Texas Performance Review Disturbing the Peace Chapter 1 Education

The Permanent School Fund should implement an option writing strategy.

Background

Any discussion of Permanent School Fund (PSF) investment strategies is, of necessity, technical and complex. But all Texans can agree that safe, smart ways to increase funds for public education should be explored.

The PSF was created as a perpetual endowment in support of free public schools in Texas. Early constitutional provisions set aside both land and money to fund the PSF, with the original assets intended to stay as untouched principal, while the income generated from these assets was deposited to the Available School Fund (ASF) to support the state's public schools. An 1854 law dedicated $2 million to the PSF from the settlement of a boundary dispute with the U.S. government. The current state constitution, adopted in 1876, dedicated additional lands and their proceeds to the PSF. In all, more than 46.5 million acres have been granted to the PSF, including mineral interests from 7.1 million acres.[1]

Today, the PSF's principal growth comes from two sources: mineral royalties and income from dedicated land managed by the General Land Office (GLO), and capital gains from the growth in the value of stock and bond investments. These capital gains can be either realized or unrealized. Realized capital gains occur when a stock or bond is sold for more than the original purchase price, while unrealized capital gains occur before the sale of a stock or bond, when the market value of the security is higher than when it was originally purchased.

Income from the PSF is allocated to the ASF for the purchase of textbooks and then for distribution to school districts. This income consists primarily of interest on bond investments, dividends from stock investments, and land lease income.

Investment opportunities have expanded since the original PSF was created, as has the wealth available for investment. Much of the original land has been sold and the proceeds invested in stocks and bonds. Indeed, virtually all the wealth in the PSF has now been converted into securities.

The State Board of Education (SBOE) has begun a program with a multiyear phase-in to reach new asset allocation limits. The new program puts greater emphasis on capital appreciation to increase the size of the PSF at the expense of current income deposited to the ASF. By increasing the fund's proportion of stocks relative to fixed income securities (asset allocation), long-term income will increase; but in the current 1996-97 biennial budget period the ASF is expected to receive $172 million less than it would have under the old portfolio mix. Total reductions in income from the new asset allocation, under the best available assumptions, are projected at nearly $2.1 billion through 2009, after which income should grow beyond what the old asset mix would have allowed.

Option writing

To increase income paid to the ASF, the PSF should engage in an "option writing" program on its equity portfolio. The investment advisory committee, created by the State Board of Education to advise the board on the PSF's administration, suggested the option writing strategy in July 1993 while looking for ways to increase income produced by the PSF. Members of the investment advisory committee described it as easy to operate and the largest income producer of seven investment methods under consideration. SBOE chose not to pursue this option because of heightened concern regarding public investment in derivatives.

Option writing is a conservative strategy that smoothes income flow and removes some of stock ownership's inherent risk. To operate option writing, the PSF would select certain stocks in its portfolio on which to write covered call and put options--essentially, agreements to sell or purchase the shares to or from a brokerage firm at an agreed-upon later date. Prudent limits would be placed on how many and which shares would be offered. In devising these options, a process called "exposing a share," the PSF staff would set a "strike price"--an amount for which each share called (sold) or put (purchased) would be transacted. The call operation works in the following manner: if the market price rises above the strike price at the end of a three-month period, the PSF then would sell the stock for the strike price. (No sale would occur if the stock fails to reach the strike price at the end of the option's expiration date.) The PSF would receive a sum known as a call premium on the day the option was written, and that "call premium" would be paid to the ASF the day it was received. The call premium is retained whether or not the stock is actually sold.

Here is a simplified explanation of how one stock position in the PSF portfolio would be affected by the call writing program. To simplify the example, the number of shares, market price, and option premium have been truncated. This operation would be repeated for every stock position in the portfolio to get total results. The example assumes the PSF owned 10,000 shares and exposed 20 percent of that position in this three-month program, beginning April 1, 1996. On April 1, 1996 the market price was $40 for Mobil stock. The calculated strike price was $44 (40 x 1.1 = 44). The option price, from the Wall Street Journal, was $1.50 on April 1, 1996. The total premium is paid to the Texas Education Agency (TEA) on April 1, 1996 by the brokerage firm. This is the total earnings process.

Name of Issue	Number of Shares Owned	Number of Shares Exposed	Premium per Exposed Share	Premium Earned
Mobil Corp.	10,000	2,000	$1.50	$3,000

Now move ahead to the date of July 1, 1996, the end of this three-month program. The market price of Mobil will either be above or below $44. In either case the TEA retains the $3,000 premium earned.

