2006 Annual Report

Minnesota State Board of Investment

02606.qxp 12/13/06 8:45 PM Page 1

2006 Annual Report

Table of Contents

Introduction ............................................................................................. 1

Funds Under Management ....................................................................... 2

Combined Funds ...................................................................................... 5

Basic Retirement Funds ........................................................................... 9

Post Retirement Fund ............................................................................ 12

Investment Pools .................................................................................... 15

Supplemental Investment Fund .............................................................. 25

State Deferred Compensation Plan ........................................................ 34

Assigned Risk Plan ................................................................................ 37

Permanent School Fund ......................................................................... 39

Environmental Trust Fund ..................................................................... 41

Closed Landfill Investment Fund........................................................... 43

Cash Management and Related Programs ............................................. 44

Other Deferred Compensation and Long Term Savings Program ......... 46

Major Policy Initiatives ......................................................................... 47

Investment Manager Summaries ............................................................ 54

Statistical Data ....................................................................................... 75

Section II ............................................................................................. 119

Auditor’s Report .................................................................................. 120

Financial Statements ............................................................................ 122

Footnotes to Financial Statements ....................................................... 125

Supplemental Financial Statements ..................................................... 131

Supplemental Investment Fund Combining Statements ................. 132

Pooled Investment Account Schedules ........................................... 150

Footnotes to Supplemental Financial Statements ........................... 158

Manager Fees ....................................................................................... 159

Summarized Asset Listings .................................................................. 161

This annual report can be accessed on our website at www.sbi.state.mn.us

MINNESOTASTATEBOARD OFINVESTMENT

Board MembersGovernorTim Pawlenty

State AuditorPatricia Anderson

Secretary of StateMary Kiffmeyer

Attorney GeneralMike Hatch

Executive Director

Howard J. Bicker

60 Empire DriveSuite 355

St. Paul, MN 55103(651) 296-3328

FAX (651) 296-9572E-mail:

minn.sbi@state.mn.uswww.sbi.state.mn.us

An Equal OpportunityEmployer

December, 2006

The Minnesota State Board of Investment (SBI) is pleased to present its report forthe fiscal year ending June 30, 2006.

Investment EnvironmentCapital markets were mixed during Fiscal Year 2006. The U.S. stock market increased 9.6%, asmeasured by the Russell 3000. Strong corporate profits, and favorable GDP growth outweighedconcerns about tensions in the Middle East, continued interest rate hikes by the Fed, and oil priceincreases.

International stock markets displayed continued strength for the third year in a row. The MorganStanley Capital International (MSCI) All Country World Index excluding the United States (ACWIEx U.S.), which represents the developed and emerging international markets outside the U.S.,returned 27.9% for the fiscal year.

The U.S. bond market, as measured by the Lehman Brothers Aggregate Bond Index, declined-0.8% during the fiscal year. The Fed raised rates eight times over the course of the fiscal year.Relatively strong economic growth over the past year coupled with increasing inflation expectationsresulted in continued Fed tightening.

SBI ResultsWithin this investment environment, the retirement assets under the Board’s control improved asfollows:

• The Basic Retirement Funds increased 12.6% during Fiscal Year 2006. Over the latest ten year period, the Funds have experienced an annualized return of 8.8%. (See page 9.)

• The Post Retirement Fund was up 12.0% for the Fiscal Year. Overall, the Fund provided a ten year annualized return of 8.3%. (See page 12.)

• The lifetime Post Retirement benefit increase for Fiscal Year 2006 will be 2.5%. The increasewill be payable to eligible retirees effective January 1, 2007.

On June 30, 2006, assets under management totaled $55.7 billion. This total is the aggregateof several separate pension funds, trust funds and cash accounts, each with different investmentobjectives. In establishing a comprehensive management program, the Board develops an investmentstrategy for each fund which reflects its unique requirements. The primary purpose of thisannual report is to communicate the investment goals, policies and performance of eachfund managed by the Board. Through the investment programs presented in this report, theMinnesota State Board of Investment seeks to enhance the management and performance of thefunds under its control.

Sincerely,

Howard BickerExecutive Director

The Legislature has established aseventeen member InvestmentAdvisory Council to advise theBoard and its staff on investment-related matters.

The mission statement of theInvestment Advisory Council is:The IAC fulfills its statutory duty tothe SBI by providing advice andindependent due diligence review ofthe investment policy andimplementation recommendationsthat guide the SBI’s investment ofassets.

The Board appoints ten membersexperienced in finance andinvestment. These memberstraditionally have come from theMinneapolis and St. Paul corporateinvestment community.

The Commissioner of Finance andthe Executive Directors of the threestatewide retirement systems arepermanent members of the Council.

Two active employee representativesand one retiree representative areappointed to the Council by theGovernor.

The Council has formed threecommittees organized around broadinvestment subjects relevant to theBoard’s decision-making process:Asset Allocation, Stock and BondManager and Alternative InvestmentManager.

Governor Tim Pawlenty, ChairState Auditor Patricia AndersonSecretary of State Mary KiffmeyerState Attorney General Mike Hatch

Investment Advisory Council

State Board of Investment

All proposed investment policies arereviewed by the appropriateCommittee and the full Councilbefore they are presented to theBoard for action.

Members of the Council

Michael L. Troutman, ChairStrategic Planning & DevelopmentBoard of Pensions EvangelicalLutheran Church in America

Malcolm W. McDonald, Vice ChairDirector & Corporate Secretary(Retired)Space Center, Inc.

Frank Ahrens, IIGovernor’s AppointeeActive Employee Representative

Jeffery BaileyDirector-Benefits FinanceTarget Corporation

David BergstromExecutive DirectorMn. State Retirement System

John E. BohanV.P., Pension Investments (Retired)Grand Metropolitan- Pillsbury

Kerry BrickManager, Pension InvestmentsCargill, Inc.

Douglas GorenceChief Investment OfficerU of M Foundation InvestmentAdvisors

Laurie Fiori HackingExecutive DirectorTeachers Retirement Association

Peggy IngisonCommissionerMn. Dept. of Finance

Heather JohnstonGovernor’s AppointeeActive Employee Representative

P. Jay KiedrowskiSenior FellowHumphrey InstituteUniversity of MN

Hon. Kenneth MaasGovernor’s AppointeeRetiree Representative

Judith W. MaresChief Investment OfficerAlliant Techsystems Inc.

Gary R. NorstremTreasurer, (Retired)City of St. Paul

Daralyn PeiferChief Investment OfficerGeneral Mills, Inc.

Mary VanekExecutive DirectorPublic Employees Retirement Assoc.

As of December 2006

Staff, Consultants & Custodians

Howard BickerExecutive Director

Mansco Perry IIIAssistant Executive Director

Investment Staff

Public EquitiesStephanie GleesonPortfolio Mgr., International Equities

Susan SuttonPortfolio Mgr., Domestic Equities

Patricia AmmannInvestment Analyst, DomesticEquities

Fixed Income andInternal InvestmentsMichael J. MenssenMgr., Long Term Internal Debt

Tammy BrusehaverPortfolio Mgr., Fixed Income

Alternative AssetsJohn N. GriebenowMgr., Private Equity Investments

Andrew ChristensenPortfolio Mgr., Private EquityInvestments

Cash ManagementSteven KuettelMgr., Short Term Debt

John J. KirbyInvestment Analyst, Short Term

Public ProgramsJames E. HeidelbergMgr., Public Programs &Governance

Deborah GriebenowAnalyst, Shareholder Services

Administrative Staff

Finance and AccountingL. Michael SchmittAdministrative Director

William NicolAccounting Supervisor, Senior

Jason WhiteAccounting Officer, Intermediate

Nancy L. WoldAccounting Officer, Intermediate

Kathy LeiszAccounting Officer, Intermediate

Support ServicesCharlene OlsonAdministrative Assistant to theExecutive Director

Carol NelsonOffice Administrative Specialist,Intermediate

Jessica FlahertyCustomer Services Specialist

Consultants

General ConsultantRichards & Tierney, Inc.Chicago, Illinois

Special Projects ConsultantPension Consulting AllianceStudio City, California

Custodian Banks

Retirement and Trust FundsState Street Bank & Trust Co.Boston, Massachusetts

State Cash AccountsWells Fargo & CompanySt. Paul, Minnesota

As of December 2006

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Introduction

The Minnesota State Board of Investment is responsible for theinvestment management of various retirement funds, trust funds andcash accounts. On June 30, 2006, the market value of all assets was$55.7 billion.

Constitutional and StatutoryAuthorityThe Minnesota State Board ofInvestment (SBI) is established byArticle XI of the MinnesotaConstitution to invest all state funds.Its membership as specified in theConstitution is comprised of theGovernor (who is designated as chairof the Board), State Auditor,Secretary of State and State AttorneyGeneral.

All investments undertaken by theSBI are governed by the prudentperson rule and other standardscodified in Minnesota Statutes,Chapter 11A and Chapter 356A.

Prudent Person RuleThe prudent person rule, as codifiedin Minnesota Statutes Section11A.09, requires all members of theBoard, Investment Advisory Council,and SBI staff to “...act in good faithand ...exercise that degree ofjudgment and care, undercircumstances then prevailing,which persons of prudence,discretion and intelligence exercisein the management of their ownaffairs, not for speculation, but forinvestment, considering the probablesafety of their capital as well as theprobable income to be derivedtherefrom.” Minnesota StatutesSection 356A.04 contains similarcodification of the prudent personrule applicable to the investment ofpension fund assets.

