One of Pennsylvania's largest pension funds today begins the process of selecting a new investment consultant that will recommend money managers and monitor the fund's performance.

The Pennsylvania Municipal Retirement System plans to mail a request for proposals to a number of firms sometime today. The system's board of directors will probably interview candidates in March.

The RFP comes two days after outgoing Gov. Robert Casey signed into law two pieces of legislation allowing municipalities in the state to sell taxable bonds to finance their pension liabilities.

Dahab Associates Inc. has been the system's investment consultant since 1987, and the firm's president, Richard Dahab, said the company will reapply for the job. The firm's three-year contract expires in September 1995.

As of Sept. 30, 1994, the retirement system has earned a rate of return of 3.8%, Dahab said. The RFP, which will help the system select a single firm as its consultant, must be completed by Jan. 31, he said.

The system, the smallest of the three statewide pension funds, manages about $432 million in pension funds for 600 local governments around the state.

Each of the three funds has a consultant that keeps tabs on portfolio managers' investment performance. The consultant also helps select money managers by proposing candidates to the fund's board of directors.

The investment consultant monitors the investment performance of each of the system's 12 money managers and presents a report every quarter to the board of directors.

The board determines the direction of investments, and the consultant proposes around a dozen money managers to execute the board's policies. Members of the system's staff "sift those down to about three," said Edward L. Bechtel, the system's assistant secretary.

The board consists of representatives nominated by various municipal groups, such as the Chiefs of Police Association, who must be approved by the governor.

By state law, Treasurer Katherine Baker Knoll and Secretary of the Commonwealth Robert Grant sit on the board.

The new investment consultant will need to be familiar with the pension fund law, which is designed to help local governments finance their unfunded pension liabilities.

Under the law, local Pennsylvania governments can sell bonds and deposit the proceeds in the pension system in the hopes of earning a profit above the costs of debt service.

The participants in the two other pension funds, the Public School Employees Retirement System of Pennsylvania and the State Employees Retirement System, are not covered by the new legislation.

Several participants in the decimated Orange County, Calif., investment pool used a similar strategy of maximizing returns, and entered technical default after the California pool announced $2 billion in losses. The pool fell flat when short-term interest rates rose, pushing its borrowing costs up and the value of its derivatives investments down.

But proponents of the Pennsylvania legislation said such losses would not result from the new laws, and staff members at the retirement system agree. Pennsylvania laws governing the investment of public funds prohibit the use of derivatives and other risky instruments.

Proponents of the laws also believe that interest rates will remain low enough for a municipality to sell debt and realize a profit on investing the proceeds. Pension funds, with their diversified portfolios, often enjoy rates of return that exceed the costs of a taxable bond issue, proponents said.

But many investors were still wary. If a municipality is forced to sell bond issue after bond issue to finance its pension liability, "it could become a monster," said Bill Grady, a portfolio manager at Van Kampen-American Capital Inc.

"Basically it's leverage," said Margie Patel, senior vice president and portfolio manager of the Advantage Municipal Bond Fund.

The legislation, which amends two state laws covering municipal investment, does not apply to school districts or Philadelphia, the state's largest municipality. School districts are required by law to participate in the public school Employees Retirement System, a statewide pension fund containing more than $25 billion.

Philadelphia is not covered by the state laws the legislation amends, and state lawmakers have not announced any plans to give the city permission through separate legislation.

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