the
written call option in the event of a substantial price increase. Because
combined options positions involve multiple trades, they result in higher
transaction costs and may be more difficult to open and close out.
CORRELATION OF PRICE CHANGES
Because there are a limited number of types of exchange-traded options and
futures contracts, it is likely that the standardized contracts available will
not match a Portfolio's current or anticipated investments exactly. Each
Portfolio may invest in options and futures contracts based on securities with
different issuers, maturities, or other characteristics from the securities in
which it typically invests, which involves a risk that the options or futures
position will not track the performance of such Portfolio's other investments.
Options and futures prices can also diverge from the prices of their
underlying instruments, even if the underlying instruments match a Portfolio's
investments well. Options and futures prices are affected by such
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factors as current and anticipated short-term interest rates, changes in
volatility of the underlying instrument, and the time remaining until expiration
of the contract, which may not affect security prices the same way. Imperfect
correlation may also result from differing levels of demand in the options and
futures markets and the securities markets, from structural differences in how
options and futures and securities are traded, or from imposition of daily price
fluctuation limits or trading halts. Each Portfolio may purchase or sell options
and futures contracts with a greater or lesser value than the securities it
wishes to hedge or intends to purchase in order to attempt to compensate for
differences in volatility between the contract and the securities, although this
may not be successful in all cases. If price changes in a Portfolio's options or
futures positions are poorly correlated with its other investments, the
positions may fail to produce anticipated gains or result in losses that are not
offset by gains in other investments.
LIQUIDITY OF OPTIONS AND FUTURES CONTRACTS
There is no assurance a liquid secondary market will exist for any
particular options or futures contract at any particular time. Options may have
relatively low trading volume and liquidity if their strike prices are not close
to the underlying instrument's current price. In addition, exchanges may
establish daily price fluctuation limits for options and futures contracts, and
may halt trading if a contract's price moves upward or downward more than the
limit in a given day. On volatile trading days when the price fluctuation limit
is reached or a trading halt is imposed, it may be impossible for a Portfolio to
enter into new positions or close out existing positions. If the secondary
market for a contract is not liquid because of price fluctuation limits or
otherwise, it could prevent prompt liquidation of unfavorable positions, and
potentially could require a Portfolio to continue to hold a position until
delivery or expiration regardless of changes in its value. As a result, a
Portfolio's access to other assets held to cover its options or futures
positions could also be impaired.
OTC OPTIONS
Unlike exchange-traded options, which are standardized with respect to the
underlying instrument, expiration date, contract size, and strike price, the
terms of over-the-counter options (options not traded on exchanges) generally
are established through negotiation with the other party to the option contract.
While this type of arrangement allows a Portfolio greater flexibility to tailor
an option to its needs, OTC options generally involve greater credit risk than
exchange-traded options, which are guaranteed by the clearing organization of
the exchanges where they are traded.
OPTIONS AND FUTURES RELATING TO FOREIGN CURRENCIES
Currency futures contracts are similar to forward currency exchange
contracts, except that they are traded on exchanges (and have margin
requirements) and are standardized as to contract size and delivery date. Most
currency futures contracts call for payment or delivery in U.S. dollars. The
underlying instrument of a currency option may be a foreign currency, which
generally is purchased or delivered in exchange for U.S. dollars, or may be a
futures contract. The purchaser of a currency call obtains the right to
purchase the underlying currency, and the purchaser of a currency put obtains
the right to sell the underlying currency.
The uses and risks of currency options and futures are similar to options
and futures relating to securities or indexes, as discussed above. Each
Portfolio may purchase and sell currency futures and may purchase and write
currency options to increase or decrease its exposure to different foreign
currencies. Each Portfolio may also purchase and write currency options in
conjunction with each other or with currency futures or forward contracts.
Currency futures and options values can be expected to correlate with exchange
rates, but may not reflect other factors that affect the value of a Portfolio's
investments. A currency hedge, for example, should protect a Yen-denominated
security from a decline in the Yen, but will not protect a Portfolio against a
price decline resulting from deterioration in the issuer's creditworthiness.
Because the value of a Portfolio's foreign-denominated investments changes in
response to many factors other than exchange rates, it may not be possible to
match the amount of currency options and futures to the value of a Portfolio's
investments exactly over time.
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ASSET COVERAGE FOR FUTURES AND OPTIONS POSITIONS
Each Portfolio will comply with guidelines established by the Securities
and Exchange Commission with respect to coverage of options and futures
strategies by mutual funds, and if the guidelines so require will set aside
appropriate liquid assets in a segregated custodial account in the amount
prescribed. Securities held in a segregated account cannot be sold while the
futures or option strategy is outstanding, unless they are replaced with other
suitable assets. As a result, there is a possibility that segregation of a
large percentage of a Portfolio's assets could impede portfolio management or
the Portfolio's ability to meet redemption requests or other current
obligations.
INVESTMENT RESTRICTIONS
As indicated in the Prospectus, each Portfolio is subject to certain
policies and restrictions which are "fundamental" and may not be changed without
shareholder approval. Shareholder approval consists of the approval of the
lesser of (i) more than 50% of the outstanding voting securities of a Portfolio,
or (ii) 67% or more of the voting securities present at a meeting if the holders
of more than 50% of the outstanding voting securities of a Portfolio are present
or represented by proxy. Limitations 1 through 8 below are deemed fundamental
limitations for each Portfolio. The remaining limitations set forth below serve
as operating policies of each Portfolio and may be changed by the Board of
Directors without shareholder approval.
Each Portfolio may not:
1. Purchase the securities of any issuer if such purchase would cause the
Portfolio to fail to meet the requirements of a "diversified company" as defined
under the Investment Company Act of 1940, as amended (the "1940 Act").
2. Purchase the securities of any issuer (other than "Government
securities" as defined under the 1940 Act) if, as a result, more than 25% of the
value of the Portfolio's total assets would be invested in the securities of
companies whose principal business activities are in the same industry.
3. Issue any senior securities, except as permitted by the 1940 Act or
the Rules and Regulations of the Securities and Exchange Commission.