Authorized InvestmentsIn addition to the prudent personrule, Minnesota Statutes Section

11A.24 contains a specific list ofasset classes available forinvestment, including commonstocks, bonds, short term securities,real estate, private equity, andresource funds. The statutesprescribe the maximum percentageof fund assets that may be investedin various asset classes and containspecific restrictions to ensure thequality of the investments.

Investment PoliciesWithin the requirements defined bystate law, the State Board ofInvestment, in conjunction with SBIstaff and the Investment AdvisoryCouncil, establishes investmentpolicies for all funds under itsmanagement. These investmentpolicies are tailored to the particularneeds of each fund and specifyinvestment objectives, risk tolerance,asset allocation, investmentmanagement structure and specificperformance standards.

The Board has adopted guidelinesconcerning investments in stockmarkets outside the U.S. Theguidelines do not prohibit investmentin any market, but do require thatadditional notification and/orpresentation be provided to SBI staffor the SBI Administrative Committeein certain cases (refer to page 52 formore information on theseguidelines).

The Board, its staff, and theInvestment Advisory Council haveconducted detailed analyses of eachof the funds under the SBI’s controlthat address investment objectives,

asset allocation policy andmanagement structure. These studiesguide the on-going management ofthese funds and are updatedperiodically.

Important NotesReaders should note that the SBI’sreturns in this report are shown aftertransactions costs and fees arededucted. Performance is computedand reported after all applicablecharges to assure that the Board’sfocus is on true net returns.

Due to the large number ofindividual securities owned by thefunds managed by the SBI, thisreport contains only summarizedasset listings. A complete list ofsecurities is available upon requestfrom the State Board ofInvestment.

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Market ValueJune 30, 2006

Basic Retirement Funds $22.0 billionThe Basic Retirement Funds contain the pension assets of thecurrently working participants in eight statewide retirement plans:

Teachers Retirement Fund $7.392 billionPublic Employees Retirement Fund 6.043 billionState Employees Retirement Fund 5.045 billionPublic Employees Police and Fire Fund 2.759 billionCorrectional Employees Fund 303 millionHighway Patrol Retirement Fund 264 millionPublic Employees Correctional Fund 125 millionJudges Retirement Fund 49 million

Post Retirement Fund $21.9 billionThe Post Retirement Investment Fund is composed of the reserves forretirement benefits to be paid to retired employees. Lifetime retirementbenefit increases are permitted based on both inflation and investmentperformance.

Supplemental Investment Fund (SIF) $1.2 billionThe Supplemental Investment Fund includes assets of the unclassifiedstate employees retirement plan, other defined contribution retirementplans, and various retirement programs for local police andfirefighters. Participants may choose among seven separate accountswith different investment objectives designed to meet a wide range ofparticipant needs and objectives.

Income Share Account stocks and bonds $455 millionCommon Stock Index Account passively managed stocks 240 millionGrowth Share Account actively managed stocks 144 millionBond Market Account actively managed bonds 136 millionInternational Share Account non-U.S. stocks 111 millionFixed Interest Account stable value investments 73 millionMoney Market Account short-term debt securities 64 million

Non-Retirement Funds $1.5 billionAssigned Risk Plan $319 millionThe Minnesota Workers Compensation Assigned Risk Planprovides worker compensation insurance for companies unableto obtain coverage through private carriers.

Permanent School Fund $635 millionThe Permanent School Fund is a trust established for the benefitof Minnesota public schools.

Environmental Trust Fund $416 millionThe Environmental Trust Fund is a trust established for theprotection and enhancement of Minnesota’s environment. It isfunded with a portion of the proceeds from the state’s lottery.

Miscellaneous Accounts $267 million

Funds Under Management

3

Market ValueJune 30, 2006

State Deferred Compensation Plan $3.1 billionThe State Deferred Compensation Plan offers eleven mutual funds,a money market fund, a fixed interest fund, and the MinnesotaFixed Fund. The assets for each offering are shown below. (Benchmarksare shown in parentheses).

Large Cap Equity: Janus Twenty (S&P 500) $331 million Smith Barney Appr Y (S&P 500) 114 million Vanguard Institutional Index Plus (S&P 500) 418 million

Mid Cap Equity: Vanguard Mid-Cap Index (MSCI US Mid-Cap 450) 109 million

Small Cap Equity: T. Rowe Price Small-Cap Stock (Russell 2000) 396 million

Balanced: Dodge & Cox Balanced Fund (60% S&P 500/40% Lehman Agg) 239 million Vanguard Balanced Index Inst. Fund (60% Wilshire 5000, 40% Lehman Agg) 164 million

Bond: Dodge & Cox Income Fund (Lehman Aggregate) 78 million Vanguard Total Bond Market Index Inst. (Lehman Aggregate) 47 million

International: Fidelity Diversified International (MSCI EAFE-Free) 229 million Vanguard Inst. Dev. Markets Index Fund (MSCI EAFE) 48 million

Stable Value: Fixed Interest 124 million Money Market 56 million MN Fixed Fund 746 million

State Cash Accounts $5.9 billionThese accounts are the cash balances of state government funds,including the Invested Treasurers Cash Fund, transportation funds,and other miscellaneous cash accounts. Assets are invested in highquality, liquid, debt securities.

Total Assets Under SBI Management $55.7 billion

4

Funds Under Management

Growth in AssetsFiscal Years 2002-2006

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The Combined Funds are so namedbecause they represent the combinedassets of both the Basic RetirementFunds (the funds for activeemployees) and Post RetirementFund (the fund for retiredemployees). Unlike most other publicand corporate pension plans, theassets of active and retiredemployees are separated understatute and therefore managed andaccounted for separately. Moreinformation on the structure andperformance of the Basic and PostFunds is contained in the followingchapters.

While the Combined Funds do notexist under statute, the Board finds itinstructive to review asset mix andperformance of all defined benefit

The “Combined Funds” represent the assets of both active andretired public employees who participate in the defined benefit plansof three state-wide retirement systems: Teachers RetirementAssociation (TRA), Public Employees Retirement Association (PERA)and the Minnesota State Retirement System (MSRS). OnJune 30, 2006, the Combined Funds had a market value of$43.9 billion.

pension assets under its control. Thismore closely parallels the structure ofother public and corporate pensionplan assets and therefore allows formore meaningful comparison withother pension fund investors. Thecomparison universe used by the SBIis the Master Trust portion of theTrust Universe Comparison Service(TUCS). This universe containsinformation on public and corporatepension and trust funds with abalanced asset mix and over$1 billion in size.

It is important to note that thehistorical data on the CombinedFunds presented in this reportreflect only the Basic RetirementFunds through fiscal year 1993.Both the Basic and Post Funds areincluded thereafter.

This distinction is necessary due tothe very different asset allocationstrategies employed by the two fundsin the past. The Basic Funds havealways been managed to maximizetotal rates of return over the long-term and, therefore, its assetallocation has historically included asubstantial stock segment. Incontrast, until the post retirementbenefit increase formula was changedin 1993, the Post Retirement Fundwas managed to maximize currentincome which necessitated a largecommitment to bonds. As a result,the investment goals of the two fundswere incompatible for analyticalpurposes until fiscal year 1994.

Combined Funds

Cumulative Returns

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Figure 1. Performance of Capital Markets -FY 1997-2006

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MedianCombined Allocation Funds in TUCS*

Domestic Equity 48.1% 44.8%International Equity 15.5 15.4Bonds 23.4 25.9Alternatives** 10.0 7.1Cash 3.0 3.4

* Represents the median allocation by asset class, and does not add to 100%. ** TUCS may include assets other than alternatives.

Combined Funds

Asset Allocation

As illustrated in Figure 1 on the priorpage, historical evidence stronglyindicates that U.S. common stockswill provide the greatest opportunityto maximize investment returns overthe long-term. As a result, the Boardhas chosen to incorporate a largecommitment to common stocks in itsasset allocation policy for theretirement funds. In order to limit theshort run volatility of returnsexhibited by common stocks, theBoard includes other asset classessuch as bonds, real estate, andresource investments in the totalportfolio. These assets diversify theFunds and reduce wide fluctuationsin investment returns on a year toyear basis. This diversificationshould not impair the Funds’ abilityto meet or exceed their actuarialreturn targets over the long-term.

Asset Mix Compared toOther Pension FundsComparisons of the CombinedFunds’ actual asset mix to themedian allocation to stocks, bondsand other assets of the funds inTUCS on June 30, 2006 aredisplayed in Figure 2.

It shows that the Combined Fundswere overweighted in domesticequities, and alternative investmentsrelative to the median allocation inTUCS and underweighted in theirallocation to bonds. Historical data onthe Combined Funds’ asset mix isshown in Figure 3.

Return Objectives

The Combined Funds are evaluatedrelative to the following total rate ofreturn objectives:

—Provide Real Returns. Over atwenty year period, the CombinedFunds are expected to producereturns that exceed inflation by3-5 percentage points on anannualized basis.

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Figure 2. Combined Funds A s s et Mix Compar is on as of June 30 , 2006

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Annualized1 Yr. 3 Yr. 5 Yr. 10 Yr.

