As of December 31, 2000, the Company leased its various office facilities. The Company's principal leasing arrangements can be summarized as follows: The Company's principal executive offices occupy approximately 30,300 square feet in a single facility in downtown Boston under a lease which expires in 2002. Keyport leases approximately 96,500 square feet in two buildings in downtown Boston under leases which expire in 2008 and approximately 19,800 square feet in a single facility in Lincoln, Rhode Island under a lease which expires in 2007. Liberty Advisors and certain of its affiliates lease approximately 219,000 square feet in two buildings in downtown Boston under leases which expire in 2006 and approximately 41,200 square feet in Aurora, Colorado under a lease which expires in 2005. Stein Roe leases 141,900 square feet in downtown Chicago under a lease which expires in 2009. Newport leases approximately 10,400 square feet in downtown San Francisco under a lease which expires in 2004. Crabbe Huson leases approximately 17,700 square feet in downtown Portland, Oregon under a lease which expires in 2003. Progress leases approximately 9,000 square feet in downtown San Francisco under a lease which expires in 2005. Independent leases approximately 25,600 square feet in Purchase, New York under a lease which expires in 2006 and approximately 2,000 square feet in Akron, Ohio under a lease which expires in 2004. Liberty Wanger leases approximately 35,200 square feet in Chicago, Illinois under leases which expire in 2009. In addition, the Company leases approximately 24,600 square feet in a building in downtown Boston under a lease which expires in 2007.
(2) Share and per share amounts have been adjusted for a three-for-two common stock split effected in the form of a 50 percent stock dividend distributed on December 10, 1997.
(3) Net operating income is defined as net income, excluding extraordinary items, net realized investment gains and losses, gain on sale of Private Capital Management, net change in unrealized and undistributed gains in private equity limited partnerships, restructuring charges, and special compensation plan expense, net of related income taxes.
PRETAX INCOME was $188.6 million in 2000 compared to $154.4 million in 1999 and $178.9 million in 1998. The increase in pretax income in 2000 compared to 1999 resulted from higher fee income, investment spread, net change in unrealized and undistributed gains in private equity limited partnerships, and gain on sale of Private Capital Management. Partially offsetting these items were higher operating expenses, amortization expense, restructuring charges, special compensation plan expense, and net realized investment losses. The lower pretax income in 1999 compared to 1998 resulted primarily from net realized investment losses in 1999 compared to net realized investment gains in 1998. Operating expenses, amortization expense and interest expense, net also increased, largely offset by higher fee and investment spread income.
INVESTMENT SPREAD is the amount by which investment income earned on the Company's investments exceeds interest credited on policyholder balances. Investment spread was $322.7 million in 2000 compared to $283.7 million in 1999 and $258.7 million in 1998. The amount by which the average yield on investments exceeds the average interest credited rate on policyholder balances is the investment spread percentage. The investment spread percentage in 2000 was 2.30% compared to 2.01% for 1999 and 1.83% for 1998.
Investment income was $862.3 million in 2000 compared to $810.3 million in 1999 and $820.9 million in 1998. The increase of $52.0 million in 2000 compared to 1999 includes a $62.5 million increase as a result of a higher investment yield and a $10.5 million decrease resulting from a lower level of average invested assets. The 2000 investment income was net of $79.7 million of S&P 500 Index call option amortization expense related to the Company's equity-indexed annuities compared to $77.2 million in 1999. The average investment yield was 6.78% in 2000 compared to 6.29% in 1999. The decrease of $10.6 million in 1999 compared to 1998 primarily relates to a $15.0 million decrease as a result of a lower average investment yield, partially offset by a $4.4 million increase resulting from a higher level of average invested assets. The 1998 investment income was net of $70.8 million of S&P 500 Index call option amortization expense. The average investment yield was 6.41% in 1998.
