NEWS

Interview by Christine Giordano and Muskan Arora

Giordano: Can we start from the top about the state of Maryland mandate and how that was issued and what that means?

Palmer: I'll go back before the mandate and talk about how the board has addressed these issues historically. The board has viewed that they have a responsibility to be prudent investors, and they have thought that being a responsible owner plays a big part in them being responsible. Many years ago, they joined an organization called UNPRI, which is the United Nations Principles Responsible Investing, to help them think through that and really to help inform them on their proxy voting and how they use their voice as asset owners.

When I arrived in 2015, that had not really been expressed very much in the portfolio. We spent some time using that UNPRI framework to look at what we were doing already and then started building out better practice that conformed to the principles. We did it in a way that we felt was helping us make better investment decisions. We looked through the principles, and when they had recommended a practice or process, we thought, "Well, how do we incorporate that into what we're doing to help make better investment decisions?" We did that, and that has been an ongoing project, and our UNPRI scores have consistently moved up, which is good.

That's been working with the staff and the board, and then we started actually reporting on this process. On our website, there were a number of reports going back on our path forward on this. We see many plans that will say, "We are going to create an ESG product or an ESG index and put some of our assets there." We have not believed that that was a sufficient practice because ESG is an important factor for all of our assets, and we need to find a way to incorporate it across the whole portfolio. That's been our practice.

In 2018, the Maryland legislature was really concerned about climate risk, and Maryland, because of the Chesapeake Bay, has got one of the largest shorelines of any state, and so it has a lot of concern about rising water levels and climate change generally. It's a big impact for the state, and they were concerned about how that was going to impact the pension plan. "We already have this risk geographically. Do we also have the risk in the pension plan?"

Initially, they were interested in having us provide them annual reports on climate. That got broadened. They're really concerned about all the risks, and now we report on not just climate risk and ESG risk, but liquidity risk and all different things go into our annual report. That's been ongoing since 2018. In 2021, we had a big, long discussion with the legislature really about climate, and the discussion was, "Why shouldn't we divest.”

We had a long discussion about that and demonstrated that being an active owner and being part of the people making decisions and how companies should be operated was better than being-- leaving the game, taking our money and going someplace else. After that discussion, the legislature was concerned to make sure that the board understood that it had a responsibility to incorporate climate risk into its administration of the pension assets. Passed the law that basically said that and created some reporting metrics associated with that.

I have some responsibilities with that and the staff does as well. Part of the responsibilities are to make sure that we are considering the impact of climate on the assets that we own and so that we are looking at those risks. The other part is that we should look for the opportunities. The investment community is not focused very much on change. They spend a lot of time running models that take relationships that have happened in the last 50 years and assuming that they go forward.

One example of this is capital market assumptions for asset allocation studies, where we work with a consultant. The consultant will say, "We think the economy is going to grow. That's going to lead to profit growth and companies can pay more dividends and they'll buy back some shares. Therefore, we think U.S. stocks will generate a return of 8% or something like that. We'll incorporate that into our expectations of the future to decide where to put money."

When we worked with our consultant to evaluate the impact of climate and we looked at some scenarios where we were able to hold climate change to a one-and-a-half degree scenario, or there wasn't much effectiveness and the transition and temperatures went to three degrees, or we started having bad outcomes and there was a policy change to impose a $100-a-ton tax on carbon, just to see how sensitive the portfolio was. What we found was that in all three of those cases, the returns went down, some cases more than others. All returns went down and inflation was higher.

What that tells me is that people are not really thinking about the future. They're just extrapolating from the past and the future is going to be different. There's a real need to think about the opportunities and the costs that might come from climate risk as you build out portfolios. I rambled a bit there, but I think that helps explain how this came to be a mandate for us because we've been focusing on these risks in the portfolio. The traditional tools don't necessarily capture them and we think it's important to make sure that they are incorporated as a factor in decision-making.

Giordano: I know you touched on this a little bit, but what were the first things that were very important to get right when you built guardrails around this?