Combined Funds Percentile Rank in TUCS* 28th 32nd 53rd 49th

* Compared to public and corporate plans greater than $1 billion, gross of fees.

Combined Funds

—Match or Exceed MarketReturns. Over a ten year period,the Combined Funds are expectedto match or exceed a composite ofmarket indices weighted using theasset mix of the Combined Funds.

Investment Results

Comparison to InflationOver the last twenty years, theCombined Funds exceeded inflationby 6.7 percentage points, an amountwell in excess of the return objectivecited above. Historical resultscompared to inflation are shown inFigure 4.

Comparison to Other FundsWhile the SBI is concerned withhow its returns compare to otherpension investors, universecomparison data should be used withgreat care. There are two primaryreasons why such comparisons willprovide an “apples-to-oranges” lookat performance:

—Differing Allocations. Assetallocation has a dominant effecton returns. The allocation tostocks among the funds in TUCStypically ranges from 20-90%, avery wide range for meaningfulcomparison. In addition, itappears that many funds do notinclude alternative asset holdingsin their reports to TUCS. Thisfurther distorts comparisonsamong funds.

—Differing Goals/Liabilities. Eachpension fund structures itsportfolio to meet its ownliabilities and risk tolerance. Thismay result in different choices onasset mix. Since asset mix willlargely determine investmentresults, a universe ranking maynot be relevant to a discussion ofhow well a plan sponsor ismeeting its long-term liabilities.

Annualized1 Yr. 3 Yr. 5 Yr. 10 Yr. 20 Yr.

Combined Funds* 12.3% 13.2% 6.4% 8.6% 9.8% Inflation 3.5 3.1 2.5 2.5 3.1

* Includes Basic Funds only through 6/30/93, Basic and Post Funds thereafter.

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Composite Index for Period Ending on June 30, 2006

Market Composite Asset Class Index Index Wts.*

Domestic Stocks Russell 3000 49.5%

Int’l. Stocks MSCI ACWI Free ex. U.S. 15.0

Domestic Bonds Lehman Aggregate 24.5

Alternative Investments Alternative Investments 9.0

Unallocated Cash 3 Month T-Bills 2.0

Total 100.0%

* Weights are reset in the composite at the start of each month to reflect the combined allocation policies of the Basic and Post Funds.

Annualized1 Yr. 3 Yr. 5 Yr. 10 Yr.

Combined Funds* 12.3% 13.2% 6.4% 8.6%Composite Index 12.2 12.9 6.4 8.3

Combined Funds

With these considerations in mind,the performance of the CombinedFunds compared to other public andcorporate pension funds with over$1 billion in assets in the MasterTrust portion of TUCS is displayedin Figure 5 on the previous page. Itshows that the Combined Funds haveranked above the median over thelast ten year period.

Comparison to Market ReturnsThe Combined Funds’ performanceis also evaluated relative to acomposite of market indices which isweighted in a manner that reflects theactual asset allocation of theCombined Funds. Performanceresults and a breakdown of thecomposite index are shown inFigure 6. The Combined Fundsexceeded the composite index by 0.3percentage point over the last tenyears and, therefore, met their statedperformance goal. The Fundsmatched the composite index overthe last five years, and exceeded by0.1 percentage point over the mostrecent fiscal year. These results arelargely a measure of value added orlost from active management after allfees and expenses have been takeninto consideration.

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Figure 7 identifies the eight differentretirement funds which comprise theBasic Funds. The Basic Funds investthe pension contributions thatemployees and employers make todefined benefit pension plans duringthe employees’ years of activeservice.

Investment Objectives

The State Board of Investment (SBI)has one overriding responsibilitywith respect to its management of theBasic Funds: to ensure that sufficientfunds are available to financepromised benefits at the time ofretirement.

Actuarial Assumed ReturnEmployee and employer contributionrates are specified in state law as a

The Basic Retirement Funds accumulate the retirement assets ofpublic employees during their working years. On June 30, 2006, theFunds covered over 360,000 active employees and had a marketvalue of $22.0 billion.

percentage of an employee’s salary.The rates are set so that contributionsplus expected investment earningswill cover the projected cost of theinitially promised pension benefits.In order to meet these projectedpension costs, the Basic RetirementFunds must generate investmentreturns of at least 8.5% on anannualized basis, over time.

Time HorizonNormally, pension assets willaccumulate in the Basic RetirementFunds for thirty to forty years duringan employee’s years of activeservice. This provides the BasicFunds with a long investment timehorizon and permits the Board totake advantage of the long run returnopportunities offered by commonstocks and other equity investmentsin order to meet its actuarial returntarget.

Return ObjectiveThe Board measures the performanceof the Basic Retirement Fundsrelative to a composite of marketindices that is weighted using theFunds’ long-term asset allocationpolicy. The Basic Funds are expectedto match or exceed their compositeindex over a ten year period.Performance is reported net of allfees and costs to assure that theBoard’s focus is on its true net return.

Asset Allocation

The allocation of assets amongstocks, bonds, alternativeinvestments and cash can have adramatic impact on investmentresults. In fact, asset allocationdecisions overwhelm the impact ofindividual security selection within atotal portfolio. The asset allocationof the Fund is under constant review.

Long-Term Allocation PolicyBased on the Basic Funds’investment objectives and theexpected long run performance ofthe capital markets, the current long-term asset allocation policy for theBasic Funds is as follows:

Domestic Stocks 45%International Stocks 15Bonds 24Alternative Assets 15Unallocated Cash 1

It should be noted that the unfundedallocation to alternative investmentsin the Basic Funds is held in

Basic Retirement Funds

Figure 7 . Compos ition o f Bas ic Funds as o f June 30 , 2006

Correctional Employees - 1.4%

Highw ay Patrol - 1.2%

Teacher's Ret. - 33.6%

Public Emp. Police & Fire - 12.6%

State Employees Ret. - 23.0%

Public Employees Ret. - 27.5%

Judges Ret. - 0.2%

Public Employee Corrections - 0.6%

Notes: Percentages may differ slightly due to rounding of values.

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domestic stocks until it is needed forinvestment. As a result, the actualamount invested in domestic stockswas above its long-term target.

Figure 8 presents the actual asset mixof the Basic Funds at the end offiscal year 2006. Historical asset mixdata are displayed in Figure 9.

During Fiscal Year 2004, the Boardprovisionally revised its long termasset allocation targets for the BasicFunds. Upon the Post RetirementFund achieving its alternativeinvestment target, the Basic Funds’allocation target may increase from15% to 20% by decreasing the fixedincome target from 24% to 19%.Additionally, the Basic Funds willinvest in yield-oriented investmentsas part of its allocation to alternativeinvestments.

Total Return VehiclesThe SBI invests the majority of theBasic Funds’ assets in commonstocks (both domestic andinternational). A large allocation isconsistent with the investment timehorizon of the Basic Funds and theadvantageous long-term risk-returncharacteristics of common stocks.

Including international stocks in theasset mix allows the SBI to diversifyits holdings across world markets andoffers the opportunity to enhancereturns and reduce the risk/volatilityof the total portfolio. The rationaleunderlying the inclusion of privateequity (e.g., venture capital andleverage buyouts) is similar.

The Board recognizes that thissizable policy allocation to commonstock and private equity likely willproduce more volatile portfolioreturns than a more conservativepolicy focused on fixed incomesecurities. It is understood that this

policy may result in quarters, or evenyears, of disappointing results.Nevertheless, the long run returnbenefits of this policy are expected tocompensate for the additionalvolatility.

Diversification VehiclesThe Board includes other assetclasses in the Basic Funds both toprovide some insulation againsthighly inflationary or deflationaryenvironments and to diversify theportfolio sufficiently to avoidexcessive return volatility.

Real Estate and resource (oil andgas) investments provide an inflationhedge that other financial assetscannot offer. In periods of rapidlyrising prices, these assets haveappreciated in value at a rate at leastequal to the inflation rate. Further,even under more normal financialconditions, such as low to moderateinflation, the returns on these assetsare not highly correlated withcommon stocks. As a result, theirinclusion in the Basic Funds servesto dampen return volatility.

The allocation to bonds acts as ahedge against a deflationaryeconomic environment. In the eventof a major deflation, high qualityfixed income assets, particularlylong-term bonds, are expected to

Basic Retirement Funds

Figure 8 . Bas ic Funds A s s e t Mix as o f June 30, 2006

Notes: Percentages may differ slightly due to rounding of values. Uninvested portions of the allocation to Alternative Assets are held in Domestic Stocks.

Dom. Stocks ($10.77 Billion) - 49.0%

Cash ($0.20 Billion) - 0.9%

Alt. Assets ($2.47 Billion) -11.2%

Int'l. Stocks ($3.47 Billion) - 15.8%

Bonds ($5.07 Billion) - 23.1%

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Figure 9 . Bas ic Funds His to r ic a l A s s e t Mix FY 2002 -2006

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protect principal and generatesignificant capital gains. Bonds, likereal estate and resource funds, undernormal financial conditions, help todiversify the Basic Funds, therebycontrolling return volatility.