4. Borrow money, except from banks for temporary or emergency purposes
provided that such borrowings may not exceed 33-1/3% of the value of a
Portfolio's net assets (including the amount borrowed). Any borrowings that
come to exceed this amount will be reduced within three days (not including
Sundays and holidays) to the extent necessary to comply with the 33-1/3%
limitation. This limitation shall not prohibit the Fund from engaging in
reverse repurchase agreements, making deposits of assets to margin or guarantee
positions in futures, options, swaps or forward contracts, or segregating assets
in connection with such agreements or contracts.
5. Act as an underwriter of securities of other issuers, except to the
extent that in connection with the disposition of portfolio securities the
Portfolio may be deemed to be an underwriter under applicable laws.
6. Purchase or sell real estate unless acquired as a result of ownership
of securities or other instruments. This restriction shall not prevent the
Portfolio from investing in securities or other instruments backed by real
estate or securities of companies engaged in the real estate business.
7. Purchase or sell commodities other than foreign currencies unless
acquired as a result of ownership of securities. This limitation shall not
prevent the Portfolio from purchasing or selling options, futures, swaps and
forward contracts or from investing in securities or other instruments backed by
commodities.
8. Make loans to other persons except to the extent not inconsistent with
the 1940 Act or the Rules and Regulations of the Securities and Exchange
Commission. This limitation does not apply to purchases of commercial paper,
debt securities or repurchase agreements, or to the lending of portfolio
securities.
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9. Purchase securities on margin, except that the Portfolio may obtain
such short-term credits as may be necessary for the clearance of purchases or
sales of securities and provided that margin payments in connection with
transactions in options, futures, swaps and forward contracts shall not be
deemed to constitute purchasing securities on margin.
10. Sell securities short, 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, swaps and forward futures contracts are
not deemed to constitute selling securities short.
11. Except as part of a merger, consolidation, acquisition, or
reorganization, invest more than 5% of the value of its total assets in the
securities of any one investment company or more than 10% of the value of its
total assets, in the aggregate, in the securities of two or more investment
companies, or acquire more than 3% of the total outstanding voting securities of
any one investment company.
12. Mortgage, pledge or hypothecate its assets except to the extent
necessary to secure permitted borrowings. This limitation does not apply to
reverse repurchase agreements or in the case of assets deposited to margin or
guarantee positions in futures, options, swaps or forward contracts or placed in
a segregated account in connection with such contracts.
13. Participate on a joint or a joint and several basis in any
securities trading account.
14. Invest more than 15% of its net assets in illiquid investments.
15. Invest directly in interests (including partnership interests) in
oil, gas or other mineral exploration or development leases or programs, except
a Portfolio may purchase or sell securities issued by corporations engaging in
oil, gas or other mineral exploration or development business.
Any of the investment policies set forth under "Investment Objectives and
Policies" in the Prospectus, or any restriction set forth above under
"Investment Restrictions" which involves a maximum percentage of securities or
assets shall not be considered to be violated unless an excess over the
percentage occurs immediately after an acquisition of securities or utilization
of assets and results there from.
PORTFOLIO TURNOVER
The portfolio turnover rate is calculated by dividing the lesser of
purchases or sales of portfolio securities for the particular fiscal year by the
monthly average of the value of portfolio securities owned by each Portfolio
during the same fiscal year. "Portfolio securities" for purposes of this
calculation do not include securities with a maturity date of less than twelve
(12) months from the date of investment. A 100% portfolio turnover rate would
occur, for example, if the lesser of the value of purchases or sales of
portfolio securities for a particular year were equal to the average monthly
value of the portfolio securities owned during such year.
INVESTMENT PERFORMANCE
Advertisements and other sales literature may refer to monthly, quarterly,
yearly, cumulative and average annual total return. Each such calculation
assumes all dividends and capital gain distributions are reinvested at net asset
value on the appropriate reinvestment dates as described in the Prospectus, and
includes all recurring fees, such as investment advisory and management fees,
charged as expenses to all shareholder accounts. Each of monthly, quarterly and
yearly total return is computed in the same manner as cumulative total return,
as set forth below.
Cumulative total return is computed by finding the cumulative rate of
return over the period indicated in the advertisement that would equate the
initial amount invested to the ending redeemable value, according to the
following formula:
14
<PAGE>
ERV-P
CTR = (-----) 100
P
Where: CTR = Cumulative total return;
ERV = ending redeemable value at the end of the period of a
hypothetical $1,000 payment made at the beginning of
such period; and
P = initial payment of $1,000
Average annual total return is computed by finding the average annual
compounded rates of return over the periods indicated in the advertisement that
would equate the initial amount invested to the ending redeemable value,
according to the following formula:
P(1+T)/n/ = ERV
Where: P = a hypothetical initial payment of $1,000;
T = average annual total return;
n = number of years; and
ERV = ending redeemable value at the end of the period of
a hypothetical $1,000 payment made at the beginning
of such period.
Reserve and Balanced Portfolios may quote yield figures from time to time.
The "yield" is computed by dividing the net investment income per share earned
during a 30-day period (using the average number of shares entitled to receive
dividends) by the net asset value per share on the last day of the period. The
yield formula provides for monthly compounding which assumes that net investment
income is earned and reinvested at a constant rate and annualized at the end of
a six-month period.
The yield formula is as follows:
YIELD = 2[(a-b) + 1)/6/ -1]
---
cd
Where: a = dividends and interest earned during the period.
b = expenses accrued for the period (net of reimbursements).
c = the average daily number of shares outstanding during the
period that were entitled to receive dividends.
d = the net asset value of the Portfolio at the end of the
period.
15
<PAGE>
The table below shows the yearly total return for the Portfolios for the
period indicated:
<TABLE>
<CAPTION>
Regional Portfolio Balanced Portfolio Reserve Portfolio
Period Ended 12/31 Total Return Total Return Total Return
- ------------------- ------------------ ------------------ -----------------
<S> <C> <C> <C>
1994 6.20% * 2.20% ** 2.25% ***
</TABLE>
* For the period commencing January 31, 1994.
