TABLE OF CONTENTS 2 Board Members 3 Letter to Trustees 8 Financial Highlights 9 Ten Year Summary 10 Independent Auditors’ Report FINANCIAL STATEMENTS 12 Management’s Discussion & Analysis 14 Statements of Net Assets 15 Statements of Changes in Net Assets 16 Notes to Financial Statements SUPPLEMENTAL FINANCIAL INFORMATION 28 Portfolio of Investments 86 Portfolio Data 88 Investment Transactions with Brokers and Dealers 92 Staff and Investment Managers Printed on contract by authority of the State of Illinois, February 2, 2007. (Requisition #1093401 - 500 copies at $12.62 each) ILLINOIS STATE BOARD OF INVESTMENT 1 BOARD MEMBERS CHAIRMAN Michael Goetz Appointed Member VICE CHAIRMAN Gordon John Mazzotti Chairman, Board of Trustees Michael Goetz Guy W. Alongi James Buchanan State Employees’ Retirement System RECORDING SECRETARY EXECUTIVE COMMITTEE Justice Thomas E. Hoffman Michael Goetz Chairman, Board of Trustees Chairman Judges’ Retirement System of Gordon John Mazzotti Illinois Vice Chairman Guy W. Alongi Thomas E. Hoffman Appointed Member Recording Secretary James Buchanan Allison S. Davis Appointed Member Member at Large Allison S. Davis Kurt M. Granberg Allison S. Davis AUDIT & COMPLIANCE Appointed Member COMMITTEE Representative Kurt M. Guy W. Alongi Granberg Kurt M. Granberg Chairman, Board of Trustees Thomas E. Hoffman General Assembly Retirement Gordon John Mazzotti System Ronald E. Powell INVESTMENT POLICY Appointed Member COMMITTEE Judy Baar Topinka Guy W. Alongi Treasurer, State of Illinois Allison S. Davis Michael Goetz Gordon John Mazzotti Ronald E. Powell Thomas E. Hoffman Gordon John Mazzotti EMERGING MANAGER COMMITTEE Allison S. Davis Michael Goetz Thomas E. Hoffman Ronald E. Powell Judy Baar Topinka Ronald E. Powell Judy Baar Topinka ILLINOIS STATE BOARD OF INVESTMENT 2 LETTER TO TRUSTEES The General Assembly Retirement System The Judges’ Retirement System of Illinois The State Employees’ Retirement System of Illinois The Illinois State Board of Investment (ISBI or Board) has fiduciary responsibility for the pension assets of the General Assembly Retirement System, the Judges’ Retirement System of Illinois and the State Employees’ Retirement System of Illinois. ISBI’s net assets totaled $ 11.3 billion at fair value at fiscal year ended June 30, 2006. For the same period ending June 30, 2005, those assets totaled $ 10.9 billion. While ISBI’s assets benefited from an 11.0% return, portfolio growth was markedly reduced by transfers out to pay participant benefits. Investment Policy Most of the new activity in fiscal year 2006 took place in the illiquid asset classes. Two core separate account real estate relationships of $300 million each were established, and $180 million was committed to six enhanced/high return real estate funds. Four long/short hedge fund of fund managers were selected with allocations of $100 million apiece. Private equity allocations totaling $115 million were made to four funds during the fiscal year. During fiscal 2006, public market searches led to the addition of four new relationships, and the termination of two. Figure 1 Asset Allocation June 30, 2006 Actual Fair Asset Policy Value Mix Target ($ in Millions) $ % % U.S. Equity 5,370.2 47 45 U.S. Equity Hedge Funds 416.5 45 International Equity 1,113.2 10 10 Fixed Income1 2,597.9 23 25 Real Estate 1,134.0 10 10 Private Equity2 482.3 45 Cash3 202.4 20 Total 11,316.5 100 100 1Maturities of one year or longer, including convertible bonds. 2Interests in limited partnerships and other entities which have limited liquidity. 3Includes money market instruments and other assets, less liabilities. ILLINOIS STATE BOARD OF INVESTMENT 3 Fixed Income 23% U.S. Equity 47% Private Equity 4% Cash 2% U.S. Equity Hedge Funds 4% Real Estate 10% International Equity 10% Investment Results In fiscal year 2006, investors benefited from strong returns in all asset classes with the exception of fixed income. The ISBI total fund was up 11.0% for fiscal year 2006, net of expenses. This follows a 10.1%, 16.4% and 0.3% return for fiscal years 2005, 2004 and 2003, respectively, and a loss of (6.9)% for fiscal 2002. The long-term objective of the 8.5% assumed actuarial interest rate was surpassed, with the portfolio trailing the composite benchmark return by 0.5% in fiscal year 2006. The Board continues to be concerned by some under- performance by specific managers; the overall performance of the fund meets or beats the expectations as expressed in the 2003 asset allocation model. Figure 2 shows results over the three, five and