Yield oriented alternativeinvestments provide the opportunityfor higher long term returns thanthose typically available from bondsyet still generate sufficient currentincome. Typically, these investments(e.g., subordinated debt, mezzanineor resource income investments suchas producing properties) arestructured more like fixed incomesecurities with the opportunity toparticipate in the appreciation of theunderlying assets. While theseinvestments may have an equitycomponent, they display a returnpattern more like a bond. As such,they will help reduce the volatility ofthe total portfolio, but should alsogenerate higher returns relative tomore traditional bond investments.

Investment Management

All assets in the Basic RetirementFunds are managed externally byoutside money management firmsretained by contract. In order to gaingreater operating efficiency, theBasic Funds share the same domesticstock, international stock, fixedincome, and alternative investmentmanagers with the Post Fund.

More information on the structure,management and performance ofthese pools of managers is includedin the Investment Pool section ofthis report.

Investment Performance

As stated earlier, the Basic Funds areexpected to match or exceed thereturn of a composite of marketindices over a ten year period.Performance relative to this standardwill measure two effects:

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Basic Funds -8.2% 1.9% 16.6% 11.0% 12.6% 13.4% 6.4% 8.8% Composite Index -8.1 2.4 16.3 10.9 12.6 13.2 6.4 8.5

Basic Retirement Funds

— The ability of the managersselected by the SBI, in aggregate,to add value to the returnsavailable from the broad capitalmarkets.

— The impact of the SBI’s re-balancing activity. The SBIrebalances the total fund whenmarket movements take the stock(domestic and international),bond, or cash segments above orbelow long term asset allocationtargets. This policy imposes alow risk discipline of “buy low-sell high” between asset classeson a total fund basis.

For the ten year period endingJune 30, 2006, the Basic Fundsoutperformed the composite index by0.3 percentage point annualized. TheFund matched the composite indexover the last five years, and matchedover the most recent fiscal year.Actual returns relative to the totalfund composite index for each of thelast five years are shown inFigure 10.

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Figure 10 . Bas ic Funds ' Per f o rmanc e v s . Compos ite Index FY 2002-2006

12

The Post Retirement Fund includesthe assets of retired public employeescovered by nine statewide retirementplans; the eight plans whichparticipate in the Basic RetirementFunds as well as the Legislative andSurvivors Retirement Fund.

Benefit Increase Formula

The retirement benefit increaseformula of the Post Retirement Fundis based on a combination of twocomponents:

— Inflation Component. Each year,retirees receive an inflation-basedadjustment equal to 100% ofinflation, up to a maximumspecified in statute. The inflationcomponent is granted regardlessof investment performance. Thecap is necessary to maintain theactuarial soundness of the entireplan. The cap is the differencebetween the return assumption forthe Basic Funds, and the returnassumption for the Post Fund.

The return assumption in theBasic Funds is 8.5%. The returnassumption for the Post Fund was5.0% through fiscal year 1997. Infiscal year 1998, the returnassumption for the Post Fund waschanged to 6.0%. This means thecap on the inflation adjustmentwas 3.5% for fiscal years 1993-1997. Since fiscal year 1998, theinflation cap has been 2.5%.

The assets of the Post Retirement Fund are used to finance monthlyannuities to retired public employees. These annuities may beadjusted upwards over the life of a retiree based on a formula thatreflects both inflation and investment performance. On June 30, 2006,the Post Fund had a market value of $21.9 billion and more than138,000 retiree participants.

Retirees were given a one timepermanent adjustment in theirpension to compensate them forthe reduction in the inflationadjustment cap.

— Investment Component. Eachyear, retirees can also receive aninvestment-based adjustment,provided net investment gains areabove the amount needed tofinance the Post Fund’s actuarialassumption and the inflationadjustment. Investment gains andlosses are spread over five yearsto smooth out the volatility ofreturns. In addition, allaccumulated investment losses

must be recovered before aninvestment-based adjustment isgranted.

Investment Objective

Time HorizonThe time horizon of the Post Fund is15 to 20 years and corresponds to thelength of time a typical retiree can beexpected to draw benefits. While thisis shorter than the time horizon of theBasic Funds, it is still sufficientlylong to allow the Board to takeadvantage of the long run returnopportunities offered by commonstocks in order to meet its actuarialreturn target as well as to financeretirement benefit increases.

Post Retirement Fund

Figure 11. Pos t Fund A s s et Mix as o f June 30, 2006

Notes: Percentages may differ slightly due to rounding of values. Uninvested portions of the Alternative Assets allocation are held in Domestic Stocks.

Alt. Assets ($1.90 Billion) - 8.7%

Bonds (5.20 Billion) - 23.7%

Dom. Stocks ($10.34 Billion) - 47.2%

Int'l. Stocks ($3.34 Billion) - 15.3%

Cash ($1.13 Billion) - 5.1%

13

Return ObjectiveThe Board measures the performanceof the Post Retirement Fund relativeto a composite of market indicesusing its long-term asset allocationpolicy. The Post Fund is expected tomatch or exceed its composite indexover a ten year period. Performanceis reported net of all fees and costs toassure that the Board’s focus is ontrue net return.

Asset Allocation

The current long-term assetallocation for the Post Fund is asfollows:

Domestic Stocks 45%Int’l. Stocks 15Bonds 25Alternative Assets 12Unallocated Cash 3

The Post Fund’s fiscal year-end assetmix is presented in Figure 11 on theprevious page. Historical asset mixdata are shown in Figure 12.

The SBI invests the majority of thePost Fund’s assets in common stocks

(both domestic and international). Alarge allocation is consistent with themoderately long time horizon of thePost Fund and the advantageous longterm risk-return characteristics ofcommon stocks. Includinginternational stocks in the asset mixallows the SBI to diversify itsholdings across world markets andoffers the opportunity to enhancereturns and reduce the risk/volatilityof the total portfolio.

As with the Basic Funds, the Boardrecognizes that this sizable allocationwill be likely to produce morevolatile portfolio returns than a moreconservative policy focused on fixedincome securities. It is understoodthat this policy may result inquarters, or even years, ofdisappointing results. Nevertheless,the long run return benefits of thispolicy are expected to compensatefor the additional volatility. The assetallocation is under constant review.During Fiscal Year 2004, the SBIrevised its long term asset allocationtargets for the Post Fund. Theallocation target for alternativeinvestments was increased from 5%to 12%, while decreasing domestic

equity from 50% to 45% anddecreasing fixed income from 27%to 25%. Additionally, the Post Fundwill invest in private equity, realestate, and resource investments aswell as yield-oriented investments aspart of its allocation to alternativeinvestments. Finally, uninvestedportions of the alternativeinvestments will be invested indomestic equities instead of bonds.

Diversified VehiclesThe Board includes other assetclasses in the Post Fund both toprovide some insulation againsthighly deflationary environments andto diversify the portfolio sufficientlyto avoid excessive return volatility.Including private equity in the PostFund is intended to enhance returnsand reduce the risk of the totalportfolio.

Real Estate and resource (oil andgas) investments provide an inflationhedge that other financial assetscannot offer. In periods of rapidlyrising prices, these assets haveappreciated in value at a rate at leastequal to the inflation rate. Further,even under more normal financialconditions, such as low to moderateinflation, the returns on these assetsare not highly correlated withcommon stocks. As a result, theirinclusion in the Post Fund also servesto dampen return volatility.

The bonds in the Post Fund act as ahedge against a deflationaryeconomic environment. In the eventof a major deflation, high qualityfixed income assets, particularly longterm bonds, are expected to protectprincipal and generate significantgains. And, under more normalfinancial conditions, bonds diversifythe Post Fund, thereby controllingreturn volatility on a year-to-yearbasis.

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Fig u r e 1 2 . Po s t Fu n d His to r ic a l A s s e t M ix FY 2 0 0 2 - 2 0 0 6

14

Yield oriented alternativeinvestments provide the opportunityfor higher long term returns thanthose typically available from bonds,yet still generate sufficient currentincome to be compatible with theobjectives of the Post Fund.Typically, these investments(e.g., subordinated debt, mezzanineor resource income investments suchas producing properties) arestructured more like fixed incomesecurities with the opportunity toparticipate in the appreciation of theunderlying assets. While theseinvestments may have an equitycomponent, they display a returnpattern more like a bond. As such,they will help reduce the volatility ofthe total portfolio but should alsogenerate higher returns relative tomore traditional bond investments.

Investment Management

In order to gain greater operatingefficiency, the Basic and Post Fundsshare the same domestic stock, fixed

income, international stock, andalternative investment managers.More information on the structure,management and performance ofthese pools of managers is includedin the Investment Pool section ofthis report.

Investment Performance

Total Fund PerformanceAs stated earlier, the Post Fund isexpected to exceed the return of acomposite of market indices over aten year period. The Post Fund’sperformance exceeded its compositemarket index by 0.3 percentage pointfor the most recent ten year period.The fund matched the compositeindex over the last five years, andexceeded by 0.2 percentage pointover the most recent fiscal year.

Actual returns relative to the totalfund composite index for each of thelast five years are shown inFigure 13.

Benefit IncreaseThe Post Fund will provide a benefitincrease of 2.5% for fiscal year 2006payable beginning January 1, 2007.As noted earlier, this increase iscomprised of two components:

—Inflation component of 2.5%which is the maximum allowableincrease. The increase in theConsumer Price Index for wageearners (CPI-W) for the twelvemonths ending June 30, 2006 was4.5%. (This is the same inflationindex used to calculate increasesin Social Security payments).