** For the period commencing February 3, 1994.
*** For the period commencing April 7, 1994.
Balanced Portfolio's yield for the thirty-day period ended December 31,
1994 was 2.73%. Reserve Portfolio's yield for the thirty-day period ended
December 31, 1994 was 4.55%.
In advertising and sales literature, a Portfolio's performance may be
compared with that of other mutual funds, indexes or averages of other mutual
funds, indexes of related financial assets or data, and other competing
investment and deposit products available from or through other financial
institutions. The composition of these indexes, averages or products differs
from that of a Portfolio. The comparison of a Portfolio to an alternative
investment should be made with consideration of differences in features and
expected performance.
Yields and total returns quoted for a Portfolio include the effect of
deducting the Portfolio's expenses, but may not include charges and expenses
attributable to any particular insurance product. Since shares of the Fund may
only be purchased through a variable annuity or variable life contract, you
should carefully review the prospectus of the insurance product you have chosen
for information on relevant charges and expenses. Excluding these charges from
quotations of a Portfolio's performance has the effect of increasing the
performance quoted. You should bear in mind the effect of these charges when
comparing a Portfolio's performance to that of other mutual funds.
MANAGEMENT
The names, addresses and positions of the directors and executive officers
of the Portfolios are given below.
<TABLE>
<CAPTION>
Aggregate Compensation Aggregate Compensation
Name and Address Position from Each Portfolio* from IAI Mutual Funds**
- ------------------------------ --------------------------- ---------------------- -----------------------
<S> <C> <C> <C>
Noel P. Rahn*** Chairman of the N/A N/A
3700 First Bank Place Board
P.O. Box 357
Minneapolis, Minnesota 55440
Richard E. Struthers*** President, Director N/A N/A
3700 First Bank Place
P.O. Box 357
Minneapolis, Minnesota 55440
Madeline Betsch Director $850 $26,350
19 South First Street
Minneapolis, Minnesota 55401
W. William Hodgson Director $850 $26,350
1698 Dodd Road
Mendota Heights, Minnesota 55118
</TABLE>
16
<PAGE>
<TABLE>
<CAPTION>
Aggregate Compensation Aggregate Compensation
Name and Address Position from Each Fund* from IAI Mutual Funds**
- ---------------- -------- ---------------------- -----------------------
<S> <C> <C> <C>
George R. Long Director $650 $24,950
29 Las Brisas Way
Naples, Florida 33963
J. Peter Thompson Director $850 $26,350
Route 1
Mountain Lake, Minnesota 56159
Charles H. Withers Director $650 $24,950
Rochester Post-Bulletin
P.O. Box 6118
Rochester, Minnesota 55903
Archie C. Black III Treasurer N/A N/A
3700 First Bank Place
P.O. Box 357
Minneapolis, Minnesota 55440
William C. Joas Secretary N/A N/A
3700 First Bank Place
P.O. Box 357
Minneapolis, Minnesota 55440
Julian P. Carlin Vice President, Investments N/A N/A
3700 First Bank Place Regional Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
Mark Hoonsbeen Vice President, Investments N/A N/A
3700 First Bank Place Regional Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
John Twele Vice President, Investments N/A N/A
3700 First Bank Place Balanced Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
David McDonald Vice President, Investments N/A N/A
3700 First Bank Place Balanced Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
Mark Simenstad Vice President, Investments N/A N/A
3700 First Bank Place Balanced Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
Timothy A. Palmer Vice President, Investments N/A N/A
3700 First Bank Place Reserve Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
Aggregate Compensation Aggregate Compensation
Name and Address Position from Each Fund* from IAI Mutual Funds**
- ---------------- -------- ---------------------- -----------------------
<S> <C> <C> <C>
Livingston Douglas Vice President, Investments N/A N/A
3700 First Bank Place Reserve Portfolio
P.O. Box 357
Minneapolis, Minnesota 55440
Kirk Gove Vice President, Marketing N/A N/A
3700 First Bank Place
P.O. Box 357
Minneapolis, Minnesota 55440
Susan Schelpf Vice President, N/A N/A
3700 First Bank Place Director of Operations
P.O. Box 357
Minneapolis, Minnesota 55440
Susan J. Haedt Vice President, N/A N/A
3700 First Bank Place Controller
P.O. Box 357
Minneapolis, Minnesota 55440
</TABLE>
- ----------------
* For the fiscal year ended December 31, 1994.
** For the calendar year ended December 31, 1994.
*** Directors of each Fund who are interested persons (as that term is defined
by the Investment Company Act of 1940) of IAI and each Fund.
Noel P. Rahn has been Chief Executive Officer and a Director of IAI since
1974.
Richard E. Struthers is Executive Vice President and a Director of IAI and
has served IAI in many capacities since 1979.
Madeline Betsch has been Executive Vice President, Director of Client
Services, of CME-KHBB Advertising since May 1985, and prior thereto was a Vice
President with Campbell-Mithun, Inc. since February 1977.
W. William Hodgson served as information manager for the North Central Home
Office of the Prudential Insurance Company of America from 1961 until 1984; he
is currently retired.
George R. Long has been Chairman of Mayfield Corp. (financial consultants
and venture capitalists) since 1973.
J. Peter Thompson has been a grain farmer in southwestern Minnesota since
1974. Prior to that, Mr. Thompson was employed by Paine Webber, Jackson &
Curtis, Incorporated, most recently as Senior Vice President and General
Partner.
Charles H. Withers was Editor of the Rochester Post-Bulletin, Rochester,
Minnesota from 1960 through March 31, 1980; he is currently retired.
Archie C. Black, III, is a Senior Vice President and Chief Financial
Officer of IAI and has served IAI in several capacities since 1987.
William C. Joas is an Associate Vice President of IAI. Prior to joining IAI
in 1990, Mr. Joas served in the legal administration department of Tricord
Systems, Inc.
Julian P. Carlin is a Senior Vice President of IAI and has been with IAI
since 1974.
