State Employees’ Retirement System A Component Unit of the Commonwealth of Pennsylvania COMPREHENSIVE ANNUAL FINANCIAL REPORT for the year ended December 31, 2001 Including the Independent Auditors’ Report of Financial Statements for the years ended December 31, 2001 and 2000 State Employees’ Retirement System A Component Unit of the Commonwealth of Pennsylvania COMPREHENSIVE ANNUAL FINANCIAL REPORT for the year ended December 31, 2001 John R. Brosius Francis J. Donlevy Executive Director Director, Office of Financial Management State Employees’ Retirement System 30 North Third Street • P.O. Box 1147 Harrisburg, PA 17108-1147 Including the Independent Auditors’ Report of Financial Statements for the years ended December 31, 2001 and 2000 COMMONWEALTH OF PENNSYLVANIA STATE EMPLOYEES’ RETIREMENT SYSTEM 30 NORTH THIRD STREET P.O. BOX 1147 HARRISBURG, PENNSYLVANIA 17108-1147 PHONE HARRISBURG: (717) 787-6293 NICHOLAS J. MAIALE CHAIRMAN June 2002 Honorable Mark Schweiker, Governor Commonwealth of Pennsylvania Members, Pennsylvania General Assembly Members, Pennsylvania State Employees’ Retirement System Dear Governor Schweiker, Legislators and Members: The Board of Trustees of the Pennsylvania State Employees’ Retirement System (SERS) is pleased to present our Comprehensive Annual Financial Report on the SERS Fund for calendar year 2001. The Fund had a total investment rate of return of -7.9% in 2001 and a total fair value of $24.7 billion as of December 31, 2001, amid turbulent market conditions. By comparison, the Fund’s annualized investment rate of return for the past five years was 9.2%, and the annualized investment rate of return for the past 10 years was 10.5%. These substantial returns have enabled SERS to maintain fully–funded status since 1992. They also validate the Board’s adherence to two key principles: ♦ prudent management of Fund assets, and ♦ ensuring payment of benefits promised by the Commonwealth to SERS retirees and beneficiaries. Also due in part to these substantial returns, the Commonwealth’s total employer rate of contribution to the Fund, which was as high as 18.87% of payroll in 1981, was reduced to 0.0% of payroll for fiscal year 2001-2002. Rest assured that the SERS Board, staff and I will continue to pursue prudent investment strategies to assure the solvency of the Fund and the quality of pension–related services to all SERS members. Sincerely, Nicholas J. Maiale SERS Board Chairman BLANK Table of Contents Introductory Section Board of Trustees ii Mission Statement iii Organizational Chart iv Administrative Support; Investment Consultants; General Service Providers v GFOA Award Certificate vi Letter of Transmittal vii Financial Section Independent Auditors’ Report 1 Management’s Discussion and Analysis 2 Financial Statements Statements of Plan Net Assets 7 Statements of Changes in Plan Net Assets 8 Notes to Financial Statements 9 Required Supplementary Information Schedule 1 – Schedule of Funding Progress 22 Schedule 2 – Schedule of Employer Contributions 22 Notes to Required Supplemental Schedules 23 Additional Financial Information Supplemental Schedule 1 Administrative Expenses 25 Supplemental Schedule 2 Investment Expenses and Consultant Fees 26 Investment Section Report on Investment Activity 27 Investment Policies 29 Investment Objectives 30 Investment Results 31 Asset Allocation 32 Largest Assets Held 43 Schedule of Broker Commissions 44 Investment Summary 46 Actuarial Section Actuary’s Certification 67 Summary of Actuarial Assumptions and Methods 69 Schedule of Active Member Valuation Data 70 Schedule of Retirants and Beneficiaries Added to and Removed from Rolls 72 Solvency Test 73 Analysis of Financial Experience 74 Summary of Plan Provisions 75 Statistical Section Schedule of Trend Data 77 Schedule of Additions to Plan Net Assets 78 Schedule of Deductions from Plan Net Assets 79 Schedule of Benefit Expenses by Type 80 Schedule of Retired Members by Type of Benefit 81 Schedule of Retired Members by Option 82 Schedule of Average Annual Benefit Payment Amounts 83 Schedule of Participating Employers 84 Prepared by the staff of the Pennsylvania State Employees’ Retirement System Board of Trustees Honorable Nicholas J. Maiale Chairman Honorable Gibson E. Armstrong Honorable Barbara Hafer State Senator State Treasurer Honorable Robert A. Bittenbender Honorable Raphael J. Musto State Secretary of the Budget State Senator David R. Fillman James E. Nevels Director, AFSCME Council 88 Financial Consultant ii COMMONWEALTH OF PENNSYLVANIA State Employees’ Retirement System Honorable Thomas G. Paese Honorable Jere L. Strittmatter Former State Secretary of Administration State Representative Honorable M. Joseph Rocks Honorable Michael R. Veon Retired Member and Former State Senator State