—Investment component of 0%.This represents a portion of themarket value increase that exceedsthe amount needed to cover theactuarial assumed rate of return(6.0% beginning FY98) and theinflation adjustment.

Benefit increases for the past tenyears are shown in Figure 14.

More detail on the calculation for thefiscal year 2006 benefit increase isincluded in the Statistical Datasection.

Figure 14. Historical Benefit Increases Granted

Benefit Fiscal Year* Increase

1997 10.1% 1998 9.8 1999 11.1 2000 9.5 2001 4.5

2002 0.72003 2.12004 2.52005 2.52006 2.5

* Payable beginning January 1,

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Post Fund -7.8% 2.8% 16.3% 10.5% 12.0% 12.9% 6.4% 8.3% Composite Index -7.4 3.3 15.7 10.2 11.8 12.5 6.4 8.0

Post Retirement Fund

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Figure 13. Pos t Fund's Per f ormanc e v s . Compos ite Index FY 2002-2006

15

The Basic Retirement Funds, PostRetirement Fund and SupplementalInvestment Fund share many of thesame stock and bond managers. Thisis accomplished by groupingmanagers together, by asset class,into several Investment Pools. Theindividual funds participate in theInvestment Pools by purchasing“units” which function much likeshares of a mutual fund.

This investment managementstructure allows the State Board ofInvestment (SBI) to gain greateroperating efficiency within assetclasses and to keep managementcosts as low as possible for allparticipants.

DomesticStock Pool

The Basic Retirement Funds haveparticipated in the Domestic StockPool since its inception in January1984. The Post Retirement Fund hasparticipated in the Pool since July1993. In addition, the Growth ShareAccount, Common Stock IndexAccount, and the stock portion of theIncome Share Account in theSupplemental Investment Fundparticipate in the Pool.

As of June 30, 2006, the dollar valueof each fund’s participation in thePool was:

Basic Funds $10.8 billion(active, passive and semi-passive)

To gain greater operating efficiency, external managers are groupedinto several “Investment Pools” which are segregated by asset class.The various retirement funds participate in one or more of the poolscorresponding to their individual asset allocation strategies.

Post Fund $10.3 billion(active, passive and semi-passive)

Growth ShareAccount $144 million(active and semi-passive)

Common StockIndex Account $240 million(passive)

Stock portion ofthe Income ShareAccount $279 million(passive)

Management StructureThe SBI uses a three-part approachto the management of the DomesticStock Pool:

— Active Management. At the endof fiscal year 2006, approximately33% of the Domestic Stock Poolwas actively managed by a groupof external money managers. Theassets allocated to each of themanagers ranged from $27 to$886 million. The activelymanaged segment of the Poolincludes managers in the SBI’sEmerging Manager Program.Generally, firms designated asEmerging Managers by the SBIare smaller organizations ormanaging newer products than thelarger active domestic equitymanagers in the Domestic StockPool.

— Semi-Passive Management. Atthe end of fiscal year 2006,approximately 34% of the

Domestic Stock Pool wasmanaged by a group of threesemi-passive external moneymanagers with portfolios rangingfrom $2.1 to $3.0 billion.

— Passive Management. At the endof fiscal year 2006, approximately33% of the Stock Pool wasmanaged passively by a singlemanager with a portfolio of$7.2 billion.

The goal of the Domestic Stock Poolis to add value to the asset classtarget, which has been the Russell3000 Index since October 1, 2003.The Russell 3000 Index can besegmented into sub-indexes orRussell style indexes. Each activemanager is expected to addincremental value over the long runrelative to a Russell style indexwhich reflects its investmentapproach or style.

Assets are allocated by the Russellstyle indexes in proportion to theirweighting within the Russell 3000.Assets are then allocated to eachmanager within the managers’designated style. This allocation isdone to minimize the misfit or stylebias within the Domestic Stock Pool.

Prior to October 1, 2003, theperformance of active managers inthe Domestic Stock Pool wasmeasured against customizedbenchmarks which reflected themanager’s unique investmentapproach or style. This type ofactive manager structure could result

Investment Pools

16

in misfit or style bias. “Misfit” isdefined as the difference between theaggregate benchmarks of the activemanagers and the asset class target.

The SBI attempted to compensate foractive manager misfit through the useof a completeness fund. A“completeness fund” is so namedbecause it is intended to fill in, orcomplete, any areas of marketexposure that are not being coveredby the aggregate benchmarks of theactive managers. The completenessfund has not been used sinceDecember 31, 2003. Since that time,the SBI has attempted to controlmisfit by allocating assets on thebasis of managers’ investment styleindexes.

The SBI’s completeness fund waspassively managed when it was firstintroduced in October 1990 untilDecember 1994. During fiscal year1995, the completeness fund movedfrom being entirely passivelymanaged to a structure that was halfpassive/half semi-passive. At the startof fiscal year 1996, the completenessfund was allocated entirely to semi-passive management. Semi-passiveapproaches provide the potential tooutperform the completeness fundbenchmark, but also incorporateprocedures that constrain the level ofrisk/volatility relative to thebenchmark.

During fiscal year 1997, severalcurrent active managers modifiedtheir investment processes in order toincrease the probability of producingvalue added in their portfolios.Three managers (Alliance CapitalMgmt., Franklin Portfolio Assoc.,and Oppenheimer Capital) wereasked to increase the level of activerisk in their portfolio resulting in areduction in the number of issuesheld at any one time. During fiscalyear 2000, Brinson (now UBSGlobal Asset Mgmt.) was asked to

eliminate investments in small post-venture companies (about 7% oftheir portfolio) and to increase theactive risk in their portfolio as well.In effect, these managers now holdmore concentrated portfolios andmake larger bets on their “best”stock ideas.

A description of each domestic stockmanager’s investment approach isincluded in the InvestmentManager Summaries section.

FY 2006 ChangesDuring fiscal year 2006, no changeswere made to the managers in theDomestic Stock Pool.

Investment PerformanceA comprehensive monitoring systemhas been established to ensure thatthe many elements of the DomesticStock Pool conform to the SBI’sinvestment policies. Publishedperformance benchmarks are usedfor each active, emerging and semi-passive stock manager. These

benchmarks enable the SBI toevaluate the managers’ results, bothindividually and in aggregate, withrespect to risk incurred and returnsachieved.

Two primary long run risk objectiveshave been established for thedomestic stock managers:

— Investment Approach. Eachmanager (active, semi-passive, orpassive) is expected to hold aportfolio that is consistent, interms of risk characteristics, withthe manager’s stated investmentapproach. In the short run, theactive stock managers may departfrom their risk targets as part oftheir specific investmentstrategies.

— Diversification. The passive andsemi-passive managers areexpected to hold highly diversifiedportfolios, while each activedomestic stock manager isexpected to hold a portfolio

Investment Pools

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Stock Pool -18.0% 0.4% 20.3% 8.6% 8.9% 12.5% 3.2% 8.0% Domestic -17.3 0.8 20.6 8.1 9.6 12.6 3.5 8.0 Equity Asset Class Target

* Reflects the Russell 3000 since 10/1/2003; the Wilshire 5000 Investable from 7/1/1999 thru 9/30/03; and the Wilshire 5000 as reported prior to FY 2000.

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Figure 15 . Domes tic Stoc k Poo l Per f ormanc e FY 2002-2006

17

appropriately diversified for theparticular investment strategy andstyle.

The domestic stock managerssuccessfully fulfilled their long-termrisk objectives during fiscal year2006. In general, the managersconstructed portfolios consistent withtheir stated investment approachesand maintained levels ofdiversification that were appropriateto their respective active, semi-passive and passive approaches.

The Board’s return objectives for itsactive and semi-passive stockmanagers are measured against theperformance of published Russellstyle indices that represent amanager’s specific investmentapproach. These indices take intoaccount the equity market forces thatat times favorably or unfavorablyimpact certain investment styles.Thus, a Russell style index orbenchmark is a more appropriatereturn target against which to judge amanager’s performance than a broadmarket index.

Individual active managers areexpected to exceed their benchmarkby an amount appropriate for theiractive risk level. This active risklevel varies by manager and isinfluenced by the manager’s statedstrategy and style.

In aggregate, the Domestic StockPool underperformed the Russell3000 Index by 0.7 percentage pointfor the fiscal year. The active andsemi-passive componentsunderperformed the respectivebenchmark, while the passivecomponent outperformed itsbenchmark. Relative to the aggregatebenchmark, the active managergroup’s underperformance was duelargely to an overweight allocation tothe consumer discretionary sectorcombined with weak stock selection.