For the case where the price is below $44 (say $42), $3,000 is paid to ASF, and PSF retains ownership of the 2,000 shares that were exposed.

For the case where the price is above $44 (say $47), $3,000 is paid to the PSF corpus, and PSF sells the 2,000 shares for $44 each. This is known as "having a share called away." The 2,000 shares (x $44) would be sold for $88,000. The entire $91,000 ($88,000 + $3,000) is retained in the corpus of the PSF. There is no loss, and the only cost is an opportunity cost to the extent that the PSF sold the stock for $44 when the market price had risen to $47. The payment of call premium to PSF corpus when shares are called away compensates the corpus for some of the lost opportunity cost. In this case the premium does not cover all of the lost opportunity cost.

The put operation works in the following manner: if the market price falls below the strike price at the end of a three-month period, the PSF would purchase the stock for the strike price. (No purchase would occur if the stock fails to reach the strike price at the end of the option's expiration date.) The PSF would receive a sum called a "put premium" on the day the option was written, and that put premium would be paid to the ASF the day it was received. The put premium is retained whether or not the stock is actually purchased.

A major Wall Street brokerage firm has conducted a dry-run pilot study taking into account the entire PSF equity portfolio from 1992 to 1995 and actual market quotes for the options. They did not actually write the options, and no money changed hands. The average annual income paid to the ASF for this four-year period would have been $15.8 million. The call program in the study caused 8.4 million shares of stock to be sold each year by the PSF at the strike price. This is 2.5 percent of the PSF's total stock portfolio. In almost every case the sale produced a profit for the corpus of the PSF. The study's put program caused 4.8 million shares of stock to be purchased each year by the PSF at the strike price, a price lower than the beginning market price. This is 1.4 percent of the PSF's total stock portfolio. All stocks purchased by the PSF were already PSF holdings. On all stocks called away or put to the PSF, the corresponding call or put premium was paid to the corpus of the PSF along with the sale proceeds. The income of $15.8 million per year is the premium remaining after the payments to the PSF corpus.

The Texas Constitution states:

[N]otwithstanding any other provisions of this constitution, in managing the assets of the permanent school fund, the SBOE may acquire, exchange, sell, supervise, manage, or retain through procedures and subject to restrictions it establishes and in amounts it considers appropriate, any kind of investment... that persons of ordinary prudence, discretion, and intelligence, exercising the judgment and care under the circumstances then prevailing, acquire or retain for their own account in the management of their affairs, not in regard to speculation but in regard to the permanent disposition of their fund, considering the probable income as well as the probable safety of their capital.[2]

This provision is commonly referred to as the "prudent person rule." Under its guidance, the PSF instituted a securities lending program in February 1993 to enhance income. It is a small program, but it is producing some $3.9 million each year in incremental income for the ASF. Option writing should be added under the same prudent person rule.

Many institutions use option strategies to enhance income returns, including the Harvard University Endowment Fund, the Houston Police Officers Pension System, the San Diego (California) County Employees Retirement System, Pennsylvania's Public School Employees Retirement System, the City of Baltimore's Employees Retirement Fund, and the Firefighters Pension and Retirement Fund of Oklahoma.

Recommendation

The State Board of Education (SBOE) should institute an option writing program by entering into a memorandum of understanding with the Comptroller of Public Accounts indicating the basic mechanism and timing of the program.

Fiscal Impact

The option writing program would generate an additional $7.9 million in revenue for 1998. Beginning in fiscal 1999 an additional $15.8 million would be made available annually to the ASF. This would be done while exposing no more than 20 percent of the equity portfolio. The option writing program would generate an additional $23.7 million in revenue for ASF spending during the 1998-99 biennium. ASF revenue is distributed to local school districts and is an offset to General Revenue. Revenue generated as a result of this program would be appropriated to school districts contingent upon a determination by the Comptroller during the 1998-99 biennium that the SBOE had complied with the provisions of the memorandum.

Fiscal Year	Gain to the Available School Fund
1998	$7,900,000
1999	15,800,000
2000	15,800,000
2001	15,800,000
2002	15,800,000

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Footnotes

[1] Texas Education Agency, Committee on the Permanent School Fund, Ensuring The Future of Texas: The Permanent School Fund (Austin, Texas, April 1992).

[2] Vernon's Ann. Tex. Const. Art. 7, SS5(d).