SBA Annual Report 2001

THE FLORIDA STATE BOARD OF ADMINISTRATION

January 1, 2002

TO THE HONORABLE MEMBERS OF THE FLORIDA SENATEAND HOUSE OF REPRESENTATIVES:

It is our privilege to submit the Annual Investment Report for the Florida State Board of Administration (FSBA) for FiscalYear 2000-2001 pursuant to the requirements of Subsection 215.44(5), F. S. The Report presents an analysis of fund per-formance and investment considerations during the fiscal year, as well as the longer-term performance, which more appro-priately reflects the long-term nature of our responsibilities.

The FSBA has as its major investment responsibilities the Florida Retirement System (FRS), the Local Government SurplusFunds Trust Fund, the debt service accounts for state bonds, the Florida Hurricane Catastrophe Trust Fund, the LawtonChiles Endowment Fund, as well as managing the assets of various other trust funds. The FSBA has also been assigned thelead implementation role in activating a new investment fund for FRS members. This new program (a defined contributionplan established under Section 401(a), Internal Revenue Code) is a voluntary, employee-directed investment option thatmarks a dramatic new course for the FRS. During the next two years, we will focus considerable attention on the success-ful establishment of this exciting new program.

FY 2000-2001 was a disappointing year for investors generally, and specifically for the FSBA. Although the FSBA outpacedits performance benchmark in relative terms by 1.2%, this translates into losing less than we might have otherwise. For thefirst time since FY 1987-1988 we ended the year with negative performance results. On an absolute basis the fund earned a–7.6% return on our investment.

The FRS is still in a surplus condition and the FSBA continues to be a disciplined long-term investor. We eagerly await thereversal of economic fortune and believe we are well positioned to take advantage of any long-term recovery.

Please don’t hesitate to contact our offices if we can provide any further information.

Respectfully submitted,

Governor, as Chairman

State Treasurer, as Treasurer

Comptroller, as Secretary

THE FLORIDA STATE BOARD OF ADMINISTRATION

GOVERNOR JEB BUSH, CHAIRMAN

STATE TREASURER TOM GALLAGHER, TREASURER

STATE COMPTROLLER ROBERT F. MILLIGAN, SECRETARY

EXECUTIVE DIRECTOR

TOM HERNDON

INVESTMENT ADVISORY COUNCIL

RANDI K. GRANT, CHAIRMAN

RUSSELL BJORKMAN, VICE CHAIRMAN

DONALD W. BURTON

JAMES DAHL

GIL HERNANDEZ

DR. DONALD A. NAST

FLORIDA STATE BOARD OF ADMINISTRATION

TABLE OF CONTENTS

SECTION I: INTRODUCTION ............................................................................................................................................1

SECTION II: REPORT OF THE EXECUTIVE DIRECTOR...................................................................................................3

II.1 The Florida Retirement System Trust Fund........................................................................................3II.2 Actuarial Investment Return and Actual Investment Performance ....................................................4II.3 Investment Management and Risk Controls .......................................................................................5II.4 Local Government Surplus Funds Trust Fund ...................................................................................6II.5 Debt Service Funds..............................................................................................................................6II.6 Lawton Chiles Endowment Fund .......................................................................................................6II.7 Administration.....................................................................................................................................6

II.7.1 Investment Issues ................................................................................................................6II.7.2 Organizational Development...............................................................................................7

II.8 Focus on Cost Control ........................................................................................................................7II.9 Florida Hurricane Catastrophe Fund ..................................................................................................8II.10 Legislative Activity ..............................................................................................................................9II.11 Corporate Governance ........................................................................................................................9II.12 Annual and Long-Term Fund Growth ..............................................................................................10II.13 Market Value Changes, By Fund .......................................................................................................11

SECTION III: FLORIDA RETIREMENT SYSTEM TRUST FUND .......................................................................................13

III.1 Overview ...........................................................................................................................................13III.1.1 The Board ..........................................................................................................................13III.1.2 Investment Advisory Council ...........................................................................................13III.1.3 The Executive Director .....................................................................................................13III.1.4 Investment Objectives .......................................................................................................14III.1.5 Risk....................................................................................................................................14III.1.6 Asset Allocation.................................................................................................................16

III.2 Economic and Market Conditions ....................................................................................................17III.3 Asset Allocation for FY 2000-2001 ...................................................................................................19III.4 Performance Evaluation for FY 2000-2001.......................................................................................20

III.4.1 Annualized Total Fund Investment Performance .............................................................20III.5 Domestic Equities Investments .........................................................................................................22III.6 International Equities Investments ...................................................................................................24III.7 Fixed Income Investments ................................................................................................................26III.8 Real Estate Investments.....................................................................................................................28III.9 Alternative Investments.....................................................................................................................30III.10 Cash/Short-Term Investments ...........................................................................................................33

FLORIDA STATE BOARD OF ADMINISTRATION

TABLE OF CONTENTS

III.11 Investment Management Fees ...........................................................................................................33III.12 Supplemental Income Program .........................................................................................................34III.13 Florida Retirement System Portfolio-Level Performance Supplement..............................................35

SECTION IV: LAWTON CHILES ENDOWMENT FUND ...................................................................................................44

IV.1 Investment Objectives .......................................................................................................................44IV.2 Endowment Cash Flow Schedule......................................................................................................45IV.3 Asset Allocation for FY 2000-2001 ...................................................................................................45IV.4 Investment Risk.................................................................................................................................46IV.5 Performance Evaluation for FY 2000-2001.......................................................................................46

IV.5.1 Annualized Total Fund Investment Performance .............................................................46

SECTION V: LOCAL GOVERNMENT SURPLUS FUNDS TRUST FUND .........................................................................50

SECTION VI: DEBT SERVICE ACCOUNTS ........................................................................................................................54

SECTION VII: OTHER INVESTMENT TRUST FUNDS........................................................................................................56

VII.1 Department of the Lottery Fund .......................................................................................................56VII.2 Retiree Health Insurance Subsidy Trust Fund ..................................................................................56VII.3 Gas Tax Trust Fund ...........................................................................................................................56VII.4 Revenue Bond Fee Trust Fund ..........................................................................................................56VII.5 Bond Proceeds Trust Fund ................................................................................................................56VII.6 Florida Hurricane Catastrophe Fund ................................................................................................56VII.7 Inland Protection Financing Corporation.........................................................................................57VII.8 Investment Fraud Restoration Financing Corporation.....................................................................57VII.9 Florida Education Fund, Inc. - McKnight Doctoral Fellowship Program........................................57VII.10 Blind Services Trust Fund .................................................................................................................58VII.11 FSBA Administrative Trust Fund ......................................................................................................58VII.12 Commingled Asset Management Program Money Market Fund......................................................58

VII.12.1 Public Employee Optional Retirement Program...............................................................58VII.12.2 Institute of Food and Agricultural Sciences Supplemental Retirement............................59VII.12.3 Florida Endowment for Vocational Rehabilitation Trust Fund ........................................59VII.12.4 Arbitrage Compliance Trust Fund ....................................................................................59VII.12.5 Police and Firefighters Premium Tax Trust Fund.............................................................59VII.12.6 Florida Prepaid College Trust Fund..................................................................................59VII.12.7 Tobacco Settlement Clearing Trust Fund..........................................................................60VII.12.8 Florida Endowment Foundation.......................................................................................60

2 0 0 0 - 2 0 0 1 I N V E S T M E N T R E P O R T 1

The Florida State Board of Administration (FSBA) has the following investment responsibilities: 1) manag-ing the assets of the Florida Retirement System TrustFund (FRSTF); 2) managing the assets of the LocalGovernment Surplus Funds Trust Fund (LGSFTF); 3)managing debt service accounts for the state of Floridabond issues; 4) managing the Florida HurricaneCatastrophe Fund (FHCF); 5) managing the LawtonChiles Endowment Fund; and 6) managing the assets ofother various trust funds. The FSBA also administrative-ly houses the Florida Division of Bond Finance and theFlorida Prepaid College Program. Both organizations aredirected by separate policy setting boards. The FSBAactivities for FY 2000-2001 are described in seven sec-tions of this report.

SECTION I Introduces the report.

SECTION II Contains the Executive Director’s reporton investments and organizational issues.

SECTION III Describes the FY 2000-2001 investmentactivities for the FRSTF. This sectiondescribes the economic environmentexisting during the year; provides ananalysis of the changes in investmentstrategy, and presents aggregate portfolioasset allocations. Further, the sectionreviews the FRSTF’s investment perform-ance and market environment for eachasset class, as written by the respectiveasset class Chiefs.

SECTION IV Provides an overview and investment per-formance of the Lawton ChilesEndowment Fund.

SECTION V Summarizes FY 2000-2001 investmentactivities for the LGSFTF, a short-term,very liquid, high quality investment vehi-cle for participating local governments.

SECTION VI Describes the investment activities indebt service accounts for state-issuedbonds.

SECTION VII Describes the other trust funds managedby the FSBA. These funds include:

• Department of the Lottery Fund

• Retiree Health Insurance Subsidy Trust Fund

• Gas Tax Trust Fund

• Revenue Bond Fee Trust Fund

• Bond Proceeds Trust Fund

• Florida Hurricane Catastrophe Fund

• Inland Protection Financing Corporation

• Investment Fraud Restoration FinancingCorporation

• Florida Education Fund, Inc.– McKnight DoctoralFellowship Program

• Blind Services Trust Fund

• FSBA Administrative Trust Fund

• Commingled Asset Management Program MoneyMarket Fund

• Public Employee Optional Retirement Program

• Institute of Food and Agricultural SciencesSupplemental Retirement

• Florida Endowment for Vocational RehabilitationTrust Fund

• Arbitrage Compliance Trust Fund

• Police and Firefighters Premium Tax Trust Fund

• Florida Prepaid College Trust Fund

• Tobacco Settlement Clearing Trust Fund

• Florida Endowment Foundation


FY 2000-2001 has been a difficult year for the Florida State Board of Administration (FSBA). Inabsolute terms, we have fallen off our peak valuation by11%. Furthermore, as this commentary is written, weknow that the market has continued to plunge, in part inresponse to the terrorist attacks on the United States.This horrendous tragedy will mark our lives forever.

In relative terms, the FSBA continues to outperform ourcomposite benchmark, but it’s difficult to take solace inthis fact. Since we are overweight in the equities marketcompared to our peers, we have benefited dispropor-tionately from the market enthusiasm and suffered dis-proportionately during this market downturn. Whenyou closely examine our performance attribution statis-tics, it’s clear that the major cause of our poor perform-ance relative to our peers is due to the equity overweightand not daily execution or overall implementation.

Nevertheless, the past months have been disappointingat best, but we maintain the view that as long-terminvestors, we must ride the downturns out and takeadvantage of buying opportunities when we can.

On other fronts, the FSBA has been fully occupied withimplementing the Public Employee Optional RetirementProgram (PEORP). It has proven to be an arduousundertaking and has consumed substantial time, energy,and money. Progress is being made, however, and theprogram is still on track, on budget, and on time.

In all other respects, the FSBA continues to functionsmoothly. Coleman Stipanovich is working as DeputyExecutive Director for the FSBA, and we have reshuffledsome other positions. Doc Schow, our longtime GeneralCounsel, has moved to a part-time position in prepara-tion for retirement, and Linda Lettera has taken his placeas General Counsel.

Aside from the normal ebb and flow of people and minororganizational changes, the FSBA has functioned well.In large measure, this is due to the talented workforcewe have and their unswerving commitment to the mem-bers of the Florida Retirement System.

During FY 2000-2001, beginning July 1, 2000 and end-ing June 30, 2001, the market value of funds under management dropped to $125,598,064,683 from$128,175,759,597, a decrease of $2,577,694,914. Thisreduction in market value represents a decrease ofapproximately two percent and each section of this

report will identify the components of this change forthe funds under management.

II.1 THE FLORIDA RETIREMENT SYSTEM TRUST FUND

The Florida Retirement System Trust Fund (FRSTF orFund) is the largest investment services “client” of theFSBA. The FSBA invests the assets of the FRSTF consis-tent with statutory guidelines, administrative rules, theFRSTF Total Fund Investment Plan (TFIP or InvestmentPlan), and internal policies of the FSBA. The InvestmentPlan was constructed with the goal of maximizing theprobability that investment results will be adequate tomake funds available when retirement benefit paymentsare due in future years and minimizing the volatility ofemployers contributions.

The Investment Plan was established in 1988. TheInvestment Plan establishes the various asset classes tobe used in the management of the Fund and defines thetarget and policy ranges for each of those respectiveasset classes. During FY 2000-2001, there was onechange made to the Investment Plan. A revised set ofasset allocation policy targets were adopted for DomesticEquities and Alternative Investments. Further detailregarding the Investment Plan asset allocation targetsand policy ranges may be found in Section III of thisreport.

The asset allocation decision is the most fundamentaldecision faced by any investor and will explain in excessof 90 percent of subsequent investment performanceexperience over time. The policy ranges established inthe Investment Plan afford the FSBA staff some invest-ment flexibility, but clearly prescribe ranges withinwhich our tactical investment activities must take place.This limits the amount of risk that can be assumedthrough active asset allocation in the decision-makingprocess. The asset classes established in the InvestmentPlan for management of FRSTF assets in FY 2000-2001include:

Domestic Equities Real Estate

International Equities Alternative Investments

Fixed Income Cash/Short-Term

Since asset allocation is the major determinant of long-term performance, the Investment Plan is designed toassure that the Fund benefits from the long-term asset

4 F L O R I D A S T A T E B O A R D O F A D M I N I S T R A T I O N

TABLE II-1FRS CUMULATIVE RETURN*

FISCAL YEARS 1976-2001

class returns, regardless of management’s potential reac-tion to short-term market phenomena. The policy rangesreflect the liquidity constraints for a portfolio the size ofthe FRSTF and the desire for a disciplined approach toinvestment management. This philosophy is bestexpressed in a book entitled, Investment Policy, authoredby Charles D. Ellis: “The principal reason for articulat-ing long-term investment policy explicitly and in writ-ing is to enable the client and portfolio manager to pro-tect the portfolio from ad hoc revisions of sound long-term policy and help them hold to long-term policywhen short-term exigencies are most distressing and thepolicy is most in doubt.”

Alterations to asset allocation within the prescribedranges are typically a consequence of natural marketmovement and economic cycles within the United Statesand internationally, as well as relative valuation acrossasset classes.

II.2 ACTUARIAL INVESTMENT RETURN AND ACTUAL

INVESTMENT PERFORMANCE

The fundamental mission of the FSBA’s investmentactivity on behalf of the FRSTF has long been defined asachieving or exceeding the “actuarial return assump-tion” over the long-term. The return assumption of thestate actuary has been eight percent per year since 1987.Historically, eight percent was a commonly used actuar-ial return assumption among pension plan sponsors;eight percent was a reasonable approximation of returnsone could anticipate by holding an appropriate mix ofthe dominant asset classes mentioned above and byusing expected returns based on historical data. Whilethe FSBA tries to establish achievable internal invest-ment targets, the most fundamental measure of ourinvestment success has been our performance relativeto the actuarial return assumption. However, a newapproach has been adopted in setting our annual invest-


ment target. The new target is based on achieving a realyield of 4.3 percent over the rate of inflation. Thischange was recommended by our consulting actuary inApril 2000, and judged to be superior to a flat actuarialrate target. Because FRS Defined Benefit (DB) plan lia-bilities are driven in significant part by inflation, thischange affords a more realistic assessment of how wellour investment performance tracks overall growth inliabilities.