Figure 16. Domestic Stock Manager Performance FY 2006

Actual BenchmarkReturn Return

Active Managers Large Cap Core (Russell 1000) Franklin Portfolio Associates 9.5% 9.1% New Amsterdam Partners 6.1 9.1 UBS Global Asset Management 9.9 9.1 Voyageur-Chicago Equity 4.0 9.1

Large Cap Growth (Russell 1000 Growth) Alliance Capital Management 6.7 6.1 Cohen Klingenstein & Marks -6.3 6.1 Holt-Smith & Yates -0.2 6.1 INTECH 6.7 6.1 Jacobs Levy Equity Mgmt. 4.0 6.1 Lazard Asset Mgmt. 7.4 6.1 Sands Capital Mgmt. 3.1 6.1 Winslow Capital Mgmt. 10.3 6.1 Zevenbergen Capital 13.0 6.1

Large Cap Value (Russell 1000 Value) Barrow, Hanley 6.7 12.1 Earnest Partners 12.0 12.1 Lord Abbett & Co. 12.4 12.1 LSV Asset Mgmt. 15.3 12.1 Oppenheimer Capital 4.5 12.1 Systematic Financial Mgmt. 12.6 12.1

Small Cap Growth (Russell 2000 Growth) McKinley Capital 18.3 14.6 Next Century Growth 30.6 14.6 Summit Creek Advisors 6.1 14.6 Turner Investment Partners 18.3 14.6

Small Cap Value (Russell 2000 Value) Goldman Sachs 12.7 14.6 Hotchkis & Wiley 4.9 14.6 Martingale Asset Mgmt. 9.3 14.6 Peregrine Capital Mgmt. 11.8 14.6 RiverSource/Kenwood 16.0 14.6

Semi-Passive Managers (Russell 1000) Barclays Global Investors 10.0 9.1 Franklin Portfolio Associates 9.2 9.1 J.P. Morgan Investment Mgmt. 7.3 9.1

Passive Manager (Russell 3000) Barclays Global Investors 9.7 9.6

Historical Aggregate 8.9 9.5 SBI Domestic Equity Asset Class Target 9.6

Investment Pools

18

Ineffective stock selection withintechnology further detracted fromperformance. The semi-passivemanagers underperformed duelargely to weak sector allocationdecisions.

Figure 15 (on page 16) providesmore detail on the historicalperformance of the entire pool.Individual manager performancerelative to their respectivebenchmarks was mixed. Fourteenactive managers outperformed, andfourteen underperformed theirbenchmarks. Two semi-passivemanagers outperformed, and oneunderperformed the benchmark.The passive manager outperformedits target, the Russell 3000 index.Individual manager performance forfiscal year 2006 is shown in Figure16 (on page 17).

Historical information on individualmanager performance and portfoliocharacteristics is included in theStatistical Data section. Section IIof the Annual Report providesSummarized Asset Listings for eachmanager and the Pool in aggregate.

Bond Pool

The Basic Retirement Funds haveparticipated in the Bond Pool sinceits inception in July 1984. The PostRetirement Fund has participated inthe Pool since July 1993. In addition,the Bond Market Account in theSupplemental Investment Fund hasutilized portions of the Pool sinceJuly 1986.

As of June 30, 2006, the dollar valueof each fund’s participation in thePool was:

Basic Funds $5.1 billion(active and semi-passive)

Post Fund $5.2 billion(active and semi-passive)

Bond Market $136 millionAccount(active and semi-passive)

Investment ManagementThe SBI uses a two-part approach forthe management of the Bond Pool:

— Active Management. No morethan one-half of the Bond Poolwill be actively managed. At theend of fiscal year 2006,approximately 50% of the BondPool was actively managed by agroup of five external moneymanagers with portfolios of$850 million to $1.4 billion each.

— Semi-Passive Management. Atleast one-half of the assetsallocated to the Bond Pool will bemanaged by semi-passivemanagers. At the end of fiscalyear 2006, approximately 50% ofthe bond segment was invested bythree managers with portfolios of$1.6 to $1.8 billion each.

The group of active bond managersis retained for its blend of investmentstyles. Each active manager has thegoal of adding incremental value tothe Lehman Aggregate Bond Indexby focusing on high quality fixedincome securities across all sectorsof the market. The managers vary,however, in the emphasis they placeon interest rate anticipation and inthe manner in which they approachsecurity selection and sectorweighting decisions. In keeping withthe objective of utilizing the BondPool as a deflation hedge, the activemanagers are restricted regarding theduration of their portfolios. Thisrequirement is designed to preventthe total pool from assuming anexcessively short-lived position andthus, severely diluting its deflationhedge capacity. In addition, theduration restriction helps to avoidextreme variability in total returns.The SBI constrains the durationrange of the active managers’portfolios to a band of plus or minustwo years around the duration of the

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Bond Pool 8.2% 10.7% 1.5% 7.1% -0.2% 2.7% 5.4% 6.6% Asset Class Target* 8.6 10.4 0.3 6.8 -0.8 2.1 5.0 6.2

* The Bond Pool asset class target has been the Lehman Brothers Aggregate Bond Index since July 1994.

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Figure 17. Bond Pool Per f o rmanc e FY 2002-2006

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Lehman Aggregate. The active bondmanagers focus on high quality(BBB or better) rated bonds. Somemanagers have been grantedauthority to invest a limited portionof their portfolios in BB and B rateddollar denominated debt or in non-dollar denominated issues. Themanagers use this additionalauthority on a tactical basis.

The goal of the semi-passivemanagers is to add incremental valueto the Lehman Brothers AggregateBond Index through superior bondselection and sector allocation. Semi-passive managers’ portfolios areconstrained to plus or minus 0.2years around the duration of theLehman Aggregate. Semi-passivemanagers seek to add value byexploiting perceived mispricingsamong individual securities or bymaking alterations in the sectorweightings within the portfolio.Although the managers seek toexceed the performance of the index,the possibility exists that the semi-

passive approach may slightly under-perform the target index during someperiods. One manager has beengranted authority to invest a limitedportion of their portfolio in BB andB rated dollar denominated debt or innon-dollar denominated issues. Themanager uses this additionalauthority on a tactical basis.

A description of each bondmanager’s investment approach isincluded in the InvestmentManager Summaries section.

Investment PerformanceThe SBI constrains the risk of theactive bond managers’ portfolios toensure that they fulfill their deflationhedge and total fund diversificationroles. As noted earlier, the managersare restricted in terms of the durationof their portfolios and the quality oftheir fixed income investments. Theactive and semi-passive bondmanagers successfully fulfilled theirlong-term risk objectives duringfiscal year 2006. The managers

constructed portfolios consistent withtheir stated investment approachesand maintained appropriate levels ofquality and duration.

The returns of each of the Board’sbond managers are compared to theLehman Aggregate. Due to the broaddiversification of each manager,customized benchmarks are notdeemed necessary for the bondmanagers at this time. Individualactive managers are expected toexceed the target by 0.25 percentagepoint annualized, over time, and eachsemi-passive manager is expected toexceed the target by 0.10 percentagepoint annualized, over time.In total, the Pool outperformed theLehman Aggregate index by 0.6percentage point for the recent fiscalyear. Relative to the benchmark, thepool benefited from a shorter thanbenchmark duration bet and securityselection.

Performance over longer periods hasbeen positive, exceeding the assetclass target by 0.4 percentage pointover the ten year period endingJune 30, 2006. In general, themanager’s various interest ratesensitivity strategies along withexposure and security selection in thespread sectors (corporate andmortgage securities) accounted forthe relative performance over thelonger term. The relativeperformance of individual activemanagers retained by the Board overthe fiscal year was good; all fivemanagers exceeded the benchmark’sperformance. Among the semi-passive managers, all three managersoutperformed the index over thefiscal year.

Figure 17 (on page 18 ) showshistorical performance for the entirePool. Individual managerperformance for fiscal year 2006 isshown in Figure 18 (on page 19).

Figure 18. Bond Manager Performance FY 2006

Actual BenchmarkReturn Return

Active Managers Aberdeen Asset Mgmt. -0.6% -0.8% Dodge & Cox Investment Mgmt. 0.7 -0.8 Morgan Stanley Investment Mgmt. 0.9 -0.8 RiverSource Investments -0.1 -0.8 Western Asset Mgmt. -0.3 -0.8

Semi-Passive Managers BlackRock Financial Mgmt. -0.4 -0.8 Goldman Sachs Asset Mgmt. -0.5 -0.8 Lehman Brothers Asset Mgmt. -0.7 -0.8

Aggregate Bond Pool -0.2 -0.8

Asset Class Target Lehman Aggregate -0.8

Investment Pools

20

Historical information on individualmanager performance and portfoliocharacteristics is included in theStatistical Data section. Section IIof this report provides SummarizedAsset Listings for each manager andthe Pool in aggregate.

InternationalStock Pool

The SBI began its international stockprogram in October 1992. The BasicRetirement Funds have participatedin the International Stock Pool sinceits inception. The Post RetirementFund began utilizing the Pool inOctober 1993. The InternationalShare Account in the SupplementalInvestment Fund has participated inthe Pool since September 1994.

On June 30, 2006, the dollar value ofeach fund’s participation in theInternational Stock Pool was:

Basic Funds $3.5 billion(active and passive)

Post Fund $3.3 billion(active and passive)

InternationalShare Account $111 million(active and passive)

Management StructureCurrently, the SBI uses a three partapproach to the managementstructure of the International StockPool:

— Active Management. The target isto have at least one-third of theInternational Stock Pool managedactively. At the end of fiscal year2006, approximately 58% of thePool was actively managed by agroup of 11 external managerswith portfolios ranging from $300to over $500 million each. Eightof these managers manage

portfolios in the developedmarkets and three manageportfolios in the emergingmarkets.

— Semi-Passive Management. Thetarget is to have up to 10% of theInternational Stock Pool managedsemi-passively. At the end offiscal year 2006, approximately11% of the Pool was semi-passively managed by a group ofthree external managers withportfolios ranging from $200 toover $300 million each.