18
<PAGE>
Mark Hoonsbeen is a Vice President of IAI. Prior to joining IAI in 1994,
Mr. Hoonsbeen served as a portfolio manager for the St. Paul Companies from 1986
to 1994.
John Twele is a Vice President of IAI. Prior to joining IAI in 1994, Mr.
Twele served as a Senior Equity Analyst with IDS Financial Services from 1987 to
1994.
David McDonald is a Vice President of IAI. Prior to joining IAI in 1994,
Mr. McDonald served as a Managing Director of Wessels, Arnold & Henderson from
1989 to 1994 and an associate Portfolio Manager with IDS Financial Services from
1986 to 1989.
Mark Simenstad is a Vice President of IAI. Prior to joining IAI in 1993,
Mr. Simenstad managed bond portfolios for Lutheran Brotherhood from 1983 to
1993.
Timothy A. Palmer is a Senior Vice President of IAI. Prior to joining IAI
in 1990, Mr. Palmer was employed at First Bank System Capital Markets Group
since 1987 and was most recently Assistant Vice President, Short Term Finance.
Livingston Douglas is a Vice President of IAI. Prior to joining IAI in
1993, Mr. Douglas served as a portfolio manager for Mackey-Shields Financial
Corp. from 1987 to 1993.
Kirk Gove is a Vice President of IAI. Prior to joining IAI in 1991, Mr.
Gove served as an Assistant Vice President of Dain Bosworth Incorporated.
Susan Schelpf is a Vice President of IAI and Director of Mutual Fund
Operations. Prior to joining IAI in 1993, Ms. Schelpf served as a Vice
President at SEI Corporation.
Susan J. Haedt is a Vice President of IAI and Funds Controller. Prior to
joining IAI in 1992, Ms. Haedt served as a Senior Manager at KPMG Peat Marwick
LLP.
No compensation is paid by the Fund to any of its officers. Directors who
are not affiliated with IAI receive $750 annually and $625 for each Board
meeting attended. For the fiscal year ending December 31, 1995, the directors
have agreed to waive all such fees. Such unaffiliated directors also are
reimbursed for expenses incurred in connection with attending meetings.
INVESTMENT ADVISORY AGREEMENT
Pursuant to an Investment Advisory Agreement between the Fund and IAI
(the "Advisory Agreement"), IAI has agreed to provide each Portfolio with
investment advice, statistical and research facilities, and certain equipment
and services, including, but not limited to, office space and necessary office
facilities, equipment, and the services of required personnel. In return, each
Portfolio pays IAI a monthly fee. Under the Advisory Agreement, IAI has the
sole authority and responsibility to make and execute investment decisions for
the Portfolios within the framework of each Portfolio's investment policies,
subject to review by the directors of the Fund.
Regional Portfolio has agreed to pay an advisory fee equal to an annual
rate of .65% of its average daily net assets. Balanced Portfolio has agreed to
pay an advisory fee equal to an annual rate of .65% of its average daily net
assets. Reserve Portfolio has agreed to pay an advisory fee equal to an annual
rate of .45% of its average daily net assets. As of December 31, 1994, Regional,
Balanced and Reserve Portfolios had net assets of $865,182, $205,668, and
$543,846, respectively. Pursuant to the Advisory Agreement, the Portfolios have
paid IAI advisory fees as follows:
19
<PAGE>
<TABLE>
<CAPTION>
Regional Portfolio Balanced Portfolio Reserve Portfolio
------------------ ------------------ -----------------
<S> <C> <C> <C>
Fiscal Period Ended
December 31, 1994 $1,734* $522** $821***
</TABLE>
* For period commencing January 31, 1994.
** For period commencing February 3, 1994.
*** For period commencing April 7, 1994.
Although investment decisions for each Portfolio are made independently
from those of the other Portfolios, funds and accounts as to which IAI gives
investment advice, it may occasionally develop that the same security is
suitable for more than one Portfolio, fund and/or other account. If and when
more than one Portfolio, fund or other account simultaneously purchase or sell
the same security, the transactions will be averaged as to price and allocated
as to amount in accordance with arrangements equitable to such Portfolios, funds
and accounts. The simultaneous purchase or sale of the same securities by more
than one Portfolio or by any Portfolio and other accounts may have detrimental
effects on each Portfolio, as they may affect the price paid or received by a
Portfolio or the size of the position obtainable by a Portfolio.
ADMINISTRATIVE AGREEMENT
The Fund has engaged IAI to serve as the Portfolios' administrative,
dividend disbursing, redemption, accounting services and transfer agent pursuant
to an Administrative Agreement. Under the Administrative Agreement, IAI has
agreed to provide to the Fund all required administrative, stock transfer,
redemption, dividend disbursing and accounting services including, without
limitation, the following: (1) the maintenance of the Portfolios' accounts,
books and records; (2) the calculations of the daily net asset value in
accordance with the Fund's current Prospectus and Statement of Additional
Information; (3) daily and periodic reports; (4) all information necessary to
complete tax returns, questionnaires and other reports requested by the Fund;
(5) the maintenance of stock registry records; (6) the processing of requested
account registration changes, stock certificate issuances and redemption
requests; and (7) the administration of payments of dividends and distributions
declared by each Portfolio. As compensation for these services, each Portfolio
has agreed to pay IAI a fee equal to an annual rate of .10% of such Portfolio's
average daily net assets. Pursuant to the Administration Agreement, for the
fiscal year ended December 31, 1994, Regional, Balanced and Reserve Portfolios
paid IAI administrative fees of $266, $85, and $183, respectively.