Interest credited to policyholders totaled $539.6 million in 2000 compared to $526.6 million in 1999 and $562.2 million in 1998. The increase of $13.0 million in 2000 compared to 1999 primarily relates to a $24.1 million increase resulting from a higher average interest credited rate, partially offset by an $11.1 million decrease resulting from a lower level of average policyholder balances. Policyholder balances averaged $12.0 billion (including $9.7 billion of fixed products, consisting of fixed annuities and a closed block of single premium whole life insurance, and $2.3 billion of equity-indexed annuities) in 2000 compared to $12.3 billion (including $10.1 billion of fixed products and $2.2 billion of equity-indexed annuities) in 1999. The average interest credited rate was 4.48% (5.27% on fixed products, consisting of fixed annuities and a closed block of single premium whole life insurance, and 0.85% on equity-indexed annuities) in 2000 compared to 4.28% (5.00% on fixed products and 0.85% on equity-indexed annuities) in 1999. Keyport's equity-indexed annuities credit interest to the policyholder at a "participation rate" equal to a portion (ranging for existing policies from 25% to 100%) of the change in value of the S&P 500 Index. Keyport's equity-indexed annuities also provide a full guarantee of principal if held to term, plus interest at 0.85% annually. For each of the periods presented, the interest credited to equity-indexed policyholders related to the participation rate was offset by investment income recognized on the S&P 500 Index call options and futures, resulting in a 0.85% net credited rate. The decrease in interest credited to policyholders of $35.6 million in 1999 compared to 1998 primarily relates to a $36.9 million decrease resulting from a lower average interest credited rate. Policyholder balances in 1998 averaged $12.3 billion (including $10.5 billion of fixed products and $1.8 billion of equity-indexed annuities). The average interest credited rate in 1998 was 4.58% (5.23% on fixed products and 0.85% on equity-indexed annuities).
Average investments in the Company's general account (computed without giving effect to Statement of Financial Accounting Standards No. 115), including cash and cash equivalents in the Company's annuity operations, were $12.7 billion in 2000 compared to $12.9 billion in 1999 and $12.8 billion in 1998. The decrease of $0.2 billion in 2000 compared to 1999 was primarily due to net redemptions and transfers to separate accounts, partially offset by the reinvestment of portfolio earnings. The increase of $0.1 billion in 1999 compared to 1998 was primarily due to the reinvestment of portfolio earnings, partially offset by net redemptions and transfers to separate accounts.
NET REALIZED INVESTMENT GAINS (LOSSES) were $(47.5) million in 2000 compared to $(42.2) million in 1999 and $2.4 million in 1998. The net realized investment losses in 2000 and 1999, and net realized investment gains in 1998 included losses of $18.9 million, $18.3 million and $28.3 million, respectively, for investments where the decline in value was determined to be other than temporary.
NET CHANGE IN UNREALIZED AND UNDISTRIBUTED GAINS IN PRIVATE EQUITY LIMITED PARTNERSHIPS is accounted for on the equity method and represents primarily increases in the fair value of the underlying investments of the private equity limited partnerships for which the Company has ownership interests in excess of 3%. This change in unrealized and undistributed gains is recorded net of the related amortization of deferred policy acquisition costs of $58.8 million and net of amounts realized, which are recognized in investment income, of $13.3 million for the year ended December 31, 2000. The financial information for these investments is obtained directly from the private equity limited partnerships on a periodic basis. The corresponding amounts in 1999 and 1998 were insignificant. There can be no assurance that any unrealized and undistributed gains will ultimately be realized or that the Company will not incur losses in the future on such investments.
Average fee-based assets under management were $55.0 billion in 2000 compared to $48.4 billion in 1999 and $41.9 billion in 1998. The increase during 2000 compared to 1999 resulted primarily from net sales for the year ended December 31, 2000 and the acquisition of Wanger Asset Management, L.P. on September 29, 2000. The increase during 1999 compared to 1998 resulted from market appreciation and net sales for the year ended December 31, 1999 and the full year impact of 1998 acquisitions. Investment advisory and administrative fees were 0.55% of average fee-based assets under management in 2000 and 1999, and 0.57% in 1998.
The amount of fee-based assets under management are affected by product sales and redemptions, acquisitions, and changes in the market values of such assets under management. Fee-based assets under management and changes in such assets are set forth in the tables below (in billions).