Perhaps most noteworthy during FY 2000-2001, wasthe fact that the investment activities of FSBA staff andoutside managers added 120 basis points (bps) of valueover and above our relative benchmark, a weighted-average of broad financial market returns. This addi-tional increment of return equates to approximately$1.2 billion in outperformance during the year.

For FY 2000-2001, the investment return for the FRSTFwas -7.6 percent, as shown in Table III-6. While actualinvestment experience for the fiscal year does notexceed the absolute target return assumption, one mustremember that it is the long-term perspective that ismost important for pension plan sponsors and benefici-aries. Investment experience will naturally vary fromyear to year with the financial market environment. Theastute observer will note investment performance inindividual years with interest, but will place the greaterweight on long-term experience and trends.

Over the past 25 years, the average actuarial assumptionhas been eight percent. Table II-1 shows how the cumu-lative return on the FRSTF has consistently exceededthe actuarial assumption, net of external managementfees. The Table also indicates the rationale for theTrustees’ decision to adopt the absolute target returnassumption. Because pension liabilities grow with infla-tion, a flat actuarial return target tends to be a decep-tively low bar during times of rising and high inflation.This is apparent in the Table, where a FRS portfolioheavily invested in bonds in the late 1970s and early1980s significantly underperformed a target rate ofreturn based on achieving a real yield of 4.3 percentover the rate of inflation. Assuming normal contribu-tions are made, if the FRS plan assets grow by 4.3 per-centage points in excess of the rate of inflation over thelong-term, the plan should maintain its fully-fundedstatus.

FY 2000-2001 was a disappointing year for the FRS.However, even with the drop in investment

performance, the cumulative return on the FRSTF stillmaterially exceeds the cumulative absolute target return.

II.3 INVESTMENT MANAGEMENT AND RISK CONTROLS

The FSBA is attuned to meeting the needs of itsinvestment clients and provides customized portfoliomanagement appropriate to the liabilities of the client.The FSBA is likewise cognizant of the priority ofmaintaining an appropriate institutional investmentenvironment, emphasizing competent management andadequate risk controls. The growth of funds undermanagement, the associated growth and expansion ofthe organization, and the complexity and increasedresponsibilities assigned to the FSBA have demandedthat risk management be a primary area of focus.Organizations which enjoy the reputation of not onlybeing good investment managers but also goodmanagers of both investment and organizational risksgenerally have the following characteristics:

• Risks are clearly identified anddetailed policies, guidelines,and/or procedures are in place tocontrol those identified risks.

• Policies, guidelines, and proce-dures are periodically reviewed todetermine if any new policiesneed to be established or existingpolicies need to be enhanced.

• A system to monitor compliancewith the policies is in place andperiodically reviewed.

• Senior management is committedto risk management as one of itsprimary objectives.

• External resources are utilized toprovide additional oversight.

We are pleased with our progress in meeting theseobjectives.

External oversight of FSBA activities is accomplished inseveral ways. Florida Statutes provide for an InvestmentAdvisory Council (IAC) to be composed of sixindividuals with appropriate financial expertise,appointed by the Trustees and confirmed by the Florida


Senate. This group meets quarterly for the purpose ofreviewing investment performance, strategy anddecision-making, and providing insights, advice, andcounsel on these and other matters when appropriate.Members of the IAC serve without compensation andprovide a constructive forum for consideration ofinvestment and organizational issues and provision ofinformation to beneficiary constituencies. Recognitionand thanks are due to those who served on this councilduring the fiscal year ending June 30, 2001:

Randi K. Grant, Chairman James Dahl

Russell Bjorkman, Vice Chairman Gil Hernandez

Donald W. Burton Dr. Donald A. Nast

An additional element of oversight is independentproduction of performance data relating to FSBA’sportfolios. Performance numbers used in this reportare generated by third-party performance reportingservices, independent from FSBA staff, to provide agreater level of credibility to users. The FSBAcurrently uses a number of external consultants andthird-party vendors to provide oversight, counsel, andprogram perspective on a variety of issues. Auditoversight is provided by the Florida Auditor General’soffice and is appropriately intensive for an investmentinstitution of the FSBA’s size and responsibilities. Also,the FSBA is subject to financial audits performed bythe Florida Legislature’s Office of Program PolicyAnalysis and Government Accountability (OPPAGA).In addition, third-party vendors utilized in themanagement of our investment activities such as bankcustodians and investment managers, are likewisesubject to regulatory authority and audit.

II.4 LOCAL GOVERNMENT SURPLUS FUNDS TRUST FUND

The Local Government Surplus Funds Trust Fund(LGSFTF) is designed to offer a liquid, high quality,low-cost investment vehicle to counties andmunicipalities in Florida, as well as to other eligiblelocal governmental entities. The LGSFTF market valueof funds under management was $10,981,847,796 onJuly 1, 2000 and $15,803,153,725 on June 30, 2001.Net contributions totaled $4,057,245,955 and incomeand investment market value gain totaled$764,059,974. Section V contains additional detailregarding this fund.

II.5 DEBT SERVICE FUNDS

The FSBA has continued to work with the Division ofBond Finance, other governmental entities, and outside technical advisors in managing compliance with federalregulations relating to investment arbitrage earnings.Investment activities designed to maximize reserveefficiencies are conducted consistent with lawfulallowances for such activity. The total market value ofDebt Service Funds managed at June 30, 2001 was$4,224,394,821. Additional details regarding DebtService activities are contained in Section VI of thisreport.

II.6 LAWTON CHILES ENDOWMENT FUND

The Lawton Chiles Endowment Fund for children andelders was established by the Legislature during 1998-99for implementation on July 1, 1999. This endowmentwas initially funded at $725 million and received twoadditional increments totaling $375 million in Januaryand February 2000. Additional funding of $200 millionin FY 2000-2001 brought the total invested principal to$1.3 billion. Withdrawals of $27,390,000 were removedfrom the fund and transferred to other state agenciesduring the year. The FSBA underperformed the target by19 basis points, and as of June 30, 2001 assets in thefund stood at $1.26 billion. See Section IV of this reportfor additional information and details on the LawtonChiles Endowment Fund activities.

II.7 ADMINISTRATION

II.7.1 INVESTMENT ISSUES

The following is a brief review of investment relatedissues pertinent to the administration of funds undermanagement during FY 2000-2001:

Domestic Equities Asset Class – Theoverall allocation to Domestic Equitieswas reduced this year, although com-pared to our peers we are still anaggressive equity investor. This changein equity allocation lowered our expo-sure to the market downturn but didnot eliminate the negative absolute per-formance. On a relative basis, the assetclass has performed well with outper-formance compared to the benchmarkof 1.27%. Fees were also reduced dur-


ing this period and performanceremained strong during all periods.

International Equities Asset Class –For International Equities, perform-ance continues to be good on a relativebasis but the effects of a worldwiderecession have been especially distress-ing. Virtually all of the investable mar-kets have been impacted with someemerging markets down so far as torival the NASDAQ in poor perform-ance. Staff continues to do a good jobhowever, and the asset class will recov-er in time.

Fixed Income Asset Class – Fallinginterest rates have highlighted almostthe entire period covered in this report.Consequently, performance has beenextremely good, although an over-weight to corporates has mitigated per-formance gains relative to the bench-mark. Nevertheless, performance wasstrong, and coupled with the non-FRSasset management activities, FixedIncome had another solid year.Organizational changes to consolidateall long-term portfolio management(active and passive) under one supervi-sory position and consolidation of sev-eral active internally managed portfo-lios into one resulted in a more effec-tive use of resources and operationalefficiency. These changes reflect the“team approach” to internal manage-ment.

Real Estate Asset Class – With therecession in full grip during this peri-od, business failures have increasedand occupancy rates have fallen.Overall, rental rates are also downthroughout the country and this hasadversely impacted the asset class per-formance. Nevertheless, performancewas good and overall the quality of theportfolio seems strong.

Alternative Investments – In excess of25% of the assets in this division are

still held at cost due to the young age ofthe investments. Furthermore, with ourself-imposed moratorium still in place,opportunities to significantly strength-en the portfolio in size or quality havebeen limited. In spite of these facts, theoverall portfolio has done well but timewill tell as to ultimate achievements.The Trustees did authorize a limitedfocus, $25 million Venture Capital pro-gram this year and implementation willoccur once the infrastructure is inplace.

II.7.2 ORGANIZATIONAL DEVELOPMENT

Staff recruitment and retention continues to be anumber one priority for the FSBA. Fortunately, ourturnover has been relatively low and our recruitmentefforts successful for the most part. Nevertheless, theFSBA completed an incentive pay plan study andcontinues to work with our Trustees to obtain approvalfor this proposal.

Our Senior Management team saw some changes thisyear as our long time General Counsel has gone to part-time in preparation for retirement. Doc Schow hasserved the FSBA ably and well for over 15 years and willbe missed. We have filled this vacancy by recruiting Ms.Linda Lettera, formerly General Counsel of theDepartment of Revenue, and she is already making herpresence felt.

In addition, Coleman Stipanovich, formerly Chief ofAdministrative Services, has been elevated to theposition of Deputy Executive Director with primaryresponsibility for oversight of the asset classes. Hecontinues to do a fine job for the FSBA.

Other changes during this time were much more routinein nature and no other significant organizational issueswarrant reporting.

II.8 FOCUS ON COST CONTROL

Fiduciary duty focuses not only on the attainment ofdesired investment returns within a prescribed level ofrisk, but also on effectively managing costs. In theprevious section on organizational development, weemphasized the FSBA’s desire to continue to recruit andretain quality staff. This is particularly important to the


FSBA since we currently manage approximately half ofthe pension fund assets and all of the local governmentand miscellaneous trust assets internally. This enables theFSBA to be an extremely cost effective provider ofinvestment services. Substantial investment activities areaccomplished internally by FSBA professionals at afraction of the cost that would be paid for similar servicespurchased from outside providers. The infrastructurewhich exists to allow the FSBA to operate the LocalGovernment Investment Pool, for instance, also enablesus to perform pooled cash management services for thelarge number of individual pension fund accounts whichmay, at various times, hold residual cash.

Our FRS investment service charge remained at 1.75basis points for the fiscal year and during the lastquarter of the fiscal year we implemented a “feeholiday”; there was no charge for services for thatquarter. Our outside manager fees increased slightlyfrom an average of .22 percent (of the average of thefiscal year’s beginning and quarter ending market valueof assets externally managed in FY 1999-2000) to .24percent in FY 2000-2001.

II.9 FLORIDA HURRICANE CATASTROPHE FUND

The Florida Hurricane Catastrophe Fund (FHCF) wascreated by the Legislature during the November 1993Special Session. The fund was one of the Legislature’sresponses to the State’s property insurance crisis, whichfollowed in the wake of Hurricane Andrew. The FHCF isa tax-exempt state trust fund administered by the FSBA.Its purpose is to provide additional insurance capacityby reimbursing insurers for a portion of theircatastrophic hurricane losses. Insurers which writeresidential property insurance on structures or theircontents are required to enter into a reimbursementcontract with the FSBA to report their exposures, to paypremiums, and to report losses by calendar year-end orat other times as required by the FSBA. Covered lossesare reimbursed on an occurrence basis.

The FHCF is obligated only to the extent of itsaccumulated assets and borrowing capacity. Obligationsof the FHCF are not obligations of the state. Shouldcurrent assets be insufficient to pay obligations underthe reimbursement agreements, the FHCF has the abilityto issue tax-exempt revenue bonds. Such revenue bondsare financed by an emergency assessment of up to fourpercent on all property and casualty insurers’ direct

written premiums, excluding workers’ compensationand accident and health insurance. Following ahurricane event, which exhausts or seriously reduces theassets available either in cash or through issuance ofrevenue bonds, the 1999 Legislature provided foradditional capacity in a subsequent contract year.Subsequent season capacity was accomplished byputting an upper limit of $11 billion on FHCFreimbursement obligations for any one contract year,providing for an additional two percent emergencyassessment for a subsequent season, and limiting theimposition of an emergency assessment in any onecontract year to four percent. The projected calendaryear-end balance of the FHCF is $4.35 billion. The 2001season bonding capacity has been estimated at $6.65billion. If initial season capacity is exhausted, it isestimated that $7.5 billion would be available for asubsequent season.

The 2001 Legislature appropriated $30 million forhurricane mitigation purposes. This represents $20million more than the $10 million that has beenappropriated in prior years.

The Florida Hurricane Catastrophe Fund AdvisoryCouncil provides information and advice to the FHCF.The members of the Council include:

William Huffcut, Chair Larry Johnson

Rade Musulin, Vice Chair Robert M. Peduto

Yolanda Cash-Jackson Joseph Varon

Jim W. Henderson James Woodside

In accordance with Section 627.0628, F.S., the FSBA has theongoing statutory assignment to house and staff the FloridaCommission on Hurricane Loss Projection Methodology(the Commission). Staffing responsibility for theCommission was assigned to the FHCF staff. For FY 2000-2001, the statutory deadline to revise hurricane-modelingstandards was successfully met. The statute provides for an11 member Commission; however, the position to be heldby an expert in insurance finance is currently vacant. Themembers of the Commission include:

Sneh Gulati, Chair Craig Fugate

Mark Homan, Vice Chair Larry Johnson


Kay Cleary Jay Newman

David Coursey Jack Nicholson

Elsie Crowell James O’Brien

II.10 LEGISLATIVE ACTIVITY

Our legislative activity for the 2001 legislative sessionlargely centered upon the ongoing implementationactivities of the Public Employee Optional RetirementProgram (PEORP). As a follow-up to last year’ssuccessful passage of HB 2393, which created thePEORP, the Legislature, industry representatives andthe FSBA negotiated a mutually acceptable piece oflegislation. Ultimately, the option of selecting bundledproviders was left in place, and the services a bundledprovider may provide to a participant was clarified.Additionally, the plan will also offer a one-time“switchback” option between the Defined Benefit (DB)and Defined Contribution (DC) plans. That is, aparticipant will be allowed to exercise the one-timeswitch from one plan to the other at any time duringtheir employment. Sections of the legislation pertainingto the FSBA and/or the PEORP were effective July 1,2001, and may be found in Chapter 2001-235, Laws ofFlorida.

The Legislature also created the PEORP Trust Fund, tobe administered by the FSBA, which is not subject totermination provisions of the State Constitution.Additionally, the FSBA is authorized to adopt rules tomaintain the qualified status of the PEORP, incompliance with the Internal Revenue Code.

The Legislature enacted legislation related to theLawton Chiles Endowment Fund, which isadministered by the FSBA. Specific intent language wascreated to provide funds for the support of public healthand biomedical research. Additional provisions weremade concerning the administration of the endowmentfund.

On behalf of the FHCF, we followed the budget processas it related to the appropriation of mitigation funds.The FHCF was tapped for a total of $30 million inmitigation funds for the upcoming year, whichrepresented an increase of $20 million over last year.The FHCF staff estimated that the $20 million increasein mitigation funds would result in a 4.14% increase in

premium rates payable to the Fund. Premium paymentsare used to maintain the current and future obligationsand expenses of the fund.