ALLOCATION OF EXPENSES
In addition to the advisory and administrative fees paid to IAI, each
Portfolio pays all its other costs and expenses, including, for example, costs
incurred in the purchase and sale of assets, interest, taxes, charges of the
custodian of the Portfolio's assets, costs of reports and proxy material sent to
Portfolio shareholders, fees paid for independent accounting and legal services,
costs of printing Prospectuses for Portfolio shareholders and registering the
Portfolios' shares, postage, fees to directors who are not "interested persons"
of each Portfolio, insurance premiums, costs of attending investment conferences
and such other costs which may be designated as extraordinary. Certain state
securities commissions may impose limitations on certain of each Portfolio's
expenses, and IAI may be required by such state commissions to reimburse each
Portfolio for expenses in excess of any limitations as a requirement to selling
shares of such Portfolio in those states. IAI, in its discretion, may from time
to time waive or reduce its management and/or administrative fee or otherwise
reimburse Fund operating expenses. IAI is not liable for any loss suffered by a
Portfolio in the absence of willful misfeasance, bad faith or gross negligence
in the performance of its duties and obligations. For the fiscal year ended
December 31, 1994, IAI voluntarily reimbursed total Portfolio operating expenses
which exceeded 1.13%, 1.25%, and .85% of the average daily net assets of
Regional, Balanced and Reserve Portfolios, respectively.
DURATION OF AGREEMENTS
The Advisory Agreement and the Administrative Agreement will terminate
automatically in the event of their assignment. In addition, each Agreement is
terminable at any time with respect to a Portfolio without penalty by the Board
of Directors of the Fund or by vote of a majority of the Portfolio's outstanding
voting
20
<PAGE>
securities on not more than 60 days' written notice to IAI, and by IAI on 60
days' notice to the Fund. Each Agreement shall continue in effect from year to
year only so long as such continuance is specifically approved at least annually
by either the Board of Directors of the Fund or by vote of a majority of the
outstanding voting securities of the affected Portfolio, provided that in either
event such continuance is also approved by the vote of a majority of directors
who are not parties to the Agreement or interested persons of such parties cast
in person at a meeting called for the purpose of voting on such approval.
CUSTODIAL SERVICE
The custodian for the Fund is Norwest Bank Minnesota, N.A. Norwest Center,
Sixth and Marquette, Minneapolis, MN 55479. Norwest has entered into an
agreement with Morgan Stanley Trust Company, 1 Pierrepont Plaza, Brooklyn, New
York ("Morgan Stanley") which enables the Fund to utilize the subcustodian and
depository network of Morgan Stanley. Such agreements, subcustodians and
depositories were approved by the Fund's Board of Directors in accordance with
the rules and regulations of the Securities and Exchange Commission, for the
purpose of providing custodial services for the Fund's assets held outside the
United States.
The following is a listing of the subcustodians and depositories currently
approved by the Fund's directors and the countries in which such subcustodians
and depositories are located:
BRANCHES OF THE CUSTODIAN
AND SUBCUSTODIAN BANKS
----------------------
Argentina Citibank, N.A., Buenos Aires Branch
Australia Australia & New Zealand Banking Group, Ltd.
Belgium Banque Bruxelles Lambert (BBL)
Botswana Barclays Bank of Botswana
Brazil Banco de Boston
Canada Toronto Dominion Bank
Chile Citibank, N.A., Santiago Branch
China Hong Kong & Shanghai Banking, Corp. Ltd.
Columbia Cititrust
Czech Republic ING Bank
France Banque Indosuez
Germany Berliner Handels-und-Frankfurter Bank
Ghana Barclays Bank of Ghana
Greece Citibank, N.A., Athens Branch
Hong Kong Hong Kong & Shanghai Banking Corp. Ltd.
Hungary Citibank, N.A., Budapest Branch
India Standard Chartered Bank
21
<PAGE>
BRANCHES OF THE CUSTODIAN
AND SUBCUSTODIAN BANKS (continued)
----------------------------------
Indonesia Hong Kong & Shanghai Banking Corp. Ltd.
Ireland Allied Irish Bank
Israel Bank Leumi
Italy Barclays Bank PLC
Japan The Mitsubishi Bank Limited
Jordan Arab Bank plc
Korea Standard Chartered Bank
Luxembourg Banque Bruxelles Lambert
Malaysia Oversea Chinese Banking Corporation
Mexico Citibank, N.A., Mexico City Branch
Morocco Banque Commerciale du Maroc
Netherlands ABN Amro Bank
New Zealand Bank of New Zealand
Pakistan Standard Chartered Bank
Papua New Guinea Australia and New Zealand Bank
Peru Citibank N.A., Lima Branch
Philippines Hong Kong & Shanghai Banking Corp. Ltd.
Poland Citibank, S.A.
Portugal Banco Commercial Portugues
Singapore Oversea Chinese Banking Corporation
South Africa First National Bank of Southern Africa
Spain Banco Santader
Sri Lanka Hong Kong & Shanghai Banking, Corp. Ltd.
Switzerland Morgan Guaranty Trust Company of New
York, Zurich Branch
22
<PAGE>
BRANCHES OF THE CUSTODIAN
AND SUBCUSTODIAN BANKS (continued)
----------------------
Taiwan Hong Kong & Shanghai Banking Corp. Ltd.
Thailand Standard Chartered Bank
Turkey Citibank, N.A., Istanbul Branch
United Kingdom Barclays Bank PLC
Uruguay Citibank, N.A., Montevideo Branch
Venezuela Citibank, N.A., Caracas Branch
Zimbabwe Barclays Bank of Zimbabwe
DEPOSITORIES
------------
Argentina Caja de Valores
Australia Clearing House Electronic Subregister System
Austria Euroclear Clearance System
OsterreicheKontrollbank
Belgium C.I.K. (Caisse Interprofessionelle de Depot et de
Virements de Titres S.A.)
Brazil Sao Paulo Stock Exchange
Canada CDS (The Canadian Depository
for Securities Ltd.)
Czech Republic Center for Securities (SCP)
Denmark Euroclear Clearance System
Vaerdipapircentralen
Finland Euroclear Clearance System
France SICOVAM (Societe Interprofessionelle la
Compensacion des Valuers Mobilieres)
Germany Kassenverein (Deutscher Kassenverein AG)
Hong Kong Central Clearing and Settlement System
Hungary Euroclear Clearance System
OsterreicheKontrollbank
Italy Monte Titoli, S.p.A
23
<PAGE>
DEPOSITORIES (continued)
------------
Japan Japan Securities Depository Center
Korea The Korean Central Depository
Malaysia The Malaysian Central Depository
Mexico Instituto para el Deposito de Valores
Netherlands NECIGEF (Netherlands Centraal Instit
voor Giraal Effectenverkeer B.V.