— Passive Management. The targetis to have at least 25% of theInternational Stock Pool managedpassively and at least 33% of thePool managed passively and semi-passively combined. At the end offiscal year 2006, approximately31% of the International StockPool was passively managed by asingle manager.

As of July 1, 1999, the SBI beganusing the combined marketcapitalization weights of the MorganStanley Capital International (MSCI)developed and emerging marketsindices as target weights for thedeveloped versus emerging marketswithin the International StockPortfolio. Eight of the eleven activemanagers and the three semi-passivemanagers invest entirely indeveloped markets, and use a varietyof investment approaches in an effortto maximize value added to theMSCI World ex U.S. index, overtime. These managers addresscurrency management as part of theirinvestment process. Their views oncurrency may be factored into theircountry and security selection, orthey may explicitly hedge currencyexposure on an opportunistic basis.Three of the eleven active managersinvest entirely in emerging markets.They are expected to add incrementalvalue, over time, relative to the

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Int’l. Stock Pool -7.0% -6.2% 30.9% 15.7% 28.2% 24.7% 11.1% 7.3% Composite Index* -8.7 -5.4 32.1 16.5 27.9 25.3 11.2 6.4

* MSCI All Country World Index (ACWI) ex U.S. since 10/1/03. Composite of EAFE-Free and Emerging Markets Free from 5/1/96 through 9/30/03. EAFE Free through 4/30/96.

Investment Pools

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Figure 19 . Interna tional S toc k Poo l Per f ormanc e FY 2002-2006

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MCSI Emerging Markets Free indexof markets in developing countriesthroughout the world.The passive manager in theInternational Stock Pool designs itsportfolio to consistently andinexpensively track the developedmarkets MSCI World ex U.S. index.Previously, a portion of the currencyexposure of the index fund wasmanaged in a dynamic hedgingprogram designed to avoid currencylosses during periods of U.S. dollarstrength. The currency overlayprogram was terminated as ofDecember 1999. All contracts thatwere in place matured by December2000.

A description of each internationalstock manager’s investment approachis included in the InvestmentManager Summaries section.

FY 2006 ChangesOn July 1, 2005, the following fouractive developed markets equitymanagers were funded: • Acadian Asset Management • Fidelity Mgmt. Trust Company• J.P. Morgan Investment Mgmt. Co.• McKinley Capital Management

In addition, the Program’s structurewas changed by adding semi-passivemanagement. The Board approvedthis change in September 2003, and

on July 1, 2005, the following threesemi-passive developed marketsequity managers were funded: • AQR Capital Management • Fidelity Mgmt. Trust Company • State Street Global Advisors

Investment PerformanceSimilar to the Domestic Stock Pool,two long term risk objectives havebeen established for the internationalequity managers:

— Investment Approach. Eachmanager (active or passive) isexpected to hold a portfolio that isconsistent with the manager’sstated investment approach.

— Diversification. While the indexmanager is expected to hold awell diversified portfolio whichclosely tracks its target index andthe semi-passive managers areexpected to hold risk-adjustedportfolios which modestlyoutperform the index, each activemanager is expected to hold aportfolio which represents theirbest ideas through active bets.

The international stock managerssuccessfully fulfilled their long-termrisk objectives during fiscal year2006. In general, the managersconstructed portfolios consistentwith their stated investmentapproaches and maintainedappropriate levels of diversification.

The Board’s return objectives for theInternational Stock Program arestated relative to the Morgan StanleyCapital International (MSCI) indices.The indices are capitalizationweighted and measured in U.S. dollarterms, with currencies unhedged.Individual active managers areexpected to exceed their benchmarkby an amount appropriate for theirlevel of active risk. The active risk

Figure 20. International Manager Performance FY 2006

ActualReturn Benchmark

Active Managers: Developed Markets Acadian Asset Management 37.0% 26.9% Fidelity Mgmt. Trust Company 27.5 26.9 Invesco Global Asset Mgmt. 25.1 26.9 J.P. Morgan Investment Mgmt. Co. 25.4 26.9 Marathon Asset Management 27.8 26.9 McKinley Capital Management 30.6 26.9 RiverSource Investments, LLC 28.5 26.9 UBS Global Asset Management 22.9 26.9

Semi-Passive Managers: Developed Markets AQR Capital Management 27.7 26.9 Fidelity Mgmt. Trust Company 27.5 26.9 State Street Global Advisors 28.9 26.9

Active Managers: Emerging Markets Alliance Capital Management 33.0 35.5 Capital International, Inc. 37.7 35.5 Morgan Stanley Investment Mgmt. 38.6 35.5

Passive EAFE Manager: Developed Markets State Street Global Advisors 27.1 26.9

Aggregate International Pool 28.2

Asset Class Target 27.9

Investment Pools

22

level varies by manager and isinfluenced by the manager’s statedstrategy and style.

Performance results for theInternational Stock Pool are shown inFigure 19, (on page 20). Inaggregate, performance over the lastten year period exceeded thebenchmark by 0.9 percentage pointand performance over the last fiveyear period underperformed thebenchmark by 0.1 percentage pointannualized. The Pool outperformedthe target for the fiscal year by 0.3percentage point.

Individual manager performanceduring fiscal year 2006 is shown inFigure 20 (on page 21). Overall, thefiscal year proved to be anotherperiod of strong marketperformance, which was helpedsomewhat by U.S. dollar weakness.The markets were driven by strongreturns in the energy and materialssectors, supported by high oil andcommodity prices. However, allsectors achieved positive absolutereturns. This environment favoredresource-rich major markets such asRussia, Brazil and South Africa inthe emerging markets and Norwayand Canada in the developedmarkets. In addition, Japan gainedthe most ground in the developedmarkets region due to an improvedeconomic outlook and a revival inmarket sentiment. The relativeperformance of the active managerswas positive. Five of the eightdeveloped markets managersoutperformed their respectivebenchmarks for the year. Two of thethree emerging markets managersoutperformed the MSCI EmergingMarkets Free index, which returned35.5% for the year. All of the semi-passive developed markets managersoutperformed for the year. Finally,the passively managed portion of theprogram exceeded its benchmark by

0.2 percentage point for the yearrelative to the MSCI World ex U.S.index.

More information on theperformance and portfoliocomposition of individual managersis included in the Statistical Datasection. Section II of this reportprovides Summarized AssetListings for each manager and thePool in aggregate.

AlternativeInvestment Pools

Like the stock and bond segments,alternative assets (private equity, realestate, resource fund and yield-oriented investments) are alsomanaged on a pooled basis. In July2003, separate pools that had beenestablished for the Basic and PostRetirement Funds were combined tocreate one alternative investmentpool.

Statutory ConstraintsThe statutory constraints regardingthe SBI’s investments in alternativeassets are the same for both the Basicand Post Funds:

Generally, each investment mustinvolve at least four other investorsand the SBI’s participation in aninvestment may not exceed 20% ofthe total investment.

Management Structure

The Basic and Post RetirementFunds have participated in theAlternative Investment Pool since itsinception in July 2003. TheAlternative Investment Pool wascreated in July 2003 from separatepools that had been previouslyestablished for the Basic and PostRetirement Funds.

Given their long investment timehorizon, the Basic and Post Fundsare especially well suited toalternative investments. As of June30, 2006, up to 15% of the marketvalue of the Basic Retirement Fundsis targeted for alternative investmentscompared to an actual investedpercentage of 11.2%. Market valueplus unfunded commitments can be1.5 times the market value allocation.

For the Post Fund, as of June 30,2006, the Board has allocated up to12% of the market value of the Fundto alternative investments comparedto an actual invested percentage of8.7%. Market value plus unfundedcommitments can be 1.5 times themarket value allocation.

A breakdown of the combined Postand Basic Funds segment is shown inFigure 21 (on page 23). As of June30, 2006, the market value of currentalternative investments was $4.4billion, or 10.0% of the CombinedFunds.

Descriptions of each of the Funds’alternative investments are includedin the Investment ManagerSummaries section.

Real Estate PoolThe real estate investment strategycalls for the establishment andmaintenance of a broadly diversifiedreal estate portfolio comprised ofinvestments that provide overalldiversification by property type andlocation. The main component ofthis portfolio consists of investmentsin diversified Real Estate InvestmentTrusts (REITs), open-endcommingled funds and closed-endcommingled funds. The remainingportion of the portfolio can includeinvestments in less diversified, morefocused (specialty) commingledfunds and REITs.Prospective real estate managers are

Investment Pools

23

reviewed and selected based on themanager’s experience, investmentstrategy and performance history.

During fiscal year 2006, the SBIapproved and closed oncommitments with Blackstone andTA Realty. The SBI will continue toreview real estate managers forpossible inclusion in the pool.

Private Equity PoolThe private equity investmentstrategy, which includes leveragedbuyouts and venture capital, is toestablish and maintain a broadlydiversified private equity portfoliocomprised of investments thatprovide diversification by industrytype, stage of corporate developmentand location.

Prospective private equity managersare reviewed and selected based,primarily, on the manager’sexperience, investment strategy,diversification potential andperformance history.

During fiscal year 2006, the SBIapproved and closed oncommitments with Blackstone,Thoma Cressey, Vestar, WayzataCapital Partners, Lexington CapitalPartners, Welsh Carson Anderson &Stowe, Thomas McNerney Partners,and GTCR Golder Rauner. The SBIwill continue to review and add newprivate equity investments asattractive opportunities are identifiedto replenish commitments that willexpire within the next five years.