We will continue to monitor a wide variety ofinvestment and pension reform issues during theupcoming 2002 Legislative Session. You may accessinformation concerning the business operations of theFSBA, including the implementation process of thePEORP, at www.fsba.state.fl.us. Additionally, as ofFebruary 25, 2002, specific educational informationrelated to the PEORP may be accessed viawww.myfrs.com.

II.11 CORPORATE GOVERNANCE

The FSBA continues to be active in the corporategovernance area, voting proxies on issues presented atannual meetings of companies in which we invest. Webelieve that corporate governance plays an importantrole in enhancing our financial objectives as a long-term investor. In addition to voting approximately2,700 proxies on various management and shareholderproposals, the FSBA has been actively involved indeveloping shareholder proposals where we feel it is inthe best interest of the beneficiaries to do so. The FSBAcontinued its participation in the Council ofInstitutional Investors, an organization that is theleading proponent of shareholder issues affecting publicpension funds in the national arena. We also continuedour activities in the area of litigation, bringing suitdirectly and through derivative actions, to protectshareholder interests. In several instances, class-actionlitigation settlements have resulted in majorimprovements in the corporate governance structures ofthe companies involved.


TABLE II-2INVESTMENTS BY PROGRAM


II.12 ANNUAL AND LONG-TERM FUND GROWTH

Table II-2 provides the market values of FSBA managedfunds, by program, for FYs 1997-2001.


TABLE II-3MARKET VALUE CHANGES, BY FUND

FISCAL YEAR 2000-2001

II.13 MARKET VALUE CHANGES, BY FUND

Table II-3 provides the annual beginning and endingasset values and sources of market value changes in theasset value of each fund managed by the FSBA, for FY2000-2001:


The FSBA provides investment management of assetscontributed and held on behalf of the Florida RetirementSystem (FRS). The investment of retirement assets is oneaspect of the activity involved in the administration ofthe FRS. The Division of Retirement (DOR), the admin-istrative agency for the FRS, provides full accountingand administration of benefits and contributions for theretirement system. The DOR initiates actuarial studies,recommends benefit and contribution changes, and pro-poses rules and regulations for the administration of theFRS. The Legislature has the responsibility of settingcontribution rates and benefit levels and providingstatutory guidance for the administration of the FRS.

III.1 OVERVIEW

III.1.1 THE BOARD

The Board has statutory responsibility for the invest-ment of FRS assets, subject to limitations as outlined inSection 215.47, F. S. The Board discharges its fiduciaryduties in accordance with the Florida statutory fiduciarystandards of care as set forth in Subsections 215.44(2)and 215.47(9), F.S. Statutory limitations include:

• no more than 80 percent of assetscan be invested in domestic com-mon stocks;

• no more than 75 percent of assetscan be invested in internally man-aged common stocks;

• no more than three percent of equi-ty assets can be invested in theequity securities of any one corpo-ration, except when the securitiesof that corporation are included inany broad equity index or withapproval of the Board; and in suchcase, no more than 10 percent ofequity assets can be invested in theequity securities of any one corpo-ration;

• no more than 80 percent of assetsshall be placed in corporate fixed-income securities;

• no more than 25 percent of assetsshall be invested in notes secured

by FHA-insured or VA-guaranteedfirst mortgages on Florida realproperty, or foreign governmentgeneral obligations with a 25-yeardefault-free history; and

• no more than 20 percent shall beinvested in foreign corporate orcommercial securities or obliga-tions; and

• no more than 5 percent of any fundin private equity through participa-tion in limited partnerships andlimited liability companies.

III.1.2 INVESTMENT ADVISORY COUNCIL

A six-member Investment Advisory Council (IAC) isappointed by the Trustees, subject to confirmation bythe Florida Senate. The IAC meets quarterly and ischarged with the review and study of general portfolioobjectives, policies, and strategies, including a review ofeconomic conditions. The IAC met quarterly through-out the fiscal year and reviewed the rules and policiesthat were adopted, which included the Total FundInvestment Plan (TFIP or Investment Plan) and sup-porting documents involved in the evaluation of theInvestment Plan.

III.1.3 THE EXECUTIVE DIRECTOR

The Executive Director is responsible for managing anddirecting all administrative, personnel, budgeting, andinvestment functions, including the strategic and tacti-cal allocation of investment assets. In addition, theExecutive Director is charged with developing specificasset class investment portfolio objectives and policyguidelines, as well as providing the Trustees withmonthly, quarterly, and annual reports of investmentactivities.

Furthermore, the Executive Director has investmentresponsibility for maintaining diversified portfolios andmaximizing returns with respect to the broad diversi-fied market standards of individual asset classes, con-sistent with appropriate risk constraints. Investmentsare made to maximize returns over a long period of timeand may utilize a broad range of investments, includingsynthetic and derivative instruments.

III.1.4 INVESTMENT OBJECTIVES

Our fiduciary standard requires that investments of theFlorida Retirement System Trust Fund (FRSTF) be madesolely for the benefit of the beneficiaries and for noother reason. The goal of the FSBA, as stated in theInvestment Plan, is to maximize the probability ofachieving a long-term real return over the rate of infla-tion of at least 4.3% per annum on the FRSTF’s portfo-lio, subject to risk considerations. This target is judgedto be superior to a flat rate actuarial target. Because FRSDefined Benefit (DB) plan liabilities are driven in signif-icant part by inflation, a long-term real return targetaffords a more realistic assessment of how well ourinvestment performance tracks overall growth in liabili-ties. In setting the framework for achieving its goal, theTrustees also set a relative investment performanceobjective for the Executive Director to meet or exceedthe composite of returns of financial market indices forthe respective asset classes, as enumerated in a static“Target Portfolio.” Individual portfolios have disciplinedinvestment strategies designed to contribute to return ina positive way on a long-term basis, measured againstperformance benchmarks.

III.1.5 RISK

Risk must ultimately be assessed in terms of the goal ofthe FRS––providing funds to cover payment of retire-ment benefits over the life of the plan. The FRS is ayoung plan, and most of these liabilities are well out inthe future, although changes set in motion by the newDefined Contribution (DC) plan could change liabilitiessignificantly. Risk is the prospect or danger of a shortfallin funds necessary to make these payments. Althoughthe FSBA concentrates on the investment risk, total riskfor the FRS is affected by both assets and liabilities.Shortfalls typically occur because assets grow moreslowly than anticipated, but shortfalls can also occurwhen liabilities grow faster than anticipated. Risk is nota generic abstraction like standard deviation, but thepossibility of a real loss.

From the investment perspective, the probability of ashortfall is determined mainly by the expected return onthe portfolio. Risk is a long-term notion related to howconfident we are in our asset return expectations overthe life of the plan. Given the great uncertainty aboutthe economic/institutional environment over this longperiod, we would like to invest in assets with very robustreturns, those that can ride out the vicissitudes of eco-

nomic and political events. From the liability perspec-tive, we would like to minimize the impact of unexpect-ed trends in liability growth due to these same events byusing assets that respond to them in much the same wayas liabilities do. In particular, FRS liability growth is sen-sitive to real economic growth. Additionally, inflation isparticularly important in determining benefit levels solow risk assets provide robust real, rather than nominalgrowth.

A related concept is the short-term volatility of thereturn––how variable the return is from period to peri-od. The more volatile an asset is, the less certain one canbe of achieving the expected return at any specific time.However, short-term volatility does not imply that thelong-term expected return is in question. The signifi-cance of volatility increases as a fund matures from aposition of net cash inflows to net cash outflows.

The classic goal of portfolio management is to maximizeexpected long-term return (thereby, reducing shortfallrisk) subject to the ability to withstand the anxiety pro-duced by the short-term volatility of the return. Theperformance characteristics of the total portfolio are afunction of the individual securities in the portfolio. Tomake the assessment of these characteristics manage-able, the securities are grouped into homogenous class-es referred to as asset classes. Studies have shown thatover 90 percent of the expected return/volatility of anybalanced portfolio is determined by the mix of the class-es of invested assets, with the remainder coming fromsecurity selection within individual portfolios. TheInvestment Plan, as approved by the Trustees, sets out atarget allocation mix or Target Portfolio, which isexpected to satisfy the requirements of the FRS with anacceptable level of risk. The characteristics of the TargetPortfolio, and thus its shortfall risk are based on twoelements: assumptions on the return/volatility of theasset classes and performance of the asset class portfo-lios. If each asset class performs according to expecta-tion, and each asset class portfolio matches its assetclass return, then the Investment Plan’s expectationswill be realized.

Examination of the sources of risk is most meaningfullydone at the asset class level. The asset classes authorizedin the Investment Plan are domestic equity, internation-al equity, fixed income, real estate, alternative invest-ments, and cash. Each of these asset classes has its owncharacteristics, which are explained in the followingparagraphs.


Stocks (international and domestic) have higher expect-ed return and larger price volatility than any of the othertraditional asset classes. Stocks are shares of ownershipin businesses, and as such, they represent a claim on itsprofits. Because of the uncertainty of return, stocks havehistorically yielded a higher return than other assets.Over the past 200 years, domestic stocks have shown aremarkable ability to provide a real return, approximate-ly three percent over the real growth rate of the econo-my and six percent over inflation. Multi-year periods ofhigh and low inflation had roughly the same return.Stocks are thus a very effective way of participating ineconomic growth over time. This growth is reassuringon two fronts. First, we can have a high level of confi-dence of achieving the long-term expected return; andsecond, stocks are sensitive to the same economic fac-tors as liabilities, suggesting they will move in tandemover time. The downside for stocks is short-term volatil-ity. Over the past 30 years, the standard deviation wasroughly 17 percent. While the expected annual realreturn is six percent per year, in any given year, there isa roughly 35 percent chance of earning zero or less,which will periodically generate a great deal of anguishwithout affecting the long-term risk. Moreover, if infla-tion remains muted in the intermediate-term, totalreturns on stocks may be close to eight percent peryear––less than one-half as strong as returns over thelast five fiscal years.

International stocks share many of the institutionalcharacteristics of domestic stocks. The most widely usedinternational performance figures began in the early1970s, when the fixed foreign exchange system waseliminated and currency prices became determined inthe market. Academic studies have examined longerreturn series beginning in the 1920s. The overall con-clusion is that international stocks have had a slightlylower return than domestic stocks, although volatilitywas higher. However, the pattern of return is significant-ly different from the pattern for domestic stocks, addinga powerful diversification effect at the total portfoliolevel.

Bonds are contractual obligations, which may be used tolock in a nominal return for an extended period (typi-cally, up to 30 years). The price of this feature is that thereal return is uncertain; locking in a nominal return alsolocks out flexibility. Over the last 200 years and majorsub-periods, real returns have been in the two to fourpercent range, but real returns have waxed and wanedwith inflation. This makes bonds a poor choice for long-

term, unknown obligations. The positive for bonds isthat their short-term volatility is less than stocks, atroughly eight percent. With an expected annual realreturn of three percent, there is a 35 percent probabilityof earning zero or less in any given year. Although bondshave lower volatility on a short-term basis, they are actu-ally more risky in the long run (i.e., there is more uncer-tainty about earning a real return commensurate withliability needs) because of their inability to respond tochanges in economic conditions.

From the FSBA perspective, real estate is an equity own-ership investment. Mortgages and bonds, even thosewith a real estate base, are still considered to be fixedincome investments. Over the relatively short availablehistory of institutional real estate portfolio returns(about 20 years), we see that expected returns andvolatility fall between those of stocks and bonds. Weexpect higher returns than bonds because of the owner-ship aspect, but the stability of rental income dampensvolatility and keeps it closer to bonds than stocks.Returns appear to be correlated with inflation, doingwell in periods of high inflation. Because of the difficul-ty in creating a large exposure and the uncertainty overwhether real estate returns will keep pace with econom-ic expansion and liability growth, real estate is lessattractive than either foreign or domestic equities.

The Alternative Investments asset class is presently com-posed of private equity investments through limitedpartnerships and captive (exclusive) relationships.Portfolio investments are predominantly equity invest-ments in domestic and international companies, butthere are a number of fundamental factors that establishthese partnerships as a separate and unique asset type.Once a contractual capital commitment is establishedwith the general partners, limited partners must satisfycapital calls and have no rights to the invested capital.Limited partnerships are also materially higher in riskthan a diversified market index of domestic securitiesbecause portfolio companies tend to have higher balancesheet leverage and the portfolios tend to be concentrat-ed. In addition, portfolios are actively managed and theportfolio investments and general partnership arrange-ments are relatively illiquid. Over the long-term, theFSBA expects its private equity investments to surpass arisk-adjusted hurdle rate of 600 basis points over thebroad United States equity market return.

The Cash asset class, from our risk perspective, posesthe highest level of risk. The long-term historical return



on cash has been lower than the other asset classes and,in real terms, has approximated zero for long periods.As a consequence, in the long run there is virtually a100 percent probability of not achieving the FRS realreturn target using cash. This leaves diversification asthe only potential role for cash. While its inclusion in aportfolio of volatile assets like domestic stocks willdampen the short-term price volatility, the cost in termsof lower portfolio return is high. As a result, cash isoverpowered by other, higher returning asset classes asa volatility reducer.

From the perspective of risk, we have some specific rea-sons to prefer domestic stocks as the principle returngenerator in the portfolio. The straightforward way toreduce shortfall risk is to invest in assets with higherexpected returns; the higher powered the portfolio’searning potential, the less likely it will earn less thanthe long-term target. The tradeoff is that stocks alsohave the greatest price volatility. Even for funds like theFRS that would not have to realize losses in marketdownturns to pay the bills, the size of unrealized short-term losses is of concern to stakeholders and theTrustees. There is a limit to how much short-termvolatility even the staunchest long-term investor cantolerate. The role of the other asset classes in the port-folio (international stocks, bonds, real estate, alterna-tive investments, and cash) is to diversify away some ofthe volatility. Each asset class has a different pattern ofprice movement so that their individual variation tendsto cancel out. A judicious combination of various assetclasses will thus reduce the total portfolio’s volatility in

the short run. In general, this is achieved at the cost oflower long-term expected returns.

The FSBA utilizes independent performance evaluationand actuarial consultants to assist in determining thetarget allocation. The target allocation addresses risk asreflected in the rules and statutes. To control for short-term volatility and excessive exposure to any specificinvestment risk, the portfolio is diversified. That is,investments are diversified as to asset class, and withinasset class by maturity, liquidity, industry, country, com-pany, and size––among other considerations.

III.1.6 ASSET ALLOCATION

This year, the FRS Total Fund Investment Plan wasamended to establish new target asset allocation andpolicy ranges for Domestic Equities and AlternativeInvestments.

Because of its unique investment characteristics andincreased size, Alternative Investment’s target allocationwas increased from 2.5% to 4.0%, and the policy rangewas increased from 1-4% to 1-6%. The Executive Directormay vary the actual asset mix from the target asset alloca-tion in order to pursue incremental investment returns.However, during the fiscal year, actual asset allocationswere kept very near to the target asset allocations by fol-lowing a rebalancing discipline that was adopted as aninternal procedure in the fall of 1997. Tables III-1 and III-2 summarize the target asset allocation and policy rangesthat were in effect during the fiscal year.