Norway Euroclear Clearance System
Verdipapirsentralen
Singapore Central Depository Pte Ltd.
Spain Servicio de Compensacion y Liquidacion de
Valores
Sweden Euroclear Clearance System
Vardepapperscentralen VPC AB
Switzerland SEGA (Schweizerische Effekten Giro A.G.)
Taiwan Taiwan Securities Depository Co.
Thailand Share Depository Center
United Kingdom Stock Exchange Talisman System
The Custodian maintains records of all cash transactions of the Fund. All
other books and records of the Fund, including books and records of the Fund's
investment portfolios, are maintained by IAI.
PORTFOLIO TRANSACTIONS AND ALLOCATION OF BROKERAGE
Fixed income and non-listed equity transactions of the Portfolios are
generally effected with dealers without the payment of brokerage commissions but
at a net price which usually includes a spread or markup. In effecting such
portfolio transactions on behalf of the Portfolios, IAI seeks the most favorable
net price consistent with the best execution. However, frequently IAI selects a
dealer to effect a particular transaction without contacting all dealers who
might be able to effect such transaction because of the volatility of the market
and the desire of IAI to accept a particular price for a security because the
price offered by the dealer meets its guidelines for profit, yield or both.
So long as IAI believes that it is obtaining the best net price (including
the spread or markup) consistent with the best execution, as described above, it
gives consideration in placing portfolio transactions to dealers furnishing
research, statistical information, or other services to IAI. This allows IAI to
supplement its own investment research activities and enables IAI to obtain the
views and information of individuals and research staffs of many different
securities firms prior to making investment decisions for the Portfolios. To
the extent portfolio transactions are effected with dealers who furnish research
services to it, IAI receives a benefit which is not capable of evaluation in
dollar amounts.
Generally, Regional Portfolio and Balanced Portfolio must deal with
brokers. IAI selects and (where applicable) negotiates commissions with the
brokers who execute the transactions for each Portfolio. The primary criteria
for the selection of a broker is the ability of the broker, in the opinion of
IAI, to secure prompt execution
24
<PAGE>
of the transactions on favorable terms, including the reasonableness of the
commission and considering the state of the market at the time. In selecting a
broker, IAI may consider whether such broker provides brokerage and research
services (as defined in the Securities Exchange Act of 1934). IAI may direct
Portfolio transactions to brokers who furnish research services to IAI. Such
research services include advice, both directly and in writing, as to the value
of securities, the advisability of investing in, purchasing or selling
securities, and the availability of securities or purchasers or sellers of
securities, as well as analyses and reports concerning issues, industries,
securities, economic factors and trends, portfolio strategy, and the performance
of accounts. By allocating brokerage business in order to obtain research
services for IAI, each Portfolio enables IAI to supplement its own investment
research activities and allows IAI to obtain the views and information of
individuals and research staffs of many different securities research firms
prior to making investment decisions for each Portfolio. To the extent such
commissions are directed to brokers who furnish research services to IAI, IAI
receives a benefit, not capable of evaluation in dollar amounts, without
providing any direct monetary benefit to each Portfolio from these commissions.
Generally, the Portfolios pay higher than the lowest commission rates available.
Consistent with the Rules of Fair Practice of the National Association of
Securities Dealers, Inc. and subject to the policies set forth in the preceding
paragraphs and such other policies as the Board of Directors of each Portfolio
may determine, IAI may consider sales of shares of each Portfolio as a factor in
the selection of broker-dealers to execute the Fund's securities transactions.
IAI believes that most research services obtained by it generally benefit
one or more of the investment companies or other accounts which it manages.
Research services obtained from transactions in fixed income securities would
primarily benefit the managed funds investing such fixed income securities and
managed accounts investing in fixed income securities.
CAPITAL STOCK
Each Portfolio is a separate portfolio of IAI Retirement Funds, Inc., a
corporation organized on September 28, 1993, pursuant to the laws of the State
of Minnesota whose shares of common stock are currently issued in three series
(Series A, B and C). Each share of a series is entitled to participate pro rata
in any dividends and other distributions of such series and all shares of a
series have equal rights in the event of liquidation of that series. The Board
of Directors of IAI Retirement Funds, Inc., is empowered under the Articles of
Incorporation of such company to issue other series of the company's common
stock without shareholder approval. IAI Retirement Funds, Inc., has authorized
10,000,000,000 shares of $.01 par value common stock to be issued as Series A
common shares, 10,000,000,000 shares of $.01 par value common stock to be issued
as Series B common shares, and 10,000,000,000 shares of $.01 par value common
stock to be issued as Series C common shares. The investment portfolio
represented by Series A common shares is referred to as IAI Regional Portfolio,
by Series B common shares as IAI Balanced Portfolio, and by Series C common
shares as IAI Reserve Portfolio. As of December 31, 1994, IAI Regional
Portfolio had 81,440 shares outstanding, IAI Balanced Portfolio had 20,125
shares outstanding, and IAI Reserve Portfolio had 54,195 shares outstanding.