DISTRIBUTION AND SERVICE FEES are based on the market value of the Company's intermediary-distributed mutual funds. Distribution fees of 0.75% are generally earned on the average assets attributable to such funds sold with 12b-1 distribution fees and contingent deferred sales charges and service fees of 0.25% (net of amounts passed on to selling brokers) are generally earned on the total of such average mutual fund assets. These fees totaled $60.7 million in 2000 compared to $60.4 million in 1999 and $52.7 million in 1998. The increases in 2000 and 1999 were primarily attributable to the higher asset levels of mutual funds with 12b-1 distribution fees and contingent deferred sales charges. As a percentage of intermediary-distributed average mutual fund assets, distribution and service fees were approximately 0.34% in 2000, 0.35% in 1999 and 0.32% in 1998.
SURRENDER CHARGES AND NET COMMISSIONS are revenues earned on: a) the early withdrawal of annuity policyholder balances and redemptions of the intermediary-distributed mutual funds which were sold with 12b-1 distribution fees and contingent deferred sales charges; b) the distribution of the Company's intermediary-distributed mutual funds (net of the substantial portion of commissions that is passed on to the selling brokers); and c) the sales of non-proprietary products in the Company's bank marketing businesses (net of commissions that are paid to the Company's client banks and brokers). Total surrender charges and net commissions were $42.3 million in 2000 compared to $36.5 million in 1999 and $33.7 million in 1998.
Surrender charges on fixed and variable annuity withdrawals generally are assessed at declining rates applied to policyholder withdrawals during the first five to seven years of the contract; contingent deferred sales charges on mutual fund redemptions are assessed at declining rates on amounts redeemed generally during the first six years. Such charges totaled $32.5 million, $24.5 million and $21.9 million in 2000, 1999 and 1998, respectively. Total annuity withdrawals represented 16.2%, 14.7% and 13.2% of the total average annuity policyholder and separate account balances in 2000, 1999 and 1998, respectively. Net commissions were $9.8 million in 2000, $12.0 million in 1999 and $11.8 million in 1998.
RESTRUCTURING CHARGES in 2000 of $18.7 million consist of severance and other expenses. The restructuring charges primarily relate to two initiatives, streamlining the Company's mutual fund product offerings and centralizing corporate functions. The first initiative followed an in-depth analysis of the Company's mutual fund and variable annuity products and considered the Wanger acquisition, which brought additional scale and products to the Company's mutual fund product offerings. As a result of this analysis, the Company merged 16 mutual funds into other Liberty funds and has liquidated 4 other funds. The second initiative involves centralizing the finance, human resources, legal and compliance, and communications functional areas. Previously, these functions were managed independently in each operating company. The functional centralization process began in August of 2000 and the Company anticipates that it will be fully implemented by the end of 2001. The Company currently expects that there will be additional pre-tax charges of approximately $5.0 million in 2001.
AMORTIZATION OF DEFERRED DISTRIBUTION COSTS relates to the distribution of mutual fund shares sold with 12b-1 distribution fees and contingent deferred sales charges. Amortization was $42.9 million in 2000 compared to $40.3 million in 1999 and $40.1 million in 1998.
STOCKHOLDERS' EQUITY as of December 31, 2000 was $1.45 billion compared to $1.19 billion as of December 31, 1999. Net income in 2000 was $127.6 million and cash dividends on the Company's preferred and common stock totaled $6.5 million. Common stock totaling $9.0 million was issued in connection with the exercise of stock options. A decrease in accumulated other comprehensive loss, which consists of net unrealized investment losses, net of adjustments to deferred policy acquisition costs and income taxes, during the period increased stockholders' equity by $127.5 million.
The Company manages the majority of its invested assets internally. The Company's general investment policy is to hold fixed maturity securities for long-term investment and, accordingly, the Company does not have a trading portfolio. To provide for maximum portfolio flexibility and appropriate tax planning, the Company classifies its entire portfolio of fixed maturity securities as "available for sale" and accordingly carries such investments at fair value. The Company's total investments at December 31, 2000 and 1999 reflected net unrealized losses of $62.0 million and $318.6 million, respectively.