ten year time periods. U.S. Equities For the twelve months ended June 30, 2006, the Wilshire 5000 Index, a broad representation of the U.S. market, was up 10.0%. Value stocks substantially exceeded growth stocks, with the Russell 3000 Value Index up 12.3%, compared to the Russell 3000 Growth Index up 6.8%. Small capitalization stocks outperformed large capitalization stocks, with the Russell 2000 Index returning 14.6% compared with the S&P 500 Index at 8.6%. ISBI’s U.S. equity portfolio was up 10.7% for the fiscal year, 0.7% above the Wilshire 5000 Index. The Board, through structure analysis, rebalancing and risk management, continues to achieve its objective of tracking the market with predictable consistency. Figure 2 shows ISBI’s U.S. stock portfolio performance for three, five and ten year time periods. The ten-year average annual return of 8.8% shows that even considering the losses in prior years, the U.S. stock market has rewarded the long-term investor. ILLINOIS STATE BOARD OF INVESTMENT 4 Figure 2 Investment Returns June 30 (Annualized) 2006 2005 2004 2003 2002 3 Yrs. 5 Yrs. 10 Yrs. %%%%% %%% Total Fund 11.0 10.1 16.4 0.3 (6.9) 12.4 5.8 8.3 Composite Benchmark* 11.5 10.9 16.3 3.5 (7.3) 12.9 6.7 8.5 Consumer Price Index 4.2 2.5 3.3 2.1 1.1 3.3 2.6 2.6 U.S. Equities 10.7 9.3 21.7 0.9 (14.6) 13.7 4.4 8.8 Wilshire 5000 Index 10.0 8.4 21.2 1.3 (16.6) 13.1 4.1 8.5 International Equities 28.9 14.8 29.8 (7.5) (6.3) 24.2 10.7 7.9 MSCI-EAFE Index 27.1 14.1 32.9 (6.1) (9.2) 24.4 10.4 6.8 Fixed Income 0.8 6.9 0.7 8.3 5.5 2.8 4.4 5.9 Lehman U.S. Universal Bond Index (0.3) 7.4 1.0 11.5 7.7 2.7 5.4 6.4 Real Estate 19.5 14.8 9.1 2.2 11.5 14.4 11.3 11.1 NCRIEF Real Estate Index 18.7 15.6 9.7 5.2 5.9 15.8 12.0 12.4 Private Equity 21.3 29.6 16.9 (4.9) (18.4) 20.8 6.5 16.0 * Composite Benchmark: Effective 12/03: 45% Wilshire 5000; 10% MSCI-EAFE; 25% Lehman Universal; 10% NCRIEF; 5% Venture Economic all Private Equity Index; 5% HFR Equity Hedged Index. Effective 4/02: 46% Russell 3000; 15% MS-AC Free ex US; 23% Lehman Universal; 8% NCRIEF; 8% Russel 2000 + 3.0% Prior to 4/02: 43% Russell 3000; 20% MS-AC Free ex US; 22% Lehman Aggregate; 7% NCRIEF; 8% absolute return of 12%. International Equities The Morgan Stanley EAFE Index returned 27.1% for the fiscal year; approximately 17 percentage points above the U.S. return. As a result, international markets were the strongest performing asset class in fiscal year 2006. Further, ISBI’s international equity portfolio was up 28.9%, exceeding the benchmark for the fiscal year by 1.8%. As with the U.S. equity portfolio, the Board has the twin objectives of limiting tracking error relative to the benchmark and adding value with active management. The returns for longer time periods are shown in Figure 2. Fixed Income The ISBI fixed income portfolio had a positive return of 0.8% for the fiscal year compared to the Lehman U.S. Universal Bond Index which returned (0.3)% for the year. The Board believes ILLINOIS STATE BOARD OF INVESTMENT 5 % Investment Returns June 30 20 Total Fund 15 Composite Benchmark 10 CPI 5 0 -5 -10 2006 2005 2004 2003 2002 that the structure adopted in December 2003 will minimize negative surprises, such as those experienced in the past, and result in more predictable fixed income returns. Figure 2 shows the long-term results for fixed income. Real Estate ISBI’s real estate portfolio earned a 19.5% return. The NCREIF Real Estate Index, a measure of core, operating, non-leveraged real estate, earned 18.7%. Prior to the 2003 asset allocation model, the Board’s real estate policy was to exploit higher risk, higher return value-added or opportunistic strategies. However, over the last three years the Board has increased the real estate strategic allocation from 5% to 10% of the total fund with the new allocation targeting 70% of its real estate to core, income producing real estate, with the balance in higher return strategies. ISBI’s real estate portfolio is invested primarily through interests in limited partnerships, trusts, and other forms of pooled investments. ISBI is in the process of converting a sizable portion of its real estate portfolio to separate account structures. Long- term results for real estate are shown in Figure 2. Private Equity ISBI’s private equity portfolio provided a return of 21.3% for the fiscal year. The private equity portfolio consists of interests in limited partnerships and other commingled vehicles that invest in venture capital, management buyouts, and other private placement equity strategy activities.