As of March 31, 1995, no person held of record, or to the knowledge of the
Fund, beneficially owned more than 5% of a Portfolio, except as set forth in the
following tables:
25
<PAGE>
<TABLE>
<CAPTION>
REGIONAL PORTFOLIO
- --------------------------------------------------------------
Name and Address Percent of
of Shareholder Number of Shares Class
- --------------------------------------------------------------
<S> <C> <C>
Lincoln Benefit Life Company 112,068.876 85.95
Annuity Products
P.O. Box 82532
Lincoln, Nebraska 68501
Lincoln Benefit Life Company 18,322.237 14.05
Life Products
P.O. Box 82532
Lincoln, Nebraska 68501
<CAPTION>
BALANCED PORTFOLIO
- --------------------------------------------------------------
Name and Address Percent of
of Shareholder Number of Shares Class
- --------------------------------------------------------------
<S> <C> <C>
Lincoln Benefit Life Company 18,767.906 85.97
Annuity Products
P.O. Box 82532
Lincoln, Nebraska 68501
Lincoln Benefit Life Company 3,062.652 14.03
Life Products
P.O. Box 82532
Lincoln, Nebraska 68501
<CAPTION>
RESERVE PORTFOLIO
- --------------------------------------------------------------
Name and Address Percent of
of Shareholder Number of Shares Class
- --------------------------------------------------------------
<S> <C> <C>
Lincoln Benefit Life Company 65,737.048 96.82
Annuity Products
P.O. Box 82532
Lincoln, Nebraska 68501
Lincoln Benefit Life Company 2,160.033 3.18
Life Products
P.O. Box 82532
Lincoln, Nebraska 68501
</TABLE>
In addition, as of March 31, 1995, none of Regional, Balanced and Reserve
Portfolios' officers and directors owned any of the outstanding shares of the
Portfolios.
Due to its ownership of more than 25% of the outstanding shares of each of
the Portfolios through its Life and Annuity Products, Lincoln Benefit Life
Company may be said to control each of such Portfolios. Lincoln Benefit Life
Company is an insurance company organized under the laws of Nebraska. Lincoln
Benefit Life Company is a wholly-owned subsidiary of Allstate Insurance Company,
which in turn is wholly-owned by The Allstate Corporation. Sears Roebuck & Co.
indirectly owns 80.1% of The Allstate Corporation.
26
<PAGE>
NET ASSET VALUE AND PUBLIC OFFERING PRICE
The portfolio securities in which the Fund invests fluctuate in value, and
hence, for each Portfolio, the net asset value per share also fluctuates.
The net asset value per share of each Portfolio is determined once daily as
of the close of trading on the New York Stock Exchange on each business day on
which the New York Stock Exchange is open for trading, and may be determined on
additional days as required by the Rules of the Securities and Exchange
Commission. The New York Stock Exchange is closed, and the net asset values per
share of each are not determined, on the following national holidays: New
Year's Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor
Day, Thanksgiving Day, and Christmas Day.
On December 31, 1994, the net asset value and public offering price per
share of each Portfolio was calculated as follows:
<TABLE>
<S> <C> <C>
REGIONAL PORTFOLIO
NAV = Net Assets ($865,182) = $10.62
---------------------------
Shares Outstanding (81,440)
BALANCED PORTFOLIO
NAV = Net Assets ($205,668) = $10.22
---------------------------
Shares Outstanding (20,125)
RESERVE PORTFOLIO
NAV = Net Assets ($543,846) = $10.03
---------------------------
Shares Outstanding (54,195)
</TABLE>
TAX STATUS
The Board of Directors intends that each of the Portfolios will comply with
the diversification requirements imposed by section 817(h) of the Internal
Revenue Code as a condition to favorable tax treatment of variable annuity and
variable life insurance contracts. Under Internal Revenue Service Regulations,
such requirements are satisfied if, at the end of each calendar quarter: (1)
not more than 55% of the Portfolio's assets are attributable to any one
investment; not more than 70% of such assets are attributable to any two
investments; not more than 80% of such assets are attributable to any three
investments; and not more than 90% of such assets are attributable to any four
investments. If a Portfolio fails to be adequately diversified within the
meaning of section 817(h) of the Internal Revenue Code, the variable contracts
funded by the Portfolio could lose their favorable tax status. See the
accompanying prospectus for your separate account for more information.
LIMITATION OF DIRECTOR LIABILITY
Under Minnesota law, the Fund's Board of Directors owes certain fiduciary
duties to the Fund and to its shareholders. Minnesota law provides that a
director "shall discharge the duties of the position of director in good faith,
in a manner the director reasonably believes to be in the best interest of the
corporation, and with the care an ordinarily prudent person in a like position
would exercise under similar circumstances." Fiduciary duties of a director of
a Minnesota corporation include, therefore, both a duty of "loyalty" (to act in
good faith and act in a manner reasonably believed to be in the best interests
of the corporation) and a duty of "care" (to act with the care an ordinarily
prudent person in a like position would exercise under similar circumstances).
Minnesota law authorizes corporations to eliminate or limit the personal
liability of a director to the corporation or its shareholders for monetary
damages for breach of the fiduciary duty of "care." Minnesota law does not,
however,
27
<PAGE>
permit a corporation to eliminate or limit the liability of a director (i) for
any breach of the director's duty of "loyalty" to the corporation or its
shareholders, (ii) for acts or omissions not in good faith or that involve
intentional misconduct or a knowing violation of law, (iii) for authorizing a
dividend, stock repurchase or redemption or other distribution in violation of
Minnesota law or for violation of certain provisions of Minnesota securities
laws, or (iv) for any transaction from which the director derived an improper
personal benefit. The Articles of Incorporation of IAI Retirement Funds, Inc.,
limit the liability of directors to the fullest extent permitted by Minnesota
statutes, except to the extent that such liability cannot be limited as provided
in the Investment Company Act of 1940 (which Act prohibits any provisions which
purport to limit the liability of directors arising from such directors' willful
misfeasance, bad faith, gross negligence, or reckless disregard of the duties
involved in the conduct of their role as directors).
Minnesota law does not eliminate the duty of "care" imposed upon a
director. It only authorizes a corporation to eliminate monetary liability for
violations of that duty. Minnesota law, further, does not permit elimination or
limitation of liability of "officers" of the corporation for breach of their
duties as officers (including the liability of directors who serve as officers
for breach of their duties as officers.) Minnesota law does not permit
elimination or limitation of the availability of equitable relief, such as
injunctive or rescissionary relief. Further, Minnesota law does not permit
elimination or limitation of a director's liability under the Securities Act of
1933 or the Securities Exchange Act of 1934, and it is uncertain whether and to
what extent the elimination of monetary liability would extend to violations of
duties imposed on directors by the Investment Company Act of 1940 and the rules
and regulations adopted under such Act.