Resource Fund PoolThe strategy for resource investmentsis to establish and maintain aportfolio of resource investmentvehicles that provide an inflationhedge and additional diversification.Resource investments will include oiland gas investments, energy serviceindustry investments and other

investments that are diversifiedgeographically and by type.Resource investments are selectedbased on the manager’s experience,investment strategy and performancehistory. No new investments wereapproved and closed on during fiscalyear 2006. The SBI will continue toreview resource investments forpossible inclusion in the pool.

Yield-Oriented PoolThe strategy for yield-orientedinvestments will target funds thattypically provide a current return andmay have an equity component suchas subordinated debt or mezzanineinvestments. Yield-orientedinvestments will providediversification by includinginvestments in the private equity,resource and real estate categories.

Managers are selected based on themanager’s performance, experienceand investment strategy.

During fiscal year 2006, the SBIapproved and closed oncommitments with DLJ InvestmentPartners and Goldman SachsMezzanine Partners. The SBI willcontinue to review yield-oriented

investment opportunities forinclusion in the pool.

Investment PerformanceThe SBI reviews performance of itsalternative investments relative toinflation, as measured by changes inthe Consumer Price Index (CPI).The Alternative Investment Pool hasprovided a positive contribution tooverall fund performance for boththe Basic and Post Retirement Funds.The Pool provided a 43.7% return inFiscal Year 2006 and has provided a17.2% return annualized over thepast ten years. Performance of theAlternative Investment Pool is shownin Figure 22 (on page 24) for theperiod ending June 30, 2006.

At this time, benchmarks have notbeen established for the alternativeinvestment fund managers. The long-term nature of these investments andthe lack of comprehensive data onthe returns provided by thealternative investment marketspreclude comprehensive performanceevaluation. In the future, as marketsfor these asset classes become moreinstitutionalized, the SBI hopes tointegrate appropriate performancestandards for these assets into itsperformance analysis.

Investment Pools

Figure 21. A lternativ e Inv es tment A s s et Mix as of June 30, 2006

Real Estate ($0.87 Billion) - 20.0%

Private Equity ($2.19 Billion) - 50.2%

Resource ($0.24 Billion) - 5.5%

Note: Percentages may differ slightly due to rounding of values.

Yield Oriented ($1.06 Billion) - 24.3%

24

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Alt. Investments -2.0% 1.6% 16.6% 27.2% 43.7% 28.7% 16.2% 17.2% Inflation 1.1 2.1 3.3 2.5 3.1 3.1 2.5 2.5

Investment Pools

A listing of individual investmentfunds can be found in the StatisticalData Section.

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Perc

entAlternatives

Inflation

Figure 22. A lternativ e Inv es tments FY 2002-2006

25

The Supplemental Investment Fund(SIF) provides investment vehiclesfor a variety of funds.

— It functions as the sole investmentmanager for all assets of theUnclassified EmployeesRetirement Plan, PublicEmployees Defined ContributionPlan, Hennepin CountySupplemental Retirement Plan,and the Post Retirement HealthCare Savings Plan.

— Minnesota State Colleges andUniversities (MnSCU) withdrewfrom the Fund on July 1, 2006.

Fund Structure

A wide diversity of investment goalsexists among the SIF’s participants.In order to meet those needs, theSupplemental Investment Fund hasbeen structured much like a “familyof mutual funds.” Participants mayallocate their investments among oneor more accounts that are appropriatefor their needs, within statutoryrequirements and rules established bythe participating organizations.Participation in the SIF isaccomplished through the purchaseor sale of shares in each account.

Fund Management

The Supplemental Investment Fundoffers seven different investmentoptions (See Figure 23). The

The Supplemental Investment Fund is an investment program thatoffers a range of investment options to state and local publicemployees. The Fund serves approximately 30,000 individuals whoparticipate in defined contribution or supplemental retirementsavings plans. On June 30, 2006, the market value of the entire Fundwas $1.2 billion.

objectives, asset allocation,management and performance ofeach account in the Fund areexplained in the following sections.

Share ValuesEach account in the SIF establishes ashare value and participants may buyor sell shares monthly, based on themost recent share value.

In the Income Share Account, theGrowth Share Account, the CommonStock Index Account, theInternational Share Account and theBond Market Account, shares arepriced monthly based on the marketvalue of each account. Individualsmeasure the performance of these

accounts by changes in share values,which in turn are a function of theincome and capital appreciation (ordepreciation) generated by thesecurities in the accounts.

In the Money Market Account andthe Fixed Interest Account, sharevalues remain constant and theaccrued interest income is credited tothe accounts through the purchase ofadditional shares. Interest income isdistributed to participants of theFixed Interest and Money MarketAccounts.

The investment returns shown in thisreport are calculated using a time-weighted rate of return formula.

Income Share a balanced portfolio of U.S. common stocks, fixedincome, and cash.

Growth Share an actively managed portfolio of U.S. common stocks.

Common Stock Index a passively managed portfolio of U.S. common stocks.

International Share a portfolio of actively, semi-passively, and passivelymanaged non-U.S. stocks.

Bond Market a portfolio of both actively and semi-passivelymanaged fixed income securities.

Money Market a portfolio of short-term, liquid debt securities.

Fixed Interest a portfolio of stable value instruments such asinsurance company investment contracts, bankinvestment contracts, and security backed contracts.

Supplemental Investment Fund

Figure 23. Accounts in the Supplemental Investment Fund

26

These returns are net of investmentmanagement fees and transactioncosts. They do not, however, reflectany administrative expensesdeducted by the retirement systems todefray their own administrative

costs.The distribution of assets in theSupplemental Investment Fund as ofJune 30, 2006 are shown by Accountin Figure 24 and by Plan inFigure 25.

Supplemental Investment Fund

Figure 24 . Compos ition by A c c ount as of June 30 , 2006

Income Share - 37.1%

Fixed Interest - 6.0%

Bond Market - 11.1%

Grow th Share - 11.8%

Int'l. Share - 9.1%

Common Stock - 19.6%

Money Market - 5.3%

MnSCU - 27.3%

PERA Defined Contribution - 2.2%

Unclassif ied Retirement Plan - 22.9%

Hennepin Co. Sup. - 10.3%

Local Police and Fire - 27.8%

Figure 25 . Par tic ipa tion by Plan as o f June 30, 2006

Healthcare Savings Plan - 9.5%

Note: Percentages may differ slightly due to rounding of values.

27

Income Share Account

ObjectiveThe investment objectives of theIncome Share Account resemblethose of the Basic and PostRetirement Funds. The Accountseeks to earn a high rate of returnboth from capital appreciation(increases in market value) andcurrent yield (dividends from stockand interest on bonds). The IncomeShare Account pursues this objectivewithin the constraints of protectingagainst adverse financialenvironments and limiting short runportfolio return volatility.

The SBI invests the Income ShareAccount in a balanced portfolio ofcommon stocks and fixed incomesecurities with the following long-term asset mix: 60% domesticcommon stocks, 35% bonds, 5%cash equivalents.

Domestic common stocks providethe potential for significant long-termcapital appreciation, while bondsprovide both a hedge againstdeflation and the diversificationneeded to limit excessive portfolioreturn volatility.

At the close of fiscal year 2006, thevalue of the Income Share Accountwas $455 million.

ManagementThe Income Share Account’sinvestment management structurecombines internal and externalmanagement. SBI staff manage thefixed income segment. The commonstock segment is managed externallyas part of a passively managed indexfund designed to track the Russell3000 Index. The manager for thisportion of the Account is BarclaysGlobal Investors.

PerformanceSimilar to the other SBI funds whichutilize a multi-manager investmentstructure, the Board evaluates theperformance of the Income ShareAccount on two levels:

— Total Account. The Income ShareAccount is expected to exceed thereturns of a composite of marketindices weighted in the sameproportion as its long term assetallocation.

— Individual Manager. The passivestock manager is expected toclosely track the performance ofthe Russell 3000. The internalbond manager for the Account isexpected to exceed the

performance of the LehmanBrothers Aggregate Bond Index.

The Income Share Account provideda return of 6.4% for fiscal year 2006,exceeding its benchmark by 0.8percentage point. Over the mostrecent ten years, the Income ShareAccount exceeded its benchmark by0.1 percentage point. Figure 26shows a ten year history ofperformance results.

Annualized2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Income Share -8.8% 4.5% 12.7% 7.7% 6.4% 8.9% 4.2% 7.7% Benchmark* -7.6 4.7 12.2 7.4 5.6 8.4 4.3 7.6

* 60% Russell 3000/35% Lehman Aggregate Bond Index/5% T-Bills composite since 10/1/03. 60% Wilshire 5000/35% Lehman Aggregate Bond Index/5% T-Bills composite through 9/30/03.

Supplemental Investment Fund

-10

-5

0

5

10

15

2002 2003 2004 2005 2006 3 Yr. 5 Yr. 10 Yr.

Perc

entIncome Share

Benchmark

Figure 26 . Inc ome Share A c c ount FY 2002-2006

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Growth Share Account

ObjectiveThe investment objective of theGrowth Share Account is to generatehigh returns from capitalappreciation. To