TABLE III-1FLORIDA RETIREMENT SYSTEM TARGET ASSET ALLOCATIONS



TABLE III-2FLORIDA RETIREMENT SYSTEM ASSET ALLOCATION POLICY RANGES


III.2 ECONOMIC AND MARKET CONDITIONS

The past fiscal year was a difficult one for investors asthat age-old bane of market economies – the businesscycle – loudly announced that reports of its demise hadbeen exaggerated. The year began with the FederalReserve still attempting to engineer a ‘soft-landing’ fromgrowth rates it viewed as being unsustainable and likelyto result in an inflationary spiral. Real GDP had grownby over 4 percent in 1998. This was somewhat higherthan what was believed to be the economy’s long-termnon-inflationary speed-limit on growth. The Fed per-ceived growing risk that tightening labor markets woulddrive up wages and prices thereby forcing the enactment ofrecession-inducing tight-money policies. Consequently, inmid-1999 the Fed began a series of incremental interestrate increases designed to brake economic activity modest-ly. The economy initially shrugged-off the higher inter-est rates with real GDP for 3rd and 4th quarter 1999shooting ahead at 4.7 percent and 8.3 percent respec-tively. Growth for the full year again registered over 4percent. The Fed’s tightening continued and by May2000 it had raised the federal funds rate a total of 175basis points to levels unseen since the early 1990’s.

As FY 2000-2001 unfolded the economy began to slowappreciably. Real GDP growth moderated to less than 2percent in both the 3rd and 4th quarters of 2000 (i.e., thefirst half of the 2000-2001 fiscal year). These were thefirst back-to-back quarters of sub-2 percent growth since1995 and were within the parameters of what might becalled a soft-landing – assuming no further loss of alti-tude. However, by late 2000 several disturbing develop-ments were leading the Fed to reassess its policy stance.

Prominent among these was a sharp run-up in oil prices.After years of comparative dormancy oil prices acceler-ated substantially in 1999 and 2000. The average priceof OPEC crude traded in the $10 per barrel rangethrough late 1998 and early 1999 but thereafter the oil-exporting countries began to flex a bit of muscle. Thirdquarter 2000 saw OPEC prices push through the $30 perbarrel mark. The impact on the U.S. economy of thishigher energy ‘tax’ was on the order of $50 billion peryear, roughly .5 percent of GDP.

Another alarming development came from the nation’sheartland as the manufacturing sector of the economylost momentum. The National Association of PurchasingManagers Index dropped below 50 in August 2000 andstayed there for the rest of the year. Readings below 50in this widely-watched index signal a reduction in man-ufacturing activity.

Equity markets were an area of increasing concern forthe Fed. A strong bull market had emerged in the late1990’s with nascent technology stocks leading thecharge to double-digit annual percent advances in mar-ket indexes. But thanks to the double-whammy of high-er interest rates and rising oil prices the markets wereshowing bear tendencies by the end of 2000. Particularlyhard-hit were technology sectors, but the broader mar-ket was also showing weakness. Stock-market gains hadbeen a major factor in stimulating consumer spendingfor some time and concerns emerged that falling shareprices would lead to a spending slowdown by house-holds. This concern was exacerbated by declines in con-sumer confidence at year-end 2000.

While business spending remained fairly strongthroughout 2000 the latter half of the year did witness adeceleration in purchases of technology-related equip-ment – one of the main drivers of the late-90’s boom.Persistent double-digit growth rates in this category ofbusiness investment had added a good deal of impetus tothe economy’s continuing strength. It has been estimat-ed that high-tech investment (i.e., spending on comput-ers and peripheral equipment, software, and telecommu-nications equipment) accounted for about one-fourth ofreal GDP growth in 1998 and 1999. But in the thirdquarter of 2000 this category of investment grew at asingle-digit pace and showed signs of further slowing.

Also flashing warning signs was the foreign trade sector.The U.S.’s major trading partners were experiencing var-ious difficulties ranging from Japan’s chronic stagnationto Europe’s need to exercise economic restraint in sup-port of the euro (the newly-introduced European cur-rency unit). This curtailed demand for U.S. exports.Developing nations had suffered economic setbacks as aresult of the 1998 financial crisis cutting further intoexport shipments - particularly to Pacific Rim nations.

By the mid-point of FY 2000-2001 the Fed had seenenough incipient weakness to persuade it that inflationwas no longer the primary near-term threat to the econ-omy. A quick about-face commenced with an unexpect-ed 50 basis point cut in the federal funds rate to ring inthe New Year. This was to be the first in a series of sixrate cuts that would lower the funds rate 275 basispoints by fiscal year-end 2000-2001. Unfortunately, theeconomy’s response was less than salutary. Whereashigh-tech spending had begun to fade a few months ear-lier, by second quarter 2001 it was in a free-fall. The sud-den, precipitous drop in high-tech investment led manyto conclude that the burst of technology-related spend-ing throughout the late 1990’s was excessive and hadresulted in significant amounts of currently unneededcapacity. This phenomenon goes under the rubric ‘over-investment’ in business-cycle nomenclature and tends tomake for a slow recovery in investment spending regard-less of interest-rate policy.

Lower interest rates are generally expected to stimulatethe stock markets, but in the extant milieu the marketshowed little enthusiasm for Fed cuts. Corporate profitswere plunging in early 2001 making valuation levels ofa year earlier seem unrealistic, and the markets mean-dered at levels well below their peaks. This negated oneavenue through which the Fed had hoped to rejuvenate

the economy – namely a stimulus to consumer spendingfrom rising stock prices. Consumer spending had heldup better than business spending throughout 2000 andearly 2001, but the Fed did not expect that the consumeralone could keep the economy aloft indefinitely.

The manufacturing sector continued to deteriorate withindustrial production and employment steadily falling.Meanwhile, the foreign sector was still experiencingproblems as economic weakness around the globe sus-tained the slide in U.S. exports.

A look back from fiscal year-end 2001 validates the Fed’smid-year policy shift. During FY 2000-2001 the econo-my grew by just 1.2 percent. This was the weakestgrowth in real GDP for any contiguous four quarterssince calendar 1991 - the first three months of whichwere the concluding quarter of the 1990-1991 recession.Talk of a soft-landing had faded. The issue had becomewhether a combination of stimulative monetary and fis-cal policy (in the form of ‘tax rebates’) would be able tokeep the economy from slipping into recession.

Many economists believed that the economy would rightitself fairly quickly. They placed their bets on the con-sumer. Buoyed by liquidity extracted from mortgage refi-nancing and funds liberated from stagnant equities, con-sumer spending maintained a healthy if unspectacularreal growth rate of roughly three percent in the first halfof 2001. Relatively low mortgage rates were helping tokeep home purchases at respectable levels. The afore-mentioned tax rebates were expected to assist house-holds in maintaining their spending. Those taking anoptimistic view also expected the business sector toturn-around near-term. They pointed to prospects for areturn to net investment in business inventories. In aslowing economy, businesses find unwanted inventoriespiling up. These must be worked off before new ordersto producers can recover to normal levels. The rate ofdecline in inventories was decreasing as the fiscal yearclosed suggesting that inventory disinvestment mighthave run its course. Also, oil prices had retreated fromtheir highs and settled near a bearable $25 per barrel.Uncertainty about future price behavior was mitigatedby OPEC’s stated intent to maintain prices in this range.

On the ever-present other hand a sizeable fraction ofeconomists felt that the near-term outlook was for fur-ther weakening. They argued that unemployment –heretofore confined mainly to the manufacturing sector– was likely to rise substantially with perverse impacts



TABLE III-3ACTUAL QUARTER-END ASSET ALLOCATION


TABLE III-4ACTUAL FISCAL YEAR-END MARKET VALUES BY ASSET CLASS


on consumer confidence and spending. A retrenchingconsumer sector would make a resurgence of corporateprofits unlikely and dissuade businesses from theresumption of investment at normal levels.

Over the 12 months ending June 30, 2001, financialmarket returns generally reflected the broad economicenvironment. Short-term U.S. Treasury Bills provided arespectable 5.6 percent return for the period as theFederal Reserve cut overnight rates six times during thesecond half of the fiscal year. With falling short-terminterest rates, fixed income returns beat cash returns bya large margin. The Lehman Brothers Aggregate Index, abroad market-weighted index containing governmentbonds, corporate bonds, and mortgage-backed securi-

ties, had a return of 10.8 percent for the year. However,on the downside, the Wilshire 2500 Index, excludingtobacco stocks, posted a -15.6 percent loss for the year.The drop in the equity markets reflected slowing world-wide economic growth and falling corporate profits,basically, a bad year for the equity markets.

III.3 ASSET ALLOCATION FOR FY 2000-2001

Tables III-3 through III-5 reflect asset allocation andmarket values by asset class. This perspective is appro-priate for monitoring compliance with statutory limita-tions on asset holdings and is consistent with the targetand range policies contained in the Investment Plan.


TABLE III-5QUARTER-END MARKET VALUES BY ASSET CLASS


III.4 PERFORMANCE EVALUATION FOR FY 2000-2001

III.4.1 ANNUALIZED TOTAL FUND INVESTMENT PERFORMANCE

The performance of each asset class is measured relativeto a broad market index as specified in the FRS TFIP andenumerated in the notes to the following tables. The per-formance of the Total Fund is measured relative to aweighted average of those indices, weighted according tothe policy ranges specified in the TFIP. These policyranges were changed during the fiscal year and are shownin Table III-2. In addition, the performance of the TFIP ismeasured relative to an absolute long-term performanceobjective as set forth in the TFIP, which is an absolute realreturn target of 4.3 percent. Assuming normal contribu-tions are made, if the FRS plan assets annually grow by4.3 percentage points in excess of the rate of inflationover the long-term, the plan should maintain its fully-funded status. Combining the absolute real return targetand actual inflation results in the absolute nominal targetrate of return, which is presented in Table III-6. Table III-7 contains detailed performance data for the public mar-ket asset classes within the FRS portfolio. This breakout isintended to allow a comparison of performance acrossvarious time periods and asset classes. The asset class tar-get indices are not adjusted for implementation costs.Research indicates that the costs of earning these particu-lar target index returns is on the order of zero, afteraccounting for typical securities lending revenue.

Table III-6 also displays aggregate investment returns forall active portfolios and all passive portfolios, and theirrelevant performance benchmarks. The selective use of

active management strategies for the FRSTF is based onthe dictate in the TFIP to maximize returns relative to thebroad market standards, subject to risk considerations.An important component of risk, in the context of theFRSTF, is the reality that most active managers have his-torically underperformed passive index alternatives. Thesheer size of assets under management for the FRSTF alsoexacerbates the transactions cost drag resulting from theturnover associated with active investment strategies.Therefore, the FSBA’s investment program for the FRSTFhas a substantial reliance on passive index funds. Indexfunds have operational risk. Index funds are intended toclosely track market indices over long periods of time, butwill occasionally lag the costless market index due to themethod of index implementation and transactions costs,although securities lending income is a positive offset tothese shortfalls. Nonetheless, index funds are the mosteffective and lowest cost methods of attaining marketreturns over the long-term.

The managed return for the Total Fund is effectively aweighted-average of the managed return for all activeportfolios and the managed return for all passive portfo-lios. However, this same aggregation approach cannotgenerally be applied to the active and passive perform-ance benchmarks with the expectation that the relativetarget return would result. Two primary factors interferewith this type of calculation: 1) the actual asset alloca-tion across asset classes can differ from the target alloca-tion used to calculate the relative target return; and 2)the actual intra-asset class allocation across sub-sectorsof each asset class could differ from the sub-sectors’weights contained in each target index.


TABLE III-6ANNUALIZED TOTAL FUND INVESTMENT PERFORMANCE*

(by fiscal year periods)

TABLE III-7ANNUALIZED PUBLIC MARKET PERFORMANCE*



III.5 DOMESTIC EQUITIES INVESTMENTS

As of June 30, 2001, the Domestic Equities asset classwas valued at $53.64 billion and accounted for 54.6 per-cent of the total FRS portfolio. The Domestic Equityasset class was broadly diversified across 14 active andfive passive portfolio strategies. Passive investmentscomprised 63 percent of the asset class at the end of thefiscal year. Strategically, the portfolio reflects a neutralmix of growth and value strategies that performed wellthis year relative to their respective benchmarks underextremely volatile conditions.

Over the year, strong outperformance from active port-folios combined with a slight positive return from pas-sive accounts, brought asset class returns to a strong1.27 percent over benchmark. With positive active andpositive misfit (0.14 percent) return, Domestic Equitiessurpassed its asset class target by 1.41 percent. Whileresults to date have been encouraging, we would benaive to forget that periods of underperformance willalways be a part of investment life.

Misfit risk is the difference between the risk exposuresof the aggregate benchmark and the asset class target.Positive misfit return (0.14 percent) was the result of anunder exposure to Internet technology. Like most invest-ment risks, misfit can have an exaggerated impact onperformance during volatile market conditions.Remaining misfit reflects mostly random statistical noisebecause misfit has been targeted to be as close to zero aspossible.

The information ratio provides a risk-adjusted measureof performance. It is computed by dividing activereturns by the standard deviation of those returns. Usingone year of trailing historical data, the information ratiofor active managers, increased from –0.78 in June 1999to 1.03 in June 2000, and then to 1.15 in June 2001. Theannualized information ratio using three years of histor-ical data was 0.72 in June 2001.

The tracking error of passive accounts has been reduced.Using one-year moving averages, passive misfit has beenreduced from 0.31 percent in June 2000 to 0.23 percentin June 2001.

Active management outperformed its aggregate bench-mark by an impressive 3.7 percent. Over the fiscal year,individual active returns within our active managergroup ranged widely from 20.8 percent to –8.5 percent.

Broad market indices continue to be dominated by large-cap companies, which suffered significant declines dur-ing the fiscal year. The S&P 500 dropped 14.9 percent,the Russell 3000 declined 14.0 percent, while theWilshire 2500 and 5000 gave up 14.9 percent and 15.3percent respectively. Small-cap and value investing werethe clear winners as evidenced by the S&P/BARRAMidcap Value Index rising 32.9 percent and the Russell2000 Value Index rising 31.1 percent. The disparitybetween winners and losers was exceptional. Losseswere pronounced in the technology heavy NASDAQComposite which declined 45.5 percent. The spreadbetween mid cap value and NASDAQ was over 78 per-cent.

The technology collapse has been astounding. Techstocks dropped over 13 percent in the third quarter of2000, 32 percent in the fourth quarter, and 24 percent inthe first quarter of 2001. A modest recovery occurred inthe final quarter as the sector regained 12 percent.Despite the small recovery, shares of many prominenttechnology companies closed the fiscal year 80 percentor more below their prior highs.

These disparate market returns occurred in an environ-ment of slowing economic growth. Rising energy pricesand a strong dollar combined with a prime rate that roseto 9.5 percent began to strain business conditions in thelast quarter of 2000. The Fed responded in January 2001with the first of a series of rate cuts designed to provideneeded stimulus. Manufacturing layoffs and ongoingpressure in computer spending continue to producesluggish business conditions despite aggressive ratereductions from the Fed. Corporate profits have weak-ened in this environment and continue to be a majorconcern to equity investors.

Reflecting volatile markets, Domestic Equities receivedrebalance allocations three times and supplied rebalanceallocations six times during the fiscal year. DomesticEquities had not received a rebalance allocation sinceOctober 1998.