FINANCIAL STATEMENTS
The financial statements, included as a part of the Fund's 1994 Annual
Report to shareholders, are incorporated herein by reference. Such Annual
Report may be obtained by shareholders on request from the Fund at no additional
charge.
28
<PAGE>
APPENDIX A
RATINGS OF DEBT SECURITIES
RATINGS BY MOODY'S
- ------------------
CORPORATE BONDS
Aaa. Bonds rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edge." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues.
Aa. Bonds rated Aa are judged to be of high quality by all
standards. Together with the Aaa group, they comprise what are generally known
as high grade bonds. They are rated lower than the best bonds because margins
of protection may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long term risks appear somewhat larger than in Aaa
securities.
A. Bonds rated A possess many favorable investment attributes and
are to be considered as upper medium grade obligations. Factors giving security
to principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future.
Baa. Bonds rated Baa are considered medium grade obligations; i.e.,
they are neither highly protected nor poorly secured. Interest payments and
principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba. Bonds which are rated Ba are judged to have speculative
elements; their future cannot be considered as well assured. Often the
protection of interest and principal payments may be very moderate, and thereby
not well safeguarded during other good and bad times over the future.
Uncertainty of position characteristizes bonds in this class.
B. Bonds rated B generally lack characteristics of the desirable
investment. Assurances of interest and principal payment or maintenance of
other terms of the contract over any long period of time may be small.
Caa. Bonds rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal or
interest.
Ca. Bonds rated Ca represent obligations which are speculative in
a high degree. Such issues are often in default or have other marked
shortcomings.
C. Bonds rated C are the lowest-rated class of bonds and issued so
rated can be regarded as having extremely poor prospects of ever attaining any
real investment standing.
Conditional Ratings. The designation "Con." followed by a rating
indicates bonds for which the security depends upon the completion of some act
or the fulfillment of some condition. These are bonds secured by (a) earnings
of projects under construction, (b) earnings or projects unseasoned in operating
experience, (c) rentals which begin when facilities are completed, or (d)
payments to which
A-1
<PAGE>
some other limiting condition attaches. Parenthetical rating denotes probable
credit stature upon completion of construction or elimination of basis of
condition.
Note: Moody's applies numerical modifiers 1, 2, and 3 in the Aa and A
classifications of its corporate bond rating system. The modifier 1 indicates
that the security ranks in the higher end of its generic rating category; the
modifier 2 indicates a mid-range ranking; and the modifier 3 indicates that the
issue ranks in the lower end of its generic rating category. With respect to
municipal securities, those bonds in the Aa, A, Baa, Ba, and B groups which
Moody's believes possess the strongest investment attributes are designated by
the symbols Aa1, A1, Baa1, Ba1, and B1.
COMMERCIAL PAPER
Moody's employs the following three designations, all judged to be
investment grade, to indicate the relative repayment capacity of rated issuers:
Prime - 1 Superior ability for repayment of senior short-term
debt obligations
Prime - 2 Strong ability for repayment of senior short-term
debt obligations
Prime - 3 Acceptable ability for repayment of senior short-
term debt obligations
If an issuer represents to Moody's that its Commercial Paper
obligations are supported by the credit of another entity or entities, Moody's,
in assigning ratings to such issuers, evaluates the financial strength of the
indicated affiliated corporations, commercial banks, insurance companies,
foreign governments, or other entities, but only as one factor in the total
rating assessment.
RATINGS BY S&P
- --------------
CORPORATE BONDS
AAA. Debt rated AAA has the highest rating assigned by S&P. Capacity
to pay interest and repay principal is extremely strong.
AA. Debt rated AA has a very strong capacity to pay interest and
repay principal and differs from the higher rated issues only in small degree.
A. Debt rated A has a strong capacity to pay interest and repay
principal although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in higher-rated
categories.
BBB. Debt rated BBB is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher-rated categories.
BB. Debt rated BB has less near-term vulnerability to default than
other speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial, or economic conditions which could lead
to inadequate capacity to meet timely interest and principal payments.
A-2
<PAGE>
B. Debt rated B has a greater vulnerability to default but
currently has the capacity to meet interest payments and principal repayments.
Adverse business, financial, or economic conditions will likely impair capacity
or willingness to pay interest and repay principal. The B rating category is
also used for debt subordinated to senior debt that is assigned an actual or
implied BB-rating.
CCC. Debt rated CCC has a currently identifiable vulnerability to
default, and is dependent upon favorable business, financial, and economic
conditions to meet timely payment of interest and repayment of principal. In
the event of adverse business, financial or economic conditions, it is not
likely to have the capacity to pay interest and repay principal.
CC. Debt rated CC is typically applied to debt subordinated to
senior debt which is assigned an actual or implied CCC debt rating.
C. The rating C typically applied to debt subordinated to senior
debt which assigned an actual or implied CCC-debt rating. The C rating may be
used to cover a situation where a bankruptcy petition has been filed but debt
service payments are continued.
C1. The rating C1 is reserved for income bonds on which no interest
is being paid.
D. Debt rated D is in payment default. The D rating category is
used when interest payments or principal payments are not made on the date due
even if the applicable grace period has not expired, unless S & P believes that
such payments will be made during such grace period. The D rating will be used
upon the filing of a bankruptcy petition if debt service payments are
jeopardized.
In order to provide more detailed indications of credit quality, S&P's
bond letter ratings described above (except for the AAA category) may be
modified by the addition of a plus or a minus sign to show relative standing
within the rating category.
COMMERCIAL PAPER
A. This highest rating category indicates the greatest capacity for
timely payment. Issues in this category are further defined with the
designations 1, 2, and 3 to indicate the relative degree to safety.
A-1. This designation indicates that the degree of safety regarding
timely payment is either overwhelming or very strong. Those issues determined
to possess overwhelming safety characteristics are designed A-1+.
A-2. Capacity for timely payments on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designed A-1.
A-3. Issues carrying this designation have adequate capacity for
timely repayment. They are, however, more vulnerable to the adverse effects of
changes in circumstances than obligations carrying the higher designations.
A-3
