Maryland Pension Plan Embraces ESG

The use of environmental, social, and governance (ESG) factors as a consideration in investment decisions is usually associated with the largest public pension plans, but the mid-sized Maryland State Retirement and Pension System is an exception. Its CIO wants to increase the number of its external managers who use ESG.

Investments in the $52 billion system are all managed by external asset management firms and 49% of managers use ESG factors, said Andrew Palmer, the system’s chief investment officer.

Palmer told CIO that the percentages would be higher, but the overall number is reduced by the system’s hedge fund managers, a high percentage of whom do not specifically integrate ESG factors into their investment decision-making processes.

Only 18% of system’s hedge funds had an ESG policy as of Dec. 31, 2017, he said. Excluding hedge funds, he said, the number of external managers using an ESG process was 67% as of the end of 2017, up from 60% as of the end of 2016.

Retirement system data shows that the Maryland plan has more than 250 external managers including 25 hedge fund managers. Collectively, hedge funds make up $5.8 billion of the system’s portfolio.

The statistics were disclosed in an ESG report by the system’s investment staff, which was presented to the board in early February. In his first media comments on the report, Palmer said a goal over the next year and beyond is to increase the numbers of managers using ESG.

“Every time we talk to a prospective manager, we want to know if they have an ESG process and how it gets incorporated into their investment process,” said Palmer. He said the use of ESG gives money managers additional information that they can use to evaluate the riskiness of a specific investment.

However, Palmer said having an ESG policy is “not a litmus test” in terms of being hired by the Maryland system. He said, for example, certain quantitative managers might not believe there is robust enough information on ESG to feed into their investment models. Palmer said hedge funds, because of the short-term investment focus they often employ, may not consider ESG as relevant when making investment decisions.

Overall, Palmer said the Maryland system needs to make sure that it is incorporating all the risk factors it can in its investment process to protect the plan’s assets.

“So, if we don’t address [ESG], we feel we will be at risk of not being able to meet our financial obligations from the investment portfolio,” he said.

The pension system had a 70.1% funding level of as June 30, 2017, the end of its fiscal year. Sixty-one cents of every dollar paid to system retirees comes from investment income, retirement plan statistics show.

The pension system had an investment gain of 10.02% for the fiscal year ending June 30, 2017, but the two prior years, it had lackluster returns of 1.16% in FY2016 and 2.68% in FY2015.

Generally, only the largest public pension plans in the US use ESG factors in their investment process, Keith Brainard, research director of the National Association of State Retirement Administrators, told CIO. ESG as an investment concept is still considered too new for many plans and hard data to monitor the effectiveness of the approach in generating better investment returns is not always robust, he said.

Large US pensions plans, such as the $355 billion California Public Employees’ Retirement System (CalPERS), the $225 billion California State Teachers’ Retirement System (CalSTRS), the $206.9 billion New York State Common Retirement Fund, and the $194 billion New York City Retirement Systems, have been in the forefront in the US in terms of pushing external managers to use ESG in their investment process.

Palmer said investment managers have always used risk factors in determining why their investment thesis may not work, such as in evaluating whether a utility company-owned, coal-powered power plant would be impacted by the move away by society from high carbon-emitting generation facilities.

The difference now in using an ESG approach, he said, is “coming up with a uniform way to discussing and measuring these risks.”

He said over the next year, the Maryland system wants to be able to look at not only whether its managers are using ESG, but whether their program is effective in assessing risk factors affecting securities.

“We want to get better at evaluating the effectiveness of outside managers’ ESG policies,” he said.

He said system investment officials will be looking at best practices from other pension plans as well as working with investment consultants to develop guidelines. He said if Maryland can develop good ESG guidelines, it can share them with all its external managers and help them improve their investment process.

“We are trying to step up our game here,” he said. Palmer said responsibilities for developing the guidelines will be shared by the system’s 16 investment staffers; the retirement plan does not have the resources for a dedicated ESG investment staffer.

Palmer said US public pension plans have been “a laggard” in embracing ESG.

“We don’t think there is a lot of push coming from public plans other than a few large plans on the east and west coast,” he said. “But if you go overseas and talk to Australian plans, European plans, and some sovereign wealth funds, this is a major part of what they do, and they have large staffs devoted to it.”

But as large US pension plans continue to push their external managers to use ESG, even smaller US plans will benefit, he said. Palmer said that the investment strategies offered by the money managers to comply with the big plans will use ESG strategies and will be the same investment mandates used by the smaller pension plans, he said.