In reallocating assets, we were guided by the competingobjectives of misfit risk control and active managementenhancement. At the beginning of the year, reallocationefforts were hampered by inadequate capacity in activelarge cap growth products. To increase capacity, two newlarge cap growth managers were hired during the year.Our passive investment declined from 65 to 63 percentas a result.

Domestic Equities makes an effort to visit all external man-agers on a yearly basis, and managers visit the FSBA on arotating schedule, or as required. Video and teleconferenc-ing meetings are held on a quarterly basis or as needed.Enhanced oversight of performance and activity has con-tributed positively to these important relationships.

Administrative initiatives during the fiscal year includethe development of a proposed risk budget within aframework common to all FSBA asset classes. A newtransactions cost-measurement vendor was selected.Considerable staff time was used to analytically supportthe development of the Defined Contribution program.Other initiatives include continued efforts to controlinvestment management costs and automation of in-house performance measurement systems to increasestaff productivity.

Asset class fees (in bps) remained relatively constant,despite an increase in active management and thedefunding or termination of lower cost underperformingmanagers. Total dollars paid in management fees were$5.6 million less than the previous year, primarilybecause the equity market downturn caused the assetclass market value, on which fees are based, to decline.

To summarize, FY 2000-2001 was extremely busy andproductive for the Domestic Equities asset class. Withthe decline in the market, Domestic Equities received itsfirst rebalance asset allocation in several years. Therestructuring of active management has been completedto the point where the remaining asset class misfit is notstructural but almost completely random statisticalnoise. During a bad year for equities, our investmentexceeded its performance target during the year, despitevolatile market conditions.


TABLE III-8ANNUALIZED DOMESTIC EQUITIES INVESTMENT PERFORMANCE*



III.6 INTERNATIONAL EQUITIES INVESTMENTS

On June 30, 2001, the International Equity portfoliowas valued at approximately $11.24 billion and wasdiversified across fifteen portfolio strategies withinvestments in more than 50 global markets. Passiveinvestments accounted for slightly more than 45 per-cent of the portfolio. The remaining 55 percent was in13 distinct active strategies targeting both developedand emerging markets. Consistent with target expo-sures, at fiscal year end roughly 89 percent of the port-folio was allocated to developed market managers andthe remaining 11 percent was invested with emergingmarket managers.

At fiscal year-end, opportunistic investments by devel-oped market active managers pushed the portfolio to aslight 1.4 percent overweight to emerging markets rela-tive to the MSCI All Country World Index Free ex-U.S.target. In the Pacific, the portfolio maintained a mod-est two percent underweight to Japan, a slight over-weight to Hong Kong, and a small 1.6 percent under-weight to the Asia/Pacific region. The portfolio was alsomodestly underweight to Continental Europe reflectingbets against France, Germany, Italy, and Switzerland.The United Kingdom remained a favorite with our man-agers who invested almost 20 percent of our portfoliothere, which represented a slight overweight relative tothe target. Within emerging markets, the portfolio wasslightly overweight to both Latin America and Asia andmaintained a neutral position in the Europe, Africa, andMiddle East regions.

For the fiscal year, the aggregate International Equityportfolio returned -20.7 percent net of all managementfees, transaction costs, and commingled custodialexpenses. This resulted in an active return of +3.3 per-cent relative to the –24.0 percent return of the aggregatebenchmark.

Misfit for the fiscal year was almost completely con-tained at +2 basis points. As expected, adoption of theintegrated developed and emerging capitalization-weighted target in November 1999 has effectively con-trolled misfit. We maintained our informal rule to rebal-ance the portfolio between developed and emergingmarkets only if the misweight exceeded three percent.Because the developed/emerging market allocation ofthe portfolio has floated roughly in tandem with theintegrated target, no rebalance was necessary under therule.

Our investment in the Barclay’s EAFE plus Canada IndexFund returned 19 basis points over its benchmark. Aneffective securities lending program, a slight cash posi-tion in a declining market, and favorable dividend taxtreatment advantaged the portfolio relative to the bench-mark.

The SsgA Emerging Market Index Fund underperformedits benchmark by 16 basis points over the fiscal year.High transaction costs and few securities lending oppor-tunities continue to make passive investing difficult inemerging markets. In addition, the migration of Greecefrom emerging to developed markets cost about 15 basispoints to transact.

The developed market active portfolio lost 16.7 percentin absolute terms, but handily beat the benchmarkreturn of –23.8 percent. Strong stock selection account-ed for most of the active return. The portfolio’s valuebias, defensive posture, and avoidance of technology andEuropean telecom stocks were important contributors toreturn. The emerging market positions of the portfoliodetracted slightly from performance as emerging mar-kets marginally underperformed developed markets.Five of the eight active managers beat their benchmarkfor the fiscal year. The disciplined, value-orientedphilosophies of Morgan Stanley, Sprucegrove, andTempleton were rewarded as these managers enjoyeddouble-digit active returns. Conversely, T. Rowe Price’sgrowth bias and Capital Guardian’s core approach,which continued to identify value in growth areas of themarket, were less successful and these two managersunderperformed for the fiscal year. Putnam also employsa core approach but better navigated the market turnfrom growth to value and had positive active perform-ance. Blairlogie struggled as their top-down focus failedto add value and stock selection was poor. We have dis-cussed our concerns with Blairlogie, whose performanceis now marginally below their benchmark since incep-tion, and will continue to monitor them closely.

The emerging market active portfolio fell by 23.8 per-cent, 218 basis points less than the benchmark declineof 25.9 percent. Emerging markets were hammered byconcerns about global growth, higher energy prices, andintermittent financial crises in Argentina and Turkey,which threatened contagion. Despite uncertain marketconditions, three of the five active managers deliveredpositive active returns. Most notable was Genesis whoadded more than 1,000 basis points of active returneliminating most of their since inception deficit. As

emerging market investors refocused on company fun-damentals, our value managers, Genesis and J.P. Morganexcelled. State Street Global’s quantitative, risk con-trolled approach continues to provide steady perform-ance, adding 120 basis points of active return. After abanner fiscal year, Capital International has been unableto add value recently. Consistent with their developedmarket counterpart, Capital International continued tofind value in technology and telecom sectors, whichhurt performance. Schroders also maintained a growthbias throughout the year and lagged the benchmark.Schroders has trailed the benchmark for the past two fis-cal years and since inception. After the fiscal year, werebalanced our target to the MSCI provisional index,which has a reduced emerging market component.Given this reduction and our continuing concern withSchroders’ performance we liquidated Schroders to fundadditional developed market investments.

When compared to the prior fiscal year end, investmentmanagement fees decreased by three basis points.During the fiscal year there was a slight reduction in thelevel of passive management, from approximately 50percent to 45 percent of the portfolio, and some loss ofeconomies of scale due to negative market performance.However, the reduced market value of the portfolioresulted in lower investment management fees relativeto last fiscal year.

To summarize, our international equity investmentsperformed relatively well during a difficult year. Equitymarkets provided investors few hiding places as earn-ings and expectations were ratcheted down in the faceof declining global economic growth. We were encour-aged that our diversified portfolio was able to add sig-nificant value relative to its target amidst volatile mar-ket conditions.


TABLE III-9ANNUALIZED INTERNATIONAL EQUITIES INVESTMENT PERFORMANCE*



III.7 FIXED INCOME INVESTMENTS

Fixed income returns, as measured by the LehmanAggregate Index, rebounded well from Fiscal Year2000’s anemic 4.57% to return 11.23% in the fiscal yearended June 30, 2001. The bulk of the return came dur-ing the first half of the year as the market correctlyanticipated an economy coming off the boil and an eas-ing in monetary policy by the Federal Reserve.Beginning the fiscal year at over 7.0%, bond yields fellto just above 6.0% by January 2001, allowing investorsto earn 3.75% in price appreciation on top of the 3.6%in coupon income. For the balance of the year howev-er, yields on longer-term securities remained steadyeven while the Fed was consistently lowering short-term rates.

Two-year treasury yields, which are highly correlatedto monetary policy, began to decline dramatically inDecember and continued to do so throughout much ofthe remainder of the fiscal year. In contrast, the netchange in ten-year yields for the entire fiscal year wasa decline of just over 55 basis points, compared to the225 basis point fall in two-year yields. With an averagematurity of over eight years, one can see how the sec-ond half of the fiscal year basically reflected the effectof coupon income on the market.

As discussed in last year’s annual report, the return ofthe aggregate target, which represents the overall mar-ket of outstanding public bond issues, masks what ishappening in the major sectors that comprise it. Wehighlighted the very substantial differences in returns,particularly between U.S. Treasury bonds and corpo-rate bonds, both high and low grade. The difference inperformance between treasuries and high grade corpo-rates was +2.31% in favor of treasuries, virtuallyunheard of in a one-year period. Much of that differ-ence was attributed to three major factors which hadnot been present and to which risk adjustments werebeing made by investors. Those factors were the effectof the shape of the yield curve and the level of rates oninterest rate swap spreads, the shrinking supply of U.S.Treasury securities and the lack of market making bydealers.

Returns in this fiscal year, as seen by the large absolutenumber of 11.23%, are indicative of investors partiallyresolving some of the above mentioned issues and theeffect of monetary easing on interest rate swaps. The

dramatic fall in short-term rates, resulting in a lowerand more positively sloped term structure had a favor-able effect on interest rate swap spreads, an importantdriver of corporate bond returns. After reaching a wideof 130 basis points in August 2000, ten-year swapspreads narrowed to less than 80 by June 2001. Thischange implied a significant reduction in the liquidityrisk premium imbedded in non-treasury bonds, allow-ing their prices to increase on a relative basis.Prospects for much slower economic growth, thereduction of budget surpluses and fewer buy backs oflong dated treasuries alleviated investors’ immediateconcerns about a scarcity premium. This had the effectof lowering treasury bond returns relative to other sec-tors in the fixed income market. While market partici-pants seem now to be unconcerned with shrinking sup-plies of treasury securities, the effect of compositionalchanges will remain an issue over the next severalyears. In the last two years alone, U.S. Treasuries out-standing declined by over $350 billion (20.4%), whilecorporate bonds increased by $512 billion (45.6%).The future growth path of these two sectors remainsboth a political and economic question. Stronger eco-nomic growth should be positive for surpluses but onlyto the extent that politicians refrain from spendingthem. Finally, the issue of dealer market making willprobably not be resolved soon. Secondary trading ofhigh-grade bonds cannot generate the high return oncapital required by broker-dealers. Consequently,inventory levels will remain small relative to the needsof an asset management community that continues toconsolidate its asset base.

All actively managed fixed income portfolios returned10.6% in fiscal year 2000-2001, exceeding their per-formance benchmark by 24 basis points. Passivelymanaged portfolios earned 11.3% versus their bench-mark return of 11.2%. The combination of all activeand passive portfolio returns, plus the return differencedue to sector allocation (misfit) against the FixedIncome Management Aggregate resulted in a 10 basispoint performance advantage in the fiscal year endedJune 30, 2001.

As was the case last year, decomposition of sectorreturns in the bond market showed large relative dif-ferences. In descending return order, high grade corpo-rates exhibited the strongest performance (12.27%),followed by mortgage-backed securities (11.28%),treasuries (9.83%) and high yield (2.82%). Compared

to last fiscal year, the performance reversal betweenhigh-grade corporates and treasuries was again sub-stantial (+2.44%). The return to favor of high-gradecorporates had a very positive effect on the internallymanaged Government/Corporate portfolios. The returnon roughly $15 billion invested in this sector exceededthe benchmark return by 49 basis points for the yearand by 13 basis points (annualized) over a three-yearperiod.

The $8 billion mortgage-backed securities portfolioreturned 1 basis point less than its target for fiscal year2001 and averaged 1 basis point above for three years.As mentioned in prior reports, our expectation is forbenchmark returns for this portfolio due to the effi-ciency of the pass-through market, a 30 percent pas-sively managed share and somewhat restrictive invest-ment guidelines. However, our internally managed“synthetic” mortgage portfolio, representing $1.6 bil-lion, continued to outperform its benchmark as expect-ed. For the year, the portfolio exceeded its target by 31basis points. In the nearly three years since inception,the portfolio exceeded the benchmark by 26 basispoints per year. The portfolio consists of AAA ratedfloating rate securities, combined with total rate ofreturn swap contracts on either the Lehman or MerrillLynch MBS index. Since its source of funds is external-ly managed active or passive mortgage portfolios, thisgenerates a savings of approximately $1 million peryear in management fees.

The high yield sector, which represents about 4.5 percentof the aggregate fixed income target, continued to sub-stantially lag the other sectors. Even with significantlygreater coupon income than default-free treasuries, highyield bond price declines more than offset the advantage.Treasury bond price return was positive 3.24 percent infiscal year 2001, while high yield price return was nega-tive 6.91 percent. The decline in price of high yieldbonds reflected investors’ demand to be compensated foradditional risk, primarily due to higher expecteddefaults. Perceptions were borne out since actual trailing12 month defaults rose from 5.73 percent in July 2000 to9.42 percent in June 2001. Breaking down the high yieldmarket into sector and quality cells, it becomes clearerwhat happened. On a purely sector basis there were twosegments which performed poorly – Telecom andTechnology, both battered by the bursting of the Techbubble in the equity market. While both sectors had largenegative returns, it was the weight of Telecom in the

index that influenced returns, especially in the single Bsector. At 11 percent of the total high yield market,Telecom is the largest single sector. Within quality cellsTelecom represents over 20 percent of single B’s, fourtimes the weight in double B’s. The return of Telecom forthe year was about –32 percent. The Technology sector,representing another 9.5 percent of the market, returned–19 percent. Together these two sectors, representingover 20 percent of the market, had a return of –26 per-cent. This large negative return in sectors with large mar-ket cap was responsible for the paltry 2.82 percent returnfor high yield. Eliminating these two sectors would haveleft the remaining high yield market with a much morepalatable 10.3 percent return for the year.

Externally managed high yield portfolios returned 151basis points less than the benchmark for the fiscal yearand 97 basis points less (annualized) over the lastthree. Both the short and longer-term records indicatethe difficulty faced in finding managers who delivergood, consistent long-term performance. Overall, sincethe inception of our high yield program, managers(both current and former) have underperformed thebenchmark by 61 basis points annually. Only two of theoriginal four managers remain. Personnel turnover,structural changes within firms and poor execution ofportfolio strategy were the major issues resulting in thetermination of two managers. Except for the latterissue, neither of the other two can be forecasted basedon historical performance or predicted based on anyinformation gleaned at the time of hire. The tworemaining managers have very recently undergonesome of the same problems alluded to above. In onecase we continue to believe the personnel in place canproduce long-term excess returns. However, we aresomewhat at risk to the firm’s strategy of growing theirhigh yield business and stretching limited expertise toothin. The other manager recently had a departure ofone member of the firm’s two-person portfolio manage-ment team. There is currently no plan to replace theindividual who departed, so once again we may findourselves more at risk to future performance. In orderto mitigate what seems to be potentially higher per-formance risk, we are in the process of hiring two addi-tional high yield managers. Each was identifiedthrough an exhaustive search process recently conclud-ed for the new PEORP pension plan to be offered toFlorida Retirement System members.



