RD55 - Virginia Retirement System Comprehensive Annual Financial Report for the Year Ended June 30, 2012


Executive Summary:
I am pleased to present to you the Virginia Retirement System (VRS) Comprehensive Annual Financial Report for the fiscal year 2012.

The Virginia Retirement System (VRS) achieved a 1.4% net return on its investment portfolio for fiscal year 2012, ending the year with $53.3 billion in assets. During fiscal year 2012, the fund's real assets program returned 11.9%. The private equity program returned 10.9%, the fixed income program returned 7.9%, and the credit strategies program returned 1.4%. The public equity program returned -4.6%, reflecting the market shifts during the year.

The portfolio included $21.8 billion in public equity, $12.5 billion in fixed income, $7.2 billion in credit strategies, $4.8 billion in private equity and $4.3 billion in real assets, as of June 30, 2012.

Although the market did not produce the returns we had hoped for, the investment staff made the best of a difficult global market, taking advantage of every opportunity to protect the portfolio and add value. In fact, the staff beat its benchmark for the fund as a whole last year.

The Euro-zone is in economic turmoil as its banks struggle to be recapitalized and its weaker countries deal with crushing debt. These struggles are rolling across the continent from Greece to Spain and back again. Although half a world away, the VRS portfolio is not insulated from European turmoil. When markets decline in Europe, the U.S. and markets worldwide are adversely affected.

Nor has the world recovered from the 2008 financial meltdown. Thus, as the market has become more volatile, the Board has redoubled its focus on the appropriate asset allocation and risk profile of the trust fund.

Presently, the fund has an asset allocation of 60% in equity-like securities. Many pension funds have higher equity allocations. If the Board maintains this equity allocation and global equities take off, VRS could be left behind its peers. On the other hand, if the Board increases its equity allocation, the portfolio would be exposed to higher volatility and a higher risk of loss. To focus on this challenge, the Board formed an Investment Policy Committee, tasked with analyzing and structuring an appropriate asset allocation and risk profile for the portfolio. The work of this committee will be ongoing over the next year as we thoroughly examine alternatives and their corresponding impacts, both long and short term.

Virginia has been taking up pension reform along with more than 40 others states that are also examining their plans for future cost savings in order to maintain their solvency. On the heels of the 2010 session of the General Assembly, which enacted a new tier of benefits called Plan 2, the 2012 session took reform even further by enacting a new hybrid plan for state and local employees, except public safety employees, hired on or after January 1, 2014. Our administrative staff is now turning its attention to many more months of effort toward implementing system changes, operational procedures, vendor selection, online tools and communication materials to get ready for the many changes in benefit plans.

Another aspect of the pension reform legislation also important to the Board is the prospect of reaching full funding of the recommended contribution rates. Contribution rates for many years have been too low, but you and your colleagues adopted a schedule by which contribution rates will gradually rise of the next four biennia. Starting with this new biennium, rates are increased to almost 70% of the Board's certified levels and are scheduled to gradually rise to 100% of the Board's levels by fiscal year 2019. I must stress that future improvements in the fiscal condition of these plans will be inextricably linked to your commitment and that of future Governors and General Assemblies to maintaining this schedule.

We estimate the funded status of the plans will gradually decline as contribution rates remain below recommended levels. Market returns are unlikely to make up the difference. Pension reform will help, but since most of the benefit changes apply to future generations of employees, the associated cost reductions will be slow in coming. Pension reform by itself, if not also accompanied by contribution increases, will not restore our funded status to prudent levels.

I would like to conclude my message by recognizing our new Chief Investment Officer, Ronald D. Schmitz, who came to VRS in October 2011. Beginning in 2002, Ron was responsible for the investment of the $52 billion Oregon Public Employees Retirement Fund, the $3 billion State Accident Insurance Fund and the $12 billion cash management account for state and local governments in Oregon. Prior to that, Ron served as the Chief Investment Officer of the Illinois State Board of Investment.

During Ron's service in Oregon, the Oregon fund was recognized as "Pension Plan of the Year" by "Plan Sponsor" magazine. During his tenure, Wilshire Associates ranked Oregon's investment performance in the top three percentile of public funds in the United States. "Private Equity Analyst Magazine" also voted the Oregon fund into its Private Equity Hall of Fame. Additionally, Ron was personally designated by "Institutional Investor" magazine as "Investment Executive of the Year." With all these achievements, he also found time to serve on the Board of the R. F. Toigo Foundation, which fosters educational scholarships and opportunities for women and minorities in the investment industry.

On behalf of the Board of Trustees and the VRS staff, I would like to express our gratitude to you for your continued support and leadership. The Board stands ready to assist you in fully implementing the reforms of the 2012 session.

Sincerely,

/s/ Diana F. Cantor
Chairman
Virginia Retirement System