Representative Mission Statement Plan Administration: To administer the retirement benefits plan for state employees and elected officials in accordance with Pennsylvania statutes; Member Services: To provide effective services to all active and retired members; Management of Retirement Fund Assets: To accumulate, manage and disburse the retirement Fund assets in accordance with fiduciary standards and at a reasonable cost to Commonwealth taxpayers; Investment Policy: To maximize investment returns while exercising a prudent person investment policy. iii COMMONWEALTH OF PENNSYLVANIA State Employees’ Retirement System SERS Organizational Chart Actuary Investment Consultants Hay Group, Inc. BARRA RogersCasey & Associates (General Consultant) State Employees’ Agent Bank and Trust Retirement The Townsend Group Accounting Services Board (Real Estate) Mellon Bank Cambridge Associates, LLC (Alternative Investments) Independent Auditor KPMG, LLP Executive Director John Brosius Communication/ Audits, Reporting Public Information Office and Compliance Sean Sanderson Leonard Knepp Director Office of Legal Office Office of Office of Investment Financial Harold E. Dunbar Member Services Information Office Management Chief Counsel Thomas Wanich Technology Peter Gilbert Frank Donlevy Director John Saponsky Chief Investment Director Director Officer iv COMMONWEALTH of PENNSYLVANIA State Employees’ Retirement System Administrative Support John Brosius Executive Director Francis J. Donlevy Peter M. Gilbert Director, Office of Financial Management Chief Investment Officer Harold E. Dunbar Andrew Deitch Chief Counsel Bruce Feldman David J. Kalman Leonard M. Knepp Mark McGrath Director, Audits, Reporting and Compliance Karen N. Nicely Adam Tosh Sean Sanderson John C. Winchester Director of Communications Investment Office Directors Investment Consultants BARRA RogersCasey* The Townsend Group General Consultant Real Estate Consultant Cambridge Associates Alternative Investments Consultant General Service Providers Hay Group, Inc. Mellon Bank Actuary Agent Bank and Trust Accounting Services KPMG, LLP Independent Auditor *On March 27, 2002, BARRA RogersCasey ceased providing consulting services to SERS when it was purchased by Capital Resource Advisors, LLC. On May 31, 2002 and after examining its options, the Board of Trustees entered into an agreement for general consulting services with Rocaton Investment Advisors, LLC, a company formed by, among others, the two former employees of BARRA RogersCasey that had primary responsibility for providing consulting services to SERS. COMMONWEALTH OF PENNSYLVANIA STATE EMPLOYEES' RETIREMENT SYSTEM 30 NORTH THIRD STREET - P.O. BOX 1147 HARRISBURG, PENNSYLVANIA 17108-1147 TELEPHONE: 717-787-6293 May 30, 2002 The Board of Trustees Pennsylvania State Employees' Retirement System Harrisburg, PA 17108-1147 Dear Mr. Chairman and Members of the Board: We are pleased to present you with the Comprehensive Annual Financial Report of the Pennsylvania State Employees' Retirement System (the “System”) for the calendar year ended December 31, 2001. During 2001, the System faced challenges from the investment market place, from sweeping legislation affecting the State Retirement Code, as well as from the day-to-day responsibilities of administering one of the largest public pension funds in the world. In spite of this difficult environment, the System maintained its fully funded status and the service its members have come to expect. The recessionary economy, uncertainty in financial markets, and surfacing of accounting irregularities in certain companies all combined to drag the stock market down to its worst two year performance since the bear market of the 1973-74. Despite a well-diversified asset allocation program, the System’s return on plan assets was -7.9%, the worst in over 25 years. Although that return was far below actuarial assumptions, SERS fared much better than the -11.9% broad market returns of the S&P 500. While we were disappointed with the returns on the portfolio, our 5 and 10 year returns, 9.2% and 10.5% respectively, have buoyed SERS into the top quartile for those periods among our peer funds. While certain funds reported staggering losses due to concentrations of investments in individual companies, the SERS strategy has been to minimize the risk of those types of losses by: • increasing asset classes for the allocation of funds • broadly diversifying individual holdings through the use of passively managed index funds • using risk management guidelines in the contracts of our actively managed portfolios to limit exposures and concentrations of individual holdings • using multiple managers with varying mandates in our portfolio rather than placing heavy “bets” with individual managers. While