TABLE III-10ANNUALIZED FIXED INCOME INVESTMENT PERFORMANCE*


III.8 REAL ESTATE INVESTMENTS

Real Estate ended the 2001 fiscal year with investments val-ued at 4.032 billion dollars which was 4.11 percent of totalFRS pension fund assets, slightly exceeding our target of 4percent. The investments are 87.39 percent directly owned,2.6 percent in pooled funds, 8.7 percent in publicly tradedstock and 1.4 percent in short term cash equivalent invest-ments. Our directly owned portfolio is diversified by prop-erty type as well as by geographic region. Office propertiesmake up 51 percent, apartments 17 percent, industrial 12percent, retail 11 percent and agricultural properties 9 per-cent. We have 48 percent of our directly owned non-agri-cultural properties in the Western region of the U.S., 13 per-cent in the Midwest, 28 percent in the East and 11 percentin the South. Our pooled funds are also diversified by prop-erty type and geographic region. Our agricultural propertiesare diversified by crop variety, permanent plantings and rowcrops, as well as geographic regions.

We have maintained our commitment to pursuing generalpurpose properties such as office buildings (suburban andcentral business district), retail (primarily groceryanchored or community centers), warehouse and distribu-

tion facilities, as well as apartments (garden style, mid-riseand high rise). While we have participated in developmentjoint ventures, our preferred investment continues to becompleted and leased properties. We do invest in valueplays where we consider the leasing and construction riskto be manageable. We have not increased our investment inagriculture investments, pooled funds, and real estate secu-rities. We have focused on directly owned assets in order toactively manage investment risk and portfolio risk.

During the fiscal year we have seen real estate markets,in general, slow in concert with the slowing nationaleconomy and GDP. The slow down is reflected in risingvacancies and slower rent growth and in some metroareas such as San Francisco, declining rents. The slowdown is across all property types. Exposure to dot comsand related tech commerce centers has proved to beespecially painful to landlords, developers and the con-struction industry. A good note is the notion in the realestate community that we are not swimming in exces-sive vacant space, at least compared to previous eco-nomic downturns. Dot coms and related tech firms arenot going away, they will continue to be important play-ers in our commerce and will once again prove to be a

significant element in the demand for space. Thoughthis year has brought challenges to the real estateinvestor, we anticipate a softer landing than in previouscycles and a more robust recovery.

We began the fiscal year with $4.2 billion of real estateassets and at our target real estate allocation of four per-cent. We focused our attention on managing the portfolio’sassets, selecting assets for disposition and looking foracquisitions to replace culled assets. We continued to over-sight the development of our office building joint venturesin Minneapolis and Phoenix as well as our warehousedevelopment ventures in Denver and Southern California.The portfolio enjoyed good occupancies and rent growth asthe year started, but our expectations became clouded asthe year progressed. We will be challenged in the comingmonths, but we have a portfolio of high quality assets andare prepared to ride out the bumps.

We acquired a 264,000 square foot community shop-ping center located in Issaquah, Washington, a submar-

ket of Seattle. The purchase price was $42 million. Wesold three assets during the fiscal year. The first was anoffice building located in Larkspur, CA. which we pur-chased in 1988. The selling price was $37.4 million.The second was a garden style apartment communitylocated in Austin, TX. which we purchased in 1994. Theselling price was $19.5 million. The third sale was anoffice building in Washington, D.C., which we pur-chased in 1988. The selling price was $73 million.

We had the pleasure of working with two interns thisyear and hope that they have benefited as much as wehave. We are continuing our efforts to quantify portfo-lio risk measurements and are developing an in housecapability to better assess specific market supply anddemand characteristics. Again, this year we have man-aged to be below the midpoint average of our peers inthe fees paid to professional service providers for ourinvestment activities.


TABLE III-11ANNUALIZED REAL ESTATE INVESTMENT PERFORMANCE*

(selected periods ending June 30, 2001)


III.9 ALTERNATIVE INVESTMENTS

On June 30, 2001, the Alternative Investmentsportfolio had a market value of $3.51 billion. Theentire portfolio is actively managed. The portfoliogenerally consists of limited partnerships, which areexternally managed by general partners, to which theSBA has made fixed commitments of capital.Alternative Investments has made commitments to 25current partnerships. Due to multiple successor funds,these partnerships are managed by 15 separate privateequity relationships.

Alternative Investments committed $950 millionduring FY 2000-2001 to new funds of existingrelationships. These commitments were madeconsistent with the goals and objectives outlined forthe asset class when it was created in November 1999.This outline included a three-component alternativeinvestment portfolio:

• a core long-term investment in arelatively small number ofsuccessful general partnerships,with places guaranteed in follow-on funds, if desired, with thosesame partners;

• a captive and innovative co-investment effort, with the Boardacting as a value-added partner,heavily involved in generatingquality deal flow; and

• an exclusive, high-quality privateequity partnership that forms asignificant part of the overallportfolio.

As of June 30, 2001, the Alternative Investment portfolioaccounted for 3.58 percent of Florida Retirement Systemassets. Earlier in the year, the target allocation forAlternative Investments was increased from 2.5 percentto 4 percent. This revised target is consistent with theexpected maturation of the portfolio in the near-term anddoes not contemplate new relationships.

On the surface, the Alternative Investment market didnot change much over the past year. Currently, dealpace remains slow and private equity firms continue to

concentrate on current portfolio companies. In thisenvironment, a significant number of capital calls aremade pursuant to follow-on needs while investmentsare exited opportunistically and infrequently. Thiscontinues a trend that began in 2000. Below thesurface, however, some of the variables of privateequity deals had been making modest progress. Thehigh yield spread above ten-year treasuries had fallento 838 basis points from a high of over 1000 earlier inthe year. With asset prices depressed for over a year,many sellers were beginning to recognize that priceswere stabilizing at depressed levels and there was arisk of greater decline. Those that desired liquiditywere beginning to explore options. The one variablethat did not change materially over the year was thelack of senior debt. Senior debt remained at 2.5x to3.0x EBITDA for buyouts for most of the year, withhistorical averages at 4.0x. This one element did moreto slow down the pace of new acquisitions than anyother during 2001. As 2001 progressed, an additionalvariable received increasing attention in the privateequity market: growing uncertainty. Although marketsare always characterized as uncertain, uncertaintyturned into apprehension as the year progressed.Bankers became increasingly fearful that they had overextended themselves. Private equity managers quietlyacknowledged that they might have paid too much forcertain assets. Portfolio companies realized thatsubsequent rounds of financing, let alone exits, wouldbe difficult. During the first half of the year, thoughtswere focused on how long the wait would be until thegood times returned. In the second half, managersasked if their portfolio companies were properlyprepared to endure a protracted slow down.Tremendous focus was brought to existing portfoliocompanies with an emphasis on reaching andsustaining positive cash flow. Some managers werereluctant to take on new acquisitions in the depressedenvironment. Many chose to focus their effort onstabilizing existing investments. Accordingly, there isan overhang of committed capital raised in recentyears that remains uninvested. It is unclear how andwhen this overhang will be deployed.

Where there is uncertainty, there is opportunity. As theyear progressed, we saw an increase in funds trying tocapitalize on the market slowdown and uncertainty.Distressed debt, mezzanine and hedge fund offeringsbecame more common. Due to allocation constraints,Alternative Investments is not actively seeking new

relationships and did not participate in these offerings.The asset class did establish tactical preferences,however, among existing managers whenimplementing our current re-up schedule. Weincreased our initial allocation from $100 million to$150 million for Apollo V. Apollo has repeatedlydemonstrated a focus on value and preservation ofcapital. Given the current outlook, portfoliomanagement deemed this increase appropriate.Carlyle III received its full $200 million commitment.Carlyle has a proven track record of successful exitsand the foresight to position their companies forpositive cash flow in a variety of market environments.Ripplewood has solid portfolio companies but nosignificant exits and has had difficulty raising theirtarget fund size; this last point would have made theSBA a larger percentage of the fund than initiallyanticipated. Accordingly, we committed $50 million ofour initial $100 million allocation. We will reserve thepotential for any additional amounts until their finalclose. At that time, portfolio management can render ajudgment whether any supplemental commitment iswarranted. Our decision will be based on our portfolioneeds, market conditions as well as Ripplewood’sprogress towards its fundraising goals and exitstrategies. One manager that did not demonstratesuperior discipline and focus during recent years, HickMuse, will receive a lower than anticipatedcommitment. We expect that Hicks Muse will refocusits investment discipline on core industries andstrategies that have brought it past success. We willmaintain our strong relationship with Hicks Muse andhope to renew our traditional commitments upon theirrefocus of historical strength. The asset class alsocommitted $200 million to Lexington IV, a secondaryfund. We expect that the drastic current liquidityneeds will bring tremendous opportunity to thesecondary market. Lexington’s strong deal flow andorganizational reach give it unique advantages toprosper in this growing market.

With the portfolio relatively well positioned in itsoriginal framework, we have begun to exploreadditional diversification. Specifically, we have begunto research the venture capital sub-asset class. Theventure community lost billions of dollars over thepast year. Additional losses will be further disclosed ascompanies run out of cash and managers report theirperiodic results. With virtually no exposure to venturecapital, the SBA has avoided near-term venture lossesincurred by most private equity investors. Long term,however, we believe that tremendous value will becreated in this sub-asset class. According to our mostrecent data, ventures funds raised between 1990 and1999 have a median IRR of 22.4% and upper quartilereturns beginning at 77.4%. Despite the existingchallenges, there remains substantial opportunity tocreate and capture value in early stage companies. Wehave begun our initial due diligence by meeting withmarket leaders and professionals in Florida and acrossthe country.

Overall, the portfolio held up well in an increasinglydifficult 2001. The majority of portfolio companies aregenerating positive cash flow. Certain investments areimpaired, however, and others have been written off.The closed IPO markets made realizations lessfrequent and the tight debt markets made acquisitionsdifficult. We expect that most managers will help addvalue until successful exits can be achieved. We alsoexpect them to make opportunistic investments in2002 if market conditions improve. Our managershave the luxury of time to reveal performance.Because partnerships generally have ten-year terms,we measure total performance over a longer period oftime than with public markets. We will provide inputand render interim judgment of performance as iswarranted through our Advisory Boards and directcommunication with our partners. We will commentin next year’s Report on our progress in venture capitalin addition to developments in the existing portfolio.



TABLE III-12ANNUALIZED ALTERNATIVE INVESTMENTS

INVESTMENT PERFORMANCE*(selected periods ending June 30, 2001)


TABLE III-13ANNUALIZED CASH INVESTMENT PERFORMANCE


TABLE III-14EXTERNAL INVESTMENT MANAGEMENT FEES BY ASSET CLASS


III.10 CASH/SHORT-TERM INVESTMENTS

The performance measurement of Cash pertains only tothe Cash and Central Custody Account, which wasvalued at $958,368,036 on June 30, 2001.

As previously discussed in the Report, Cash is also heldin other asset class portfolios. Although it is reported

in the market value for those portfolios, it is managedin a pooled fashion by internal Fixed Income staff.Existing infrastructure enables the FSBA to providecash management services for FRSTF portfolios at alower cost than those supplied by external serviceproviders, without sacrificing return.

III.11 INVESTMENT MANAGEMENT FEES

Investment management fees on FRSTF portfoliosmanaged externally are deducted from the portfoliosand are not included in budgetary allocations. TableIII-14 shows investment management fees by assetclass for FY 2000-2001.

Brokerage commissions are paid for executions of secu-rities orders and are paid on trades of exchange-listedequity investments. Brokerage commissions, net of com-

mission recapture rebates, were as follows for FY 2000-2001 (by asset class):

Domestic Equities $32,270,248International Equities $10,276,940Fixed Income $1,534*Alternative Investments $80,376

*Fixed Income brokerage commissions resulted from thesale of equity securities received in high yield accountsas distributions in corporate actions.


TABLE III-15SECURITIES LENDING REVENUE (NET), LAST FIVE FISCAL YEARS

Commissions recaptured are credited to the accounts thatgenerated the dollars. Therefore, the amounts reportedabove are net brokerage commissions. The FSBA has oneoutstanding third party vendor relationship that providescommission dollars to fund performance evaluation andresearch. The FSBA follows Employee Retirement IncomeSecurity Acts (ERISA) standards that specifically addresscommission dollars and deem them to be considered asplan assets.

III.12 SUPPLEMENTAL INCOME PROGRAM

Securities lending is an incremental income program effect-ed through multiple providers. During the periods securi-ties are on loan, collateral equal to or greater than 100 per-cent of market value is received in a form consisting ofmarket value plus accrued interest for United States gov-ernment and agency securities or cash. Cash is reinvestedin securities authorized by the Board.

During the fiscal year, we utilized our master custodian ofthe FRSTF as a securities lending agent for equities andfixed income products. We also had principal programswith two security dealers where a portion of the Fixed

Income assets were borrowed directly. The passive long-term Fixed Income portfolio (the Florida Government/Credit Index Fund) consistently maintains an index expo-sure to U.S. Treasury securities. Dealers are willing to payattractive spreads for access to these large blocks of treas-ury securities, particularly when the program is structuredas a lending arrangement coupled with a tri-party repur-chase agreement for the cash reinvestment. ChaseManhattan Bank serves as custodian for the FSBA in thistri-party arrangement. Collateral is held in accounts in theFSBA’s name and marked to market daily. These principalprograms have the advantage of ensuring that lendingincome is generated on 100 percent of a portion of thetreasury holdings in the portfolio. These types of programscan most efficiently be used for a portion of the portfoliothat is not frequently traded. The principal arrangementsgenerated $6,347,285 of the income shown in Table III-15for FY 2000-2001 for the FRSTF. Securities lending incomeis also generated through our participation in commingledindex funds in domestic and international equities.

Net income from all FRSTF securities lending programs forthe previous five years, including FY 2000-2001 is shownin Table III-15.


TABLE III-16FRS PENSION FUND MARKET VALUE AT END OF QUARTER


III.13 FLORIDA RETIREMENT SYSTEM PORTFOLIO-LEVEL

PERFORMANCE SUPPLEMENT

Table III-16 provides the aggregate market value of eachindividual portfolio on a quarterly basis.


TABLE III-16 (continued)FRS PENSION FUND MARKET VALUE AT END OF QUARTER



TABLE III-16 (continued)FRS PENSION FUND MARKET VALUE AT END OF QUARTER



TABLE III-17DOMESTIC EQUITIES INVESTMENTS


TABLE III-18INTERNATIONAL EQUITIES INVESTMENTS

Tables III-17 through III-22 provide relevant informationfor Florida Retirement System Trust Fund (FRSTF) portfo-lios, by asset class, during FY 2000-2001. Real Estate per-formance is presented by manager account and market val-ues are grouped by property type for direct-owned proper-ties. The intent of the latter presentation is to provide thereader with further insight into the diversified nature ofdirect-owned properties and partnership interests in indi-vidual properties. Tabled information includes:

• characteristics of the portfolios as to internal orexternal management;

• characteristics as to active or passive management;

• market values at the beginning and end of the fiscalyear;

• net contributions for the fiscal year;

• investment returns for the portfolios measured indollars;

• rate of return for FY 2000-2001; and

• attainment of benchmark returns for active andpassive portfolios over the fiscal year, prior threefiscal years and prior five fiscal years, afterdeduction of external manager fees.