The Company routinely reviews its portfolio of investment securities. The Company identifies monthly any investments that require additional monitoring, and reviews the carrying value of such investments at least quarterly to determine whether specific investments should be placed on a nonaccrual basis and to determine declines in value that may be other than temporary. In making these reviews, the Company principally considers the adequacy of collateral (if any), compliance with contractual covenants, the borrower's recent financial performance, news reports, and other externally generated information concerning the borrower's affairs. In the case of publicly traded fixed maturity securities, management also considers market value quotations if available. As of December 31, 2000 and 1999, the carrying value of fixed maturity securities that were non-income producing was $24.4 million and $22.6 million, respectively, which constituted 0.2% of investments in each year.
The active management of market risk is integral to the Company's operations. The Company may use the following approaches to manage its exposure to market risk within defined tolerance ranges: rebalance its existing asset and liability portfolios, change the character of future investment purchases, or use derivative instruments to modify the market risk characteristics of existing assets and liabilities or assets expected to be purchased.
The Company's portfolio strategy is designed to achieve acceptable risk-adjusted returns by effectively managing portfolio liquidity and credit quality.
The Company has investment guidelines that define the overall framework for managing market and other investment risks, including the accountability and control over these activities. In addition, the Company has specific investment policies that delineate the investment limits and strategies that are appropriate given the Company's liquidity, product and regulatory requirements.
The Company monitors and manages its exposure to market risk through asset allocation limits, duration limits, and stress tests. Asset allocation limits place restrictions on the aggregate fair value which may be invested within an asset class. Duration limits on the aggregate investment portfolio, and, as appropriate, on individual components of the portfolio, place restrictions on the amount of interest rate risk that may be taken. Stress tests measure downside risk to fair value and earnings over longer time intervals and for adverse market scenarios.
The Company manages the interest rate risk inherent in its assets relative to the interest rate risk inherent in its liabilities. One of the measures the Company uses to quantify this exposure is effective duration. Effective duration is a common measure for the price sensitivity of assets and liabilities to changes in interest rates. It measures the approximate percentage change in the fair value of assets and liabilities when interest rates change by 100 basis points. This measure includes the impact of estimated changes in portfolio cash flows from features such as prepayments and bond calls. The effective duration of assets and related liabilities are produced using standard financial valuation techniques. At December 31, 2000 and 1999, the estimated difference between the Company's asset and liability duration was approximately 0.8 and 1.8, respectively. The Company believes this positive duration gap indicates that the fair value of the Company's assets is somewhat more sensitive to interest rate movements than the fair value of its liabilities.
liabilities subject to policyholder surrenders. Additionally, the Company's calculation assumes that the current relationship between short-term and long-term interest rates (the term structure of interest rates) will remain constant over time. As a result, these calculations may not fully capture the impact of non-parallel changes in the term structure of interest rates and/or large changes in interest rates.
Equity price risk is the risk that the Company will incur economic losses due to adverse changes in a particular stock or stock index. At December 31, 2000 and 1999, the Company had approximately $76.4 million and $37.9 million, respectively, in common stocks and $337.7 million and $701.1 million, respectively, in other equity investments (primarily equity options and equity futures).
At December 31, 2000 and 1999, the Company had $2.1 billion and $2.4 billion, respectively, in equity-indexed annuity liabilities which provide customers with contractually guaranteed participation in price appreciation of the Standard & Poor's 500 Composite Price Index ("S&P 500 Index"). The Company purchases equity-indexed options and futures to hedge the risk associated with the price appreciation component of equity-indexed annuity liabilities.
The simulations do not consider the effects of other changes in market conditions that could accompany changes in the equity option and futures markets including the effects of changes in implied dividend yields, interest rates, and equity-indexed annuity policy surrenders.
