RD8 - Virginia Retirement System Comprehensive Annual Financial Report for the Year Ended June 30, 2014


Executive Summary:
I am pleased to present the Virginia Retirement System (VRS) Comprehensive Annual Financial Report for fiscal year 2014.

VRS achieved a 15.7% net return on its investment portfolio for fiscal year 2014, allowing the trust fund to end the year with a net position of $66.2 billion.

During fiscal year 2014, the public equity program returned 21.6%; the private equity program returned 23.2%; the real assets program returned 14.2%; the credit strategies program returned 12.2%; and the fixed income program returned 4.9%.

The portfolio included $28.8 billion in public equity; $11.9 billion in credit strategies; $12.2 billion in fixed income; $7.0 billion in real assets; and $5.1 billion in private equity, as of June 30, 2014.

For the second consecutive year, VRS investments yielded double-digit returns. This year the return resulted in a $9 billion gain for the system's portfolio. Approximately one-third of the portfolio is managed internally by VRS staff at considerable cost savings. The remainder is invested by external managers, subject to supervision by VRS staff. According to an outside study, the skill exhibited by VRS staff in performing these functions in comparison with their public fund peers saves the portfolio about $31 million annually in fees.

Strong market returns and skilled management were bolstered by the Board's decision to change the asset allocation strategy, which increases real assets and private equity and decreases fixed income and credit strategies. Private equities performed below their benchmarks for most of fiscal year 2014, but performed well in June 2014 and are expected to pay higher returns over the long term.

We believe this strategy improves our chances of meeting the actuarially assumed rate of return, 7% on an annualized basis, without significantly increasing the volatility of the portfolio. VRS is phasing in this strategy over a five-year period.

The VRS Board acknowledges the skills and efforts exhibited by the professional investment staff, who provided superior investment management and generated an average annual excess return of $310 million earned above the policy benchmark for the previous 10 years, which will help provide benefits for members of the system.

While the investment team was implementing the Board's asset allocation strategy, the administrative staff was managing the launch of the Hybrid Retirement Plan, a significant accomplishment for fiscal year 2014. The agency-wide effort included development or modification of policies, procedures and processes for the hybrid plan; changes to VRS systems; procuring a new defined contribution plans record keeper; training and communications for external and internal stakeholders; and extensive outreach to employers. Post-implementation, staff continued to monitor system functionality, work with employers on payroll readiness and review operations with the record keeper and the Department of Accounts.

ICMA-RC became the provider of record-keeping services for the Hybrid Retirement Plan and the Commonwealth of Virginia Defined Contribution Plans in fiscal year 2014. The transition from ING, former record keeper for the defined contribution plans, was effected electronically at the beginning of January 2014 and resulted in the transfer of $2.3 billion in assets and the reconciliation of approximately 153,000 participant accounts. No action was required from participants, who enjoyed the same investment lineup and lower administrative fees.

Soon after the launch of the Hybrid Retirement Plan, Plan 1 and Plan 2 members could make an irrevocable election to opt into the hybrid plan. To assist eligible members in determining if they wanted to opt into the Hybrid Retirement Plan, VRS staff constructed an online calculator to help members compare VRS Plans 1 and 2 with the hybrid plan. This resource proved its value to more than 18,000 users of the calculator.

The VRS Board of Trustees recognizes and commends the VRS staff for implementing the Hybrid Retirement Plan, which required effort from many different areas within the agency and development of a new partnership with ICMA-RC. During this successful implementation, staff exemplified the agency's Core Values -- integrity, teamwork, accountability and agility -- in their work to launch the Hybrid Retirement Plan.

Following the implementation of the Hybrid Retirement Plan, VRS prepared to continue its Modernization program. Employers across Virginia began using myVRS Navigator in 2012 for reporting and submitting contributions and reviewing employees' VRS accounts. During the past two years, this platform has proven a strong foundation for future enhancements that will advance both efficiency and customer service. In Modernization Phase IV, beginning in fiscal year 2015, myVRS Navigator will expand to include online services available to members, such as requesting refunds, simulating alternative benefit options and applying for retirement.

VRS also has begun implementing the Governmental Accounting Standards Board (GASB) Statement Number 67, "Financial Reporting for Pension Plans," which addresses financial reporting for state and local pension administrators, and Statement Number 68, "Accounting and Financial Reporting for Pensions," which establishes new accounting and financial reporting requirements for state and local governments that provide their employees with pensions. For the first time, in fiscal year 2015, employers that issue financial statements will have to report retirement plan liabilities on their financial statements.

These statements effect important changes in how governments calculate and report costs and obligations associated with pensions. Employers will begin reporting net liabilities for pension plans in their fiscal year 2015 financial statements using fiscal year 2014 actuarial valuation data. Each employer that issues financial statements will have to report retirement plan liabilities on those statements. The new standards require the net pension liabilities of cost-sharing plans, such as VRS' teacher retirement plan, to be apportioned to each of the participating local governing bodies. To aid employers in meeting the new standards, VRS has created an online resource center that includes financial reporting guidelines, GASB guidance documents and presentations.

As we enter the second biennium of the phasing in of higher contribution rates, we appreciate your continuing commitment to achieving our share goal of fully funding the rates, especially as you face extremely difficult choices in today's economic climate. However, you have recognized that favorable investment returns, although encouraging, cannot support the entire system, and reduced costs from pension reform, although significant in the long term, will not have an immediate effect. Therefore, approval of the 80% funding rate for the 2014-2016 biennium was an important step toward funding the contribution rates at 100% of the Board-certified levels by fiscal year 2019.

We are fortunate that the Governor and the General Assembly continue to appoint skilled and capable VRS board members to guide the system through times of change. William H. Leighty was appointed by the Governor in March as the higher education representative. In April, Joseph W. Montgomery was appointed by the Joint Rules Committee as an investment expert.

In closing, I would like to offer my personal thanks for the opportunity to serve as Chairman of the Virginia Retirement System over the past few years. As my term as Chairman comes to a close in the spring of next year, let me express that it has been an honor to work with the Board of Trustees and VRS staff as we met great challenges and accomplished significant goals.

On behalf of the Board of Trustees and the VRS staff, I would like to express our gratitude for your continuing leadership and support. As always, the Board stands ready to assist you.

Sincerely

/s/ Diana F. Cantor
Chairman
Virginia Retirement System