TABLE III-19FIXED INCOME INVESTMENTS


TABLE III-20REAL ESTATE INVESTMENTS


TABLE III-21ALTERNATIVE INVESTMENTS

TABLE III-22CASH INVESTMENTS

Section IVLawton Chiles

Endowment Fund

he Florida State Board of Administration (FSBA)has the statutory authority and responsibility for theinvestment of the Lawton Chiles Endowment Fundassets, subject to limitations as outlined in Section215.47, F.S. and consistent with a Total Fund InvestmentPlan (TFIP or Investment Plan) approved by the Board.These investment limitations are cited in Section III.1.1of this report. The Board discharges its fiduciary dutiesin accordance with the fiduciary standards of care as setforth in Subsection 215.47(9), F.S.

Additionally, the Board delegates to the ExecutiveDirector the administrative and investment authority,within the statutory limitations, to manage the invest-ment of the Endowment assets. The Executive Directoris responsible for managing and directing all administra-

tive, personnel, budgeting, and investment functions,including the strategic and tactical allocation of invest-ment assets. The Executive Director is also charged withdeveloping specific asset class investment portfolioobjectives and policy guidelines, and providing theBoard with monthly, quarterly, and annual reports ofinvestment activities.

Furthermore, the Executive Director has investmentresponsibility for maintaining diversified portfolios andmaximizing returns with respect to the broad diversifiedmarket standards of individual asset classes, consistentwith appropriate risk constraints. Investments are madeto maximize returns over a long period of time and mayutilize a broad range of investments, including syntheticand derivative instruments.


T

TABLE IV-1LAWTON CHILES ENDOWMENT FUNDS UNDER MANAGEMENT

JULY 1, 2000 - JUNE 30, 2001

IV.1 INVESTMENT OBJECTIVES

Pursuant to Subsection 215.5601(5), F.S., the Endowmentis managed as an annuity and consistent with anInvestment Plan approved by the Board. The investmentgoals of the Chiles Endowment, as stated in the InvestmentPlan, are twofold:

• to provide a specific real (inflation-adjusted)annual cash flow for legislative appropria-tion, as nonrecurring revenue; and

• to maximize the probability of maintainingthe real value of any original principal invest-ments in the Endowment by the Legislatureat the end of a 30-year planning horizon.


TABLE IV-2LAWTON CHILES ENDOWMENT

TARGET ASSET ALLOCATION AND POLICY RANGESJULY 1, 2000 - JUNE 30, 2001

The Board’s principle means for achieving these goals isthrough investment directives to the Executive Directorin the form of a target asset allocation and identificationof the asset class target indices. Asset class target indicesare generally broad financial market indices that definethe structure of the asset class investments and serve asperformance benchmarks. The Board directs theExecutive Director to manage the Endowment to maxi-mize the likelihood of achieving the investment objec-tives. The Board sets a relative investment performanceobjective for the Executive Director to meet or exceedthe composite of returns of financial market indices forthe respective asset classes, as enumerated in a staticTarget Portfolio. Individual portfolios have disciplinedinvestment strategies designed to contribute to thereturn in a positive way on a long-term basis, measuredagainst performance benchmarks.

IV.2 ENDOWMENT CASH FLOW SCHEDULE

According to the Investment Plan, for each $100 of orig-inally invested real principal at the beginning of a fiscalyear, there shall be $4.32 in real dollars available for leg-islative appropriations at the beginning of the subse-quent fiscal year. Real amounts are measured in 1999purchasing power. For example, an original investmentof $1,700,000,000 on July 1, 1999 would result in$73,440,000 available for appropriation on July 1, 2000.That amount, adjusted upward by the annual inflation

rate, would be available for appropriation in each yearthereafter for the term of the annuity.

However, in accordance with the provisions ofSubsection 215.5601(6)(a), F.S., in no event can theamounts available for appropriation exceed the follow-ing limitations:

• for the appropriation available July 1,2000, three percent of the fund averagenet asset value on July 1, 1999;

• for the appropriation available July 1,2001, four percent of the fund averagenet asset value for the prior two years;

• for the appropriation available July 1,2002, five percent of the fund average netasset value for the prior three years; and

• for appropriations available July 1, 2003and each year thereafter, six percent ofthe fund average net asset value for theprior three years.

IV.3 ASSET ALLOCATION FOR FY 2000-2001

The current Investment Plan, effective January 5, 2000,identifies the target asset allocation shown in Table IV-2.

Table IV-3 reflects the actual asset allocation of theEndowment at quarter-end during the reporting period.

The actual asset allocation of the Endowment remained rel-atively close to the target allocations throughout the year.


TABLE IV-3LAWTON CHILES ENDOWMENT ACTUAL ASSET ALLOCATION

JULY 1, 2000 - JUNE 30, 2001

IV.4 INVESTMENT RISK

Risk is the possibility of not achieving the goals of theinvestment program. The best chance of achieving theEndowment’s specific goals is through investing inassets with:

• a sufficiently high investmentreturn to generate necessary corpusgrowth and cash flows; and

• a reasonably reliable investmentreturn through periods of fluctuat-ing inflation.

Historically, equity assets have had these characteris-tics and they represent the largest share of theEndowment’s investments. While equity assets can beexpected to have greater short-term market volatilitythan bonds or cash, in the long-run they provide thebest opportunity for achieving the Endowment’sgoals. The use of inflation-indexed bonds also materi-ally adds to the probability of meeting the investmentgoals. We anticipate that, over time, as the market forthese relatively new securities broadens and deepens,our allocation to them will increase. A more detailedexposition on the risk factors associated with differ-ent asset types can be found in Section III of thisreport.

IV.5 PERFORMANCE EVALUATION FOR FY 2000-2001

IV.5.1 ANNUALIZED TOTAL FUND INVESTMENT PERFORMANCE

The Endowment just edged out its since inception relativetarget return, however, the Endowment lagged its relative tar-get return for the fiscal year. Also, the Endowment underper-formed its long-term absolute target for the fiscal year andsince inception. The long-term absolute target is defined asthat rate of return that would allow annual cash flows toremain on plan and preserve the real purchasing power of theoriginal principal deposits over a 30-year horizon. Based onthe annuity formula for the Endowment’s spending plan, thelong-term annual real target rate of return is 4.32 percent.Combining the actual rate of inflation over the 12-month andsince inception periods, 3.2 percent and 3.5 percent respec-tively, with the 4.32 percent annual real target, produces thelong-term absolute target returns of 7.7 percent for the fiscalyear and 8.0 percent since inception. (Note: The combinationis compounded, not additive).

The performance of the Endowment is also measured accord-ing to a relative target, the “Target Portfolio” described above.The performance of each asset class is measured relative to abroad market index as specified in the Chiles EndowmentTotal Fund Investment Plan, and enumerated in the notes toTable IV-4. The Endowment’s relative target return is an aver-age of those indices’ returns, weighted according to the targetallocations specified in the Investment Plan (see Table IV-2).Managed returns, net of external manager fees, and returns ofthe target indices are presented in Table IV-4.


TABLE IV-4LAWTON CHILES ENDOWMENT PERFORMANCE

JULY 1, 2000 - JUNE 30, 2001

Section VLocal Government

Surplus Funds Trust

he Local Government Surplus Funds Trust Fund(LGSFTF) was established to assist units of local gov-ernment in maximizing net earnings on invested sur-plus funds, reducing the need for the imposition ofadditional taxes upon local constituents. The portfolioobjective is to provide a short-term, very liquid, highquality investment vehicle to participating local gov-ernments. Local governments typically invest in thepooled fund, but may establish separate specialaccounts, when specific needs exist, at the discretion ofthe Executive Director. The FSBA operates the poollike a 2a-7 fund and complies with all investmentrequirements contained in that SEC regulation, as wellas all accounting and reporting requirements ofGovernmental Accounting Standards Board StatementNo. 31, which governs investment pools for govern-mental entities.

The pooled account emphasizes liquidity and partici-pants’ funds are made available on a daily basis. OnJune 30, 2001, there were 781 local government partic-ipants holding 1,714 accounts, with funds under man-agement valued at $15,446,050,263. A short averagematurity range, consistent with projected cash needs ofthe accounts, was maintained. The average maturityon June 30, 2001 was 32 days. Average maturity isadjusted during the year, depending upon market con-ditions and cash flows. For FY 2000-2001, the rate ofreturn averaged 5.83 percent. Investment policy enu-merates authorized securities for both pooled and spe-cial accounts, which consist of United States govern-ment and agency securities and high quality moneymarket instruments.

Since the local government investment pool typicallyowns a substantial amount of Treasury bills and notes,as well as agency discount notes, we utilize four secu-rities lending programs to generate supplementalincome. Two of the programs are principal programswhere the FSBA loans securities directly to the dealer;the other two are agent programs where the agent loansto multiple borrowers. This income is used to pay a

significant portion of the fees associated with the poolwhich otherwise would have to be paid from regularpool earnings.

Our agent programs were effected throughMetropolitan West Securities and Deutsche Bank.Securities are loaned to qualified borrowers, and theFSBA receives collateral equal to or greater than 100percent of market value, in a form consisting of marketvalue plus accrued interest for U.S. Government secu-rities or cash. Cash received as collateral is reinvestedin securities authorized by the FSBA. During the fiscalyear these programs generated income of $5,601,007.

We also continued to participate in principal programswith Credit Suisse First Boston and Lehman Brothers.Attractive spreads are paid for access to large blocks ofTreasury securities, particularly when the program isstructured as a lending arrangement coupled with a tri-party repurchase agreement for cash reinvestment.Chase Manhattan Bank serves as custody agent for theFSBA, and collateral is delivered into an account in theFSBA’s name and marked to market daily. These pro-grams allow us to generate significant lending incomeon a portion of the U.S. Treasuries and agencies in theportfolio. During the year, these programs generatedincome of $2,365,815.

The FSBA invests funds on an individual basis for localgovernments with specific needs. There were only twoindividual participants on June 30, 2001 with totalmarket value under management of $357,103,462.Rates of return for separately managed local govern-ment accounts may vary from those earned on the LGS-FTF due to their special needs and differing investmentstrategies.

Tables V-I, V-2, and V-3 show the funds under manage-ment for the LGSFTF for fiscal years 1997-2001 andJune 30, 2001 pooled and non-pooled accounts, bytype of investment.


T


TABLE V-1LOCAL GOVERNMENT SURPLUS FUNDS TRUST FUND

POOLED AND NONPOOLEDFISCAL YEARS ENDING JUNE 30, 1997-2001



POOLED INVESTMENT ACCOUNT


NON-POOLED INVESTMENT ACCOUNTS

Section VIDebt Service Accounts


n accordance with Subsection 215.69(1), F.S., theFSBA administers all debt service funds for bondsissued by the Division of Bond Finance (the Division)on behalf of any state agency, except as otherwise pro-vided. Pursuant to Subsection 215.69(4), F.S., the FSBAis the agent of the Division for the investment of allfunds of the Division, including all reserve funds. TheFSBA also acts as the trustee of any sinking funds orother funds as provided for in Subsection 215.69(5),F.S. All such funds are invested by the FSBA in a man-ner consistent with the provisions of the authorizingbond resolutions, official statements, and the currentstrategy of the FSBA. While the Division operatesautonomously, it is administratively and budgetarilyhoused at the FSBA. Investment policy enumeratesauthorized securities, consisting of U.S. Treasury secu-rities and repurchase agreements backed by U.S.Treasury securities.

From time to time, the FSBA, as trustee and as escrowagent, enters into an Escrow Deposit Agreement (theEscrow Agreement) with a state agency, or the Divisionon behalf of a state agency, for the purpose of refundingpreviously issued debt (the Refunded Bonds) by theissuance of new debt. An irrevocable trust fund, alsoknown as an escrow fund, is created and establishedwith the FSBA and held in the custody of the FSBA, sep-arate and apart from all other funds. The state agencymakes provision for payment of the Refunded Bonds by

depositing in such escrow fund monies and/or securi-ties in an amount which, together with the investmentearnings thereon, are sufficient to pay the principal of,interest on, and redemption premiums, if any, on theRefunded Bonds as the same mature or are called forredemption. A verification of such sufficiency isrequired to be provided, in accordance with the EscrowAgreement, by an independent firm. During the fiscalyear, six existing bond issues were either partially orcompletely defeased through the issuance of new debt.Two of these six bond issues were defeased through cur-rent refundings and were called for redemption duringthis fiscal year. Four other bond issues were either par-tially or completely defeased by depositing availablemonies in escrow funds. One of these bond issues wascalled for redemption during this fiscal year. The bondissues, which were not called for redemption, are cur-rently being administered by the FSBA, as escrow agent.In prior years, bonds have been defeased by placing theproceeds of the new bonds in an irrevocable trust toprovide for all future debt service payments of the oldbonds. At June 30, 2001, $3,476,866,000 of bonds out-standing had been defeased.

Table VI-1 shows the total cash and market value ofinvestments held by the FSBA as trustee and escrowagent for all above-mentioned funds as of June 30, 2000and June 30, 2001.

I

TABLE VI-1DEBT SERVICE ACCOUNTS

CASH AND INVESTMENTS AS OF JUNE 30, 2000 AND 2001


Section VIITrust Funds

Other Investment


The FSBA is charged with the investment responsi-bility for various non-pension trust and endowmentfunds. Contingent upon portfolio structure and size,these funds may be managed on an individual basis ormay be commingled and managed in one or more of thecommingled vehicles created under our CommingledAsset Management Program. These vehicles include theFixed Income Passive Government/Credit CommingledFund, the Domestic Equities Passive Commingled Fund,and the Commingled Asset Management ProgramMoney Market (CAMPMM) fund.

The FSBA separately manages the first eight trust fundslisted below in relatively short-term fixed income instru-ments. The portfolio structures vary, depending uponeach investment objective and time horizon. Authorizedinvestments for these funds may include United Statesgovernment and agency securities, repurchase agree-ments, or high quality money market instruments. Eachfund is fully compliant with its respective investmentpolicy guideline. The next three trust funds or endow-ments are invested in multiple commingled vehiclesconsistent with their investment objectives. The remain-ing are invested solely in the CAMPMM fund.

VII.1 DEPARTMENT OF THE LOTTERY FUND

In 1989, the FSBA accepted responsibility for investingfunds provided by the Department of the Lottery intoU.S. Treasury zero-coupon bonds (STRIPS). DuringFiscal Year 1998-99, the “Lotto” payout was changedfrom a 20-year term to a 30-year term coincident withthe Lottery offering a cash option to winners. The FSBAnow purchases up to 29 serial amounts depending uponthe game, which, along with one cash payment, reflectthe prize winnings available for disbursement to thosewinners electing annual payments. The FSBA also pro-vides investment services for the following Departmentof Lottery games: “Win for Life,” “Big Ten InstantTicket,” “Monthly Bonus,” “TV Game Show,” and “Wina Million”. During FY 2000-2001, investments weremade only for the “Lotto” game. All Lottery investmentsat market totaled $2,032,150,012 at June 30, 2001.

A securities lending program remains in place for theLottery securities. For FY 2000-2001, Deutsche Bankacted as agent for the FSBA, lending securities to variousauthorized dealers. Net lending income for the yeartotaled $5,432,148.

VII.2 RETIREE HEALTH INSURANCE SUBSIDY TRUST FUND

In 1987, the Legislature enacted Section 112.363, F.S.,which funded a health insurance subsidy for all retiredstate employees. The Retiree Health Insurance SubsidyTrust Fund is utilized to account for all Division ofRetirement cash flows in this regard. This fund providesmonthly subsidy payments to retired members of anystate-administered retirement system to assist in payingthe costs of health insurance. At June 30, 2001, themarket value of the fund was $56,004,038.