There are risks associated with some of the techniques the Company uses to match its assets and liabilities. The primary risk associated with swap, cap and call option agreements is counterparty non-performance. The Company believes that the counterparties to its swap, cap and call option agreements are financially responsible and that the counterparty risk associated with these transactions is minimal. Futures contracts trade on organized exchanges and therefore have minimal credit risk. In addition, swap and cap agreements have interest rate risk and call options, futures and certain total return swap agreements have stock market risk. These swap and cap agreements hedge fixed-rate assets and the Company expects that any interest rate movements that adversely affect the market value of swap and cap agreements would be offset by changes in the market values of such fixed rate assets. However, there can be no assurance that these hedges will be effective in offsetting the potential adverse effects of changes in interest rates. Similarly, the call options, futures and certain total return swap agreements hedge the Company's obligations to provide returns on equity-indexed annuities and certain separate account liabilities based upon the S&P 500 Index, and the Company believes that any stock market movements that adversely affect the market value of S&P 500 Index call options, futures and certain total return swap agreements would be substantially offset by a reduction in policyholder and certain separate account liabilities. However, there can be no assurance that these hedges will be effective in offsetting the potentially adverse effects of changes in S&P 500 Index levels. The Company's profitability could be adversely affected if the value of its swap and cap agreements increase less than (or decrease more than) the change in the market value of its fixed rate assets and/or if the value of its S&P 500 Index call options, futures and certain total return swap agreements increase less than (or decrease more than) the value of the guarantees made to equity-indexed and certain separate account policyholders.
The cumulative effect, reported after tax and net of related effects of deferred policy acquisition costs, upon adoption of the Statement at January 1, 2001 will decrease net income and stockholder's equity by approximately $55.0 million. The adoption of the Statement may increase volatility in future reported income due, among other reasons, to the requirements of defining an effective hedging relationship under the Statement as opposed to certain hedges the Company believes are effective economic hedges. The Company anticipates that it will continue to utilize its current risk management philosophy, which includes the use of derivative instruments.
The Company is a holding company whose liquidity needs include the following: (i) operating expenses; (ii) debt service; (iii) dividends on preferred stock and common stock; (iv) acquisitions; and (v) working capital where needed by its operating subsidiaries. The Company's principal sources of cash are dividends from its operating subsidiaries, and, in the case of funding for acquisitions and certain long-term capital needs of its subsidiaries, long-term borrowings and offerings of preferred and common stock. In connection with the Wanger acquisition, the Company issued $200.0 million of debt to Liberty Mutual Insurance Company and its affiliates. Such debt is payable upon any change of control of the Company. In connection with the Crabbe Huson acquisition in 1998, the Company entered into a $100.0 million revolving credit facility with a commercial bank (the "Bridge Facility"). The Bridge Facility matured on March 30, 1999 and bore interest at a per annum rate equal to LIBOR plus twenty-five basis
points. The Company borrowed $90.0 million under the Bridge Facility to finance the acquisition of Crabbe Huson. In November 1998, the Company issued $450.0 million of senior debt securities. The offering consisted of $300.0 million of 6 3/4% 10-year notes due November 15, 2008 and $150.0 million of 7 5/8% 30-year debentures due November 15, 2028. The proceeds were utilized to repay the $90.0 million borrowed under the Bridge Facility, to repay notes payable to affiliates of $229.0 million and for general corporate purposes.
The Company also has a $150.0 million revolving credit facility (the"Facility") which is utilized to finance sales commissions paid in connection with the distribution of mutual fund shares sold with 12b-1 distribution fees and contingent deferred sales charges. The Facility was established in April 1999 and replaced a $60.0 million revolving credit facility which was used for the same purpose. This five year Facility is secured by such 12b-1 distribution fees and contingent deferred sales charges. Interest accrues on the outstanding borrowings under the Facility at a rate determined by sales of highly rated commercial paper backed in part by the security interest in such fees and charges. At December 31, 2000, the interest rate on borrowings under the Facility was 6.65% per annum.
Based upon the historical cash flow of the Company, the Company's current financial condition and the Company's expectation that there will not be a material adverse change in the results of operations of the Company and its subsidiaries during the next twelve months, the Company believes that cash flow provided by operating activities over this period will provide sufficient liquidity for the Company to meet its working capital, capital investment and other operational cash needs, its debt service obligations, its obligations to pay dividends on the preferred stock and its intentions to pay dividends on the common stock. The Company may require external sources of liquidity in order to finance material acquisitions where the purchase price is not paid in equity.