VII.3 GAS TAX TRUST FUND

The Gas Tax Trust Fund is used to account for thereceipt and disbursement of monies received underSection 9(c) of Article XII of the State Constitution. Gastax collections are remitted to the Department ofRevenue and to the Department of Highway Safety andMotor Vehicles. These collections are then transferredto the FSBA to fulfill existing debt service requirements.The FSBA subsequently returns to the respective coun-ties any excess not required for debt service. The mar-ket value of the Gas Tax Trust Fund on June 30, 2001was $0.

VII.4 REVENUE BOND FEE TRUST FUND

The Revenue Bond Fee Trust Fund was created in 1969by Section 215.65, F.S. This fund is utilized to accountfor fees and expenses of the Division of Bond Financerelated to the issuance or proposed issuance and sale ofbonds, notes, or certificates pursuant to the provisionsof the State Bond Act. At June 30, 2001, the marketvalue of the fund was $2,176,272.

VII.5 BOND PROCEEDS TRUST FUND

The Bond Proceeds Trust Fund is a fiduciary fund estab-lished to hold good faith deposits or bond proceedsreceived by the Division of Bond Finance. These moniesare held by the Division of Bond Finance until bondissuance. At June 30, 2001, the market value of the fundwas $0.

VII.6 FLORIDA HURRICANE CATASTROPHE FUND

The Florida Hurricane Catastrophe Fund (FHCF) wascreated during the November 1993 legislative sessionby Section 215.555, F.S. The FHCF is a state program


administered by the FSBA. It was created followingHurricane Andrew, which caused significant volatilityin the Florida property insurance market. Under thisprogram, insurers enter into contracts with the FSBA,which provide reimbursement for a portion of their cat-astrophic hurricane losses. By protecting the solvencyof insurers, the FHCF adds capacity and ensures stabil-ity in this vital market. The market value of the FHCFat June 30, 2001 was $3,798,479,154.

A securities lending program remains in place for theinvestments in the FHCF and is utilized as market con-ditions warrant. For FY 2000-2001, Deutsche Bankacted as agent, lending securities to various authorizeddealers. Net lending income for the year totaled$249,437.

VII.7 INLAND PROTECTION FINANCING CORPORATION

In 1992, the Florida Legislature passed a law makingthe cleanup of leaking underground storage tanks atop priority. The legislation established theDepartment of Environmental Protection as the custo-dian of the program, with the Inland Protection TrustFund as the funding source for claims. Several monthsafter the program’s inception, it became obvious thatthere were many more contaminated sites than wereoriginally identified. Consequently, the quantity andcost of claims against the fund outstripped its financialcapacity.

The backlog of claims subsequently grew at an alarmingrate, increasing to approximately $500 million. At thispoint, the Governor and the Legislature halted the pro-gram to seek a solution, which would ensure the pay-ment of the claim backlog and a continuation of thecleanup program.

During the 1996 legislative session, a revision to theexisting program was passed. A central component ofthe new law was the establishment of the InlandProtection Financing Corporation (Corporation) as theentity charged with eliminating the backlog of claims.The Corporation was given the ability to issue bonds topay claimants and was further authorized to use fundsfrom the Inland Protection Trust Fund to pay debt serv-ice. The legislation also provided that the Corporationwould be housed and staffed by the FSBA.

On February 11, 1998, the Corporation issued$253,335,000 in bonds to finance the payment of a por-tion of the claim backlog. The remainder of the claimbacklog will be paid from monies transferred from theInland Protection Trust Fund, by the Department ofEnvironmental Protection, to the Inland ProtectionFinancing Corporation. Once all bonds issued are sub-sequently paid, which, pursuant to Subsection376.3075(5), F.S., can take no longer than six yearsfrom the date of original issuance, the Corporation’sstatutory responsibilities will cease and the FSBA willhave no further responsibility to the program.Subsection 376.3075(1), F.S. provides that theCorporation shall terminate on July 1, 2011. The mar-ket value of the fund at June 30, 2001 was $12,326,770,which included $34,752 in operating monies that wereinvested in the CAMPMM fund.

VII.8 INVESTMENT FRAUD RESTORATION FINANCING

CORPORATION

During the 1998 legislative session, the InvestmentFraud Restoration Financing Corporation (IFRFC) wascreated pursuant to Section 517.1204, F.S. The IFRFCwas created as a non-profit, public benefits corporationto finance the compensation of approximately 1,200Florida citizens who suffered security losses as a resultof actions by Guaranteed Investment Contract (GIC)Government Securities, Inc. The total amount of losseswas nearly $25 million, with the IFRFC expected to sat-isfy remaining claims of approximately $10.8 million.The GIC claims account was funded primarily by theissuance of bonds issued by the IFRFC in the amount of$8,935,000. The bonds are being repaid by monies fromthe Department of Banking and Finance, which arederived from a portion of the application and renewalfees paid by “associate persons” for licensure underChapter 517, F.S. During the 2000-2001 fiscal year,$152,517 in claims were paid from the GIC claimsaccount. The market value of this fund at June 30, 2001was $789,130 of which $1,434 represented operatingmonies invested in the CAMPMM fund.

VII.9 FLORIDA EDUCATION FUND, INC. - MCKNIGHT

DOCTORAL FELLOWSHIP PROGRAM

The Florida Education Fund, Inc. entered into a trustagreement with the FSBA in June 1999 to manageendowment monies for the McKnight Doctoral


Fellowship Program. This program assists candidateswith educational endeavors and enhances opportunitiesfor program graduates to be hired for faculty positionsin Florida. The initial transfer of $9 million in securitiesis, at the present time, client-directed, meaning that theFSBA is responsible for custody of the securities, butnot for managing them. Income from these assets that isnot withdrawn by the client is invested in the CAMP-MM fund, whose investments the FSBA does manage.The trust agreement also makes available to the clientthree FSBA-managed commingled pools: the CAMPMMfund, the Fixed Income Passive Government/CreditCommingled Fund, and the Domestic Equities PassiveCommingled Fund. At June 30, 2001, the market valueof this fund totaled $9,473,673.

VII.10 BLIND SERVICES TRUST FUND

The Division of Blind Services of the Department ofEducation entered into a trust agreement with the FSBAin November 1999 to invest monies for the Division.After a rigorous transition of direct investment holdingsfrom November 1999 through June 2000, the Division’sfunds were invested in various FSBA investment funds.The trust agreement makes available to the client threeFSBA-managed commingled pools: the CAMPMM, theFixed Income Passive Government/Credit CommingledFund, and the Domestic Equities Passive CommingledFund. The market value of the Blind Services TrustFund on June 30, 2001 was $3,780,710.

VII.11 FSBA ADMINISTRATIVE TRUST FUND

The FSBA Administrative Trust Fund was created toreceive and disburse funds for operating expenses. TheFSBA allocates and collects its total operating expensesfrom the various funds under management in accor-dance with the provisions of Sections 215.44, 215.515,and 218.409, F.S. and from various bond sinking fundsin accordance with an allocation plan approved by theFSBA. Portfolio structure is dependent upon liquidityneeds to meet operational expenses. Budgeted adminis-trative expenses of the FSBA for FY 2000-2001 totaled$23,225,601, while actual administrative expenses forthe period totaled $20,130,364. At June 30, 2001, themarket value of the fund was $34,502,258, and the fundwas invested in the Fixed Income PassiveGovernment/Credit Commingled Fund and the CAMP-MM fund.

VII.12 COMMINGLED ASSET MANAGEMENT PROGRAM

MONEY MARKET FUND

The number of non-pension trust and endowment fundsunder FSBA management continues to grow. Since thesefunds are typically small and have similar investmentobjectives, the most efficient way to manage these man-dates is in a commingled fashion. On July 1, 1999, theCAMPMM fund was created to provide a high quality, liq-uid vehicle for small accounts with short investment hori-zons. The CAMPMM pool was structured as a 2a-7 fund,consistent with Part 270 of the Investment Company Act of1940 (17 CFR 270.2a-7, Money Market Funds).Authorized investments may include United States govern-ments and agencies, repurchase agreements, and high qual-ity money market instruments. The market value of theCAMPMM fund at June 30, 2001 was $235,934,288.

In addition to commingling entire various trust andendowment funds with similar objectives, the CAMPMMpool also invests the cash allocation component or residualcash for longer term, multi-asset class portfolios. TheLawton Chiles Endowment Fund, the Florida EducationFund, Inc. - McKnight Doctorial Fellowship Program, andthe Blind Services Endowment are three multi-asset classportfolios with the cash allocation component invested inthe CAMPMM fund.

The following accounts are members of the CAMPMMfund:

VII.12.1 PUBLIC EMPLOYEE OPTIONAL RETIREMENT PROGRAM

The Public Employee Optional Retirement Program(PEORP) was created within the Florida RetirementSystem by Section 121.4501, F.S. in Chapter 2000-169,Laws of Florida, effective July 1, 2002. PEORP was cre-ated in compliance with Section 401(a) of the InternalRevenue Code, which requires that funds to implementPEORP be held in trust.

The PEORP Trust Fund was created by Section121.4502, F.S. in Chapter 2000-255, Laws of Florida,effective July 1, 2001. The PEORP Trust Fund was cre-ated to hold the assets of the PEORP in trust for theexclusive benefit of the PEORP participants and benefi-ciaries, and for the payment of reasonable expenses ofthe PEORP.

The .10% contribution rate per employee we are charg-ing all FRS employers from July 2000 to June 2002 hasbeen and will continue to be used to fund the start-upcosts of the PEORP. This money is currently going intothe PEORP Trust Fund. At June 30, 2001, the marketvalue of the fund was $14,647,836.

VII.12.2 INSTITUTE OF FOOD AND AGRICULTURAL

SCIENCES SUPPLEMENTAL RETIREMENT

In 1984, the Florida Legislature enacted the Institute ofFood and Agricultural Sciences (IFAS) SupplementalRetirement Act to provide a supplement to the retire-ment benefits of those paid under the Federal CivilService Retirement System. The beneficiaries of thisprogram are retirees of IFAS at the University of Floridawho, based upon their service with IFAS, are not enti-tled to benefits from either a state-supported retirementsystem or social security. The FSBA is responsible forinvesting funds set aside for this supplement. At June30, 2001, the market value of the fund was$14,169,227.

VII.12.3 FLORIDA ENDOWMENT FOR VOCATIONAL

REHABILITATION TRUST FUND

In 1990, the Florida Legislature enacted the FloridaEndowment for Vocational Rehabilitation Act (Section413.615, F.S.) to provide various programs related toservices for disabled persons. Funding for the trust isgenerated from certain authorized municipal sur-charges, such as fines imposed against designated civilpenalties. At June 30, 2001, the market value of thefund was $1,799,785.

VII.12.4 ARBITRAGE COMPLIANCE TRUST FUND

The Arbitrage Compliance Trust Fund is utilized toaccount for the fees and expenditures of the Division ofBond Finance related to ensuring compliance with theprovisions of federal arbitrage laws. At June 30, 2001,the market value of the fund was $848,434.

VII.12.5 POLICE AND FIREFIGHTERS PREMIUM TAX TRUST

FUND

Pursuant to Sections 3 and 7 of Chapter 95-250, Lawsof Florida, effective July 1, 1995, the FSBA invests themonies of the Police and Firefighters’ Premium Tax

Trust Fund. Funding is generated from quarterly pay-ments from insurance companies collected by theDepartment of Revenue. Distributions are made annual-ly, by the Division of Retirement, to eligible municipal-ities. At June 30, 2001, the market value of the fund was$110,304,525.

VII.12.6 FLORIDA PREPAID COLLEGE TRUST FUND

The FSBA administratively and budgetarily houses theFlorida Prepaid College Program. Recognizing the needfor timely financial planning for postsecondary atten-dance, the Legislature created the Florida PrepaidCollege Program in 1987, pursuant to Section 240.551,F.S. The Florida Prepaid College Program allows par-ents, grandparents, businesses, and others to lock in thecost of college at current college rates. The programguarantees to cover the cost––no matter how much col-lege tuition, fees, and housing increase in the future.The plan prices vary based on the plan type, paymentoption selected, and the age of the child. More than660,000 plans have been purchased statewide.

The College Savings Program was created during the1999 Legislative Session to complement the currentprepaid plan. It will help families save for collegeexpenses not covered by the current prepaid plan,including books, off-campus housing, food, and gradu-ate studies. It will allow families to save for any quali-fied college, anywhere in the United States. The CollegeSavings Program is authorized by Section 240.553,Florida Statutes, and is governed by Rule 19B, FloridaAdministrative Code. Program development began in2000 with the addition of 2 full-time positions andimplementation is targeted for Spring 2002.

The enabling legislation created the Florida PrepaidCollege Trust Fund (FPCTF) under the responsibility ofthe Florida Prepaid College Board (Prepaid CollegeBoard). The FPCTF consists of “state appropriations,monies acquired from other governmental or privatesources, and monies remitted in accordance withadvance payment contracts.” The FPCTF is used tomake contracted payments for tuition, dormitory andlocal fees, reimbursements to purchasers who elect outof the program, and administrative expenses of thatfund. The Prepaid College Board is charged to adminis-ter the FPCTF in an actuarially sound manner and toinvest fund assets in accordance with a comprehensive


investment plan, which is established with the approvalof the FSBA.

Although the program operates independently and theFPCTF is invested externally by the Prepaid CollegeBoard, the FSBA provides investment management serv-ices with respect to 1) interim cash balances pendingtransfer to external managers selected by the PrepaidCollege Board, and 2) the Florida Prepaid CollegeFoundation, Inc. (Foundation). The interim cash bal-ances and Foundation assets are invested by the FSBAin the Florida Prepaid College Program Trust Fund. AtJune 30, 2001, the market value of funds invested bythe FSBA was $3,752,723. The market value of thefunds invested by the FSBA for the Foundation at June30, 2001 was $11,171,095.

At June 30, 2001, the market value of funds investedwith external managers was $2,719,563,219. The FSBAprovides tracking, reconciliation, and accounting serv-ices for these funds.

VII.12.7 TOBACCO SETTLEMENT CLEARING TRUST FUND

The FSBA was assigned the responsibility to manage theassets for the Tobacco Settlement Clearing Trust Fund,established within the Department of Banking andFinance (DBF), pursuant to Subsection 17.41(4), F.S.These funds are to be invested by the FSBA, pendingnotification by the DBF that funds should be released tomeet specified program needs approved through the leg-islative budget process. The DBF is then responsible forthe subsequent distribution of monies to the respectiveagencies. The market value of the Tobacco SettlementClearing Trust Fund at June 30, 2001 was $0.

VII.12.8 FLORIDA ENDOWMENT FOUNDATION

During the 1998 legislative session, the FloridaEndowment Foundation was created by the Jobs forFlorida’s Graduates Act. This Foundation was created asa direct-support organization of the Department ofEducation, supporting the school-to-work transition for12th grade at-risk students. The FSBA is charged withinvestment responsibilities for the endowment, which isfunded through legislative appropriation, grants, anddonations. On June 30, 2001, the market value of thisfund was $560,200.


Notes

Notes

Notes

Documents

SBA Annual Report 2001