Each of the Company's business segments has its own liquidity needs and financial resources. In the Company's annuity insurance operations, liquidity needs and financial resources pertain to the management of the general account assets and policyholder balances. In the Company's asset management business, liquidity needs and financial resources pertain to the investment management and distribution of mutual funds and institutional accounts. The Company expects that, based upon their historical cash flow and current prospects, these operating subsidiaries will be able to meet their liquidity needs from internal sources and, in the case of Liberty Funds Group LLC, also from its credit facility used to finance sales of mutual fund shares sold with 12b-1 distribution fees and contingent deferred sales charges.
Inflation has not had a material effect on the Company's consolidated results of operations to date. The Company manages its investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the market value of the Company's fixed maturity portfolio increases or decreases in inverse relationship with fluctuations in interest rates, and the Company's net investment income increases or decreases in direct relationship with interest rate changes. For example, if interest rates decline, the Company's fixed maturity investments generally will increase in market value, while net investment income will decrease as fixed maturity investments mature or are sold and the proceeds are reinvested at reduced rates. Inflation may result in increased operating expenses that may not be readily recoverable in the prices of the services charged by the Company.
The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). Investors are cautioned that all statements not based on historical fact, trend analyses and other information contained in this report or in any of the Company's filings under Section 13 or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"), relative to the Company's plans, markets for the Company's products and trends in the Company's operations or financial results, as well as other statements including words such as "anticipate", "believe", "plan", "estimate", "expect", "intend" and other similar expressions, constitute forward-looking statements under the Reform Act. These forward-looking statements are made based on current expectations and assumptions and are subject to known and unknown risks, uncertainties and other factors, many of which are beyond the Company's control, that may cause actual results to be materially different from those expressed or implied by the forward-looking statements. Such factors include, among other things: (1) general economic conditions and market factors, such as prevailing interest rate levels, stock market performance and fluctuations in the market for retirement-oriented savings products and investment management products, which may adversely affect the ability of the Company to sell its products and services and the market value of the Company's investments and assets under management and, therefore, the portion of its revenues that are based on a percentage of assets under management; (2) the Company's ability to manage effectively its investment spread (i.e. the amount by which investment income exceeds interest credited to annuity and life insurance policyholders) as a
result of changes in interest rates and crediting rates to policyholders, market conditions and other factors (the Company's results of operations and financial condition are significantly dependent on the Company's ability to manage effectively its investment spread); (3) that the net change in unrealized and undistributed gains in private equity limited partnerships will not be realized or that future losses on such investment will not occur; (4) levels of surrenders, withdrawals and net redemptions of the Company's retirement-oriented insurance products and investment management products; (5) relationships with investment management clients, including levels of assets under management; (6) the ability of the Company to manage effectively certain risks with respect to its investment portfolio, including risks relating to holding below investment grade securities and the ability to dispose of illiquid and/or restricted securities at desired times and prices, and the ability to manage and hedge against interest rate changes through asset/liability management techniques; (7) competition in the sale of the Company's products and services, including the Company's ability to establish and maintain relationships with distributors of its products; (8) changes in financial ratings of Keyport or those of its competitors; (9) the Company's ability to attract and retain key employees, including senior officers, portfolio managers and sales executives; (10) the impact of and compliance by the Company with existing and future regulation, including restrictions on the ability of certain subsidiaries to pay dividends and any obligations of the Company under any guaranty fund assessment laws; (11) changes in applicable tax laws which may affect the relative tax advantages and attractiveness of some of the Company's products; (12) the result of any litigation or legal proceedings involving the Company; (13) changes in generally accepted accounting principles and the impact of accounting principles and pronouncements on the Company's financial condition and results of operations; (14) changes in the Company's senior debt ratings; (15) changes in operating expense levels; (16) acquisition risks, including risks that the acquisition and integration of Wanger Asset Management, L.P. will not be as successful as anticipated; (17) risks that the Company will not achieve favorable effective tax rates; (18) risks that the Company's restructuring efforts and retention efforts will not be successful, and risks that the Company's exploration of strategic alternatives will not be successful or result in a transaction; and (19) the other risk factors or uncertainties contained from time to time in any document incorporated by reference in this report or otherwise filed by the Company under the Exchange Act. Given these uncertainties, prospective investors are cautioned not to place undue reliance on such forward-looking statements and no assurances can be given that the estimates and expectations reflected in such statements will be achieved.