Palmer: From my perspective, this is a risk management practice for the most part. What we do with risk management is we evaluate managers' ability to manage risk. We ask them questions about how do they handle these types of things? We don't think it's appropriate for us to prescribe how people should do it. We want to understand what they're doing and how they're incorporating it.

We also think there's some situational factors that we need to consider. If it's a government bond portfolio, and maybe you would say the U.S. government has got a lot of climate risk in it, but generally, you would not really have to incorporate climate risk in government securities. If it's a midstream pipeline, private equity portfolio, you have a lot of questions about what they're doing.

We try to be situational and understand what the businesses are that we're investing in and how people are mitigating the risks. Sometimes they're mitigating the risk by, if it's a private company, before they buy it, they identify the places where they can make improvements and establish goals for benchmarks for where they're going to be when they want to sell this property. For public companies, we incorporate the risk of stranded assets and management's practices to make sure that they are appropriately protecting the system's interest in that company by having good practice.

Muskan Arora: I would also love to shed a bit of light on how you overcame some of the biggest challenges successfully?

Palmer: In terms of ESG type things?

Arora: Yes.

Palmer: I guess I would say it's part of the overall challenges we've had, just in terms of, it's not different really from the challenges we've had with the investment program generally. What we've been working on is building a high-performing investment team that's strong enough to handle the asset growth that we expect. Actuaries project that this plan will be $110 billion in assets in the not too distant future as we fill in our unfunded liabilities and do higher contributions and as the liabilities continue to grow.

We needed to make sure we had a team that was resilient and expert enough to do that. One of the challenges in addressing this ESG was making sure we had the appropriate number and quality of staff with longevity that will stay here and invest in the mission-driven people. Mission is to provide benefits for our beneficiaries, but that mindset also helps in adding these considerations into the consideration of the managers and assets.

That's been some of the bigger challenges, like how you build out the team. There's a little bit of a leadership push to make sure this happens and require it. We've put together an ESG committee here and all the different asset classes have people on it. We've worked through the best practices in each of the asset classes. Now, we've added it to our risk function. [sound cut] We're looking at these tools to help us mitigate risks and find opportunities to invest and make more money.

Stakeholders and some of the outside parties believe that we should be using the system's assets to solve societal problems. There's some overlap there that we can invest in ways that are profitable in the system that also help mitigate some of these issues, but it's not our primary purpose. We are constantly trying to figure out the best way to communicate and listen to each other, listen to the concerns that they have, and express our purpose and mission and how they intersect.

There is a big communication issue. We spend a lot of time with outside parties and with our board on communicating what we're doing, why we're doing it, why we think it's effective, and how we think it meets with their objectives.

Arora: That sounds good. You've hit all your one, three, and five-year benchmarks. Are there any particular strategies or approaches that you took?

Palmer: Yes, that's a good question. It goes back to what I was just talking about. We needed to build the team and the processes. All of that process was hand in glove. We were working on building out the team. As we built out the team, we had more resiliency, we had more time to think about these types of things. As we built out the team, we tried to make sure that the culture was growing alongside. We changed the old culture to an outcome, people own the outcomes.

The whole organization reviews every investment we make. If we're managing directly assets, we're not looking at every bond and stock, but if we're making allocations to managers or larger commitments, the whole team has a voice in that. It's a culture of owning the outcomes and being disciplined about implementing it. We've added a fair amount of time on managing our betas to the benchmark. Historically, through active management, we were adding value, but the managers added value by having basically low beta strategies, and we were using the alpha to fill in our beta hole. The managers felt good about themselves individually, but when we put them all together they weren't keeping up with the benchmark. We managed those betas more directly now. It's all come from having a stronger discipline and working on our culture.

One small thing, the legislature and the board instituted a modest incentive program in 2018, and that is, it really does change behaviors when people have clear objectives. It's really not so much the money as the pride of actually achieving those return targets which they're not trivial, they're not easy. When people can do that, they really are focused and it does make a difference on their behaviors.

Arora: Makes sense. Would you say that having an open channel of communication was something that worked really well?

Palmer: What we're learning about communication is, it's a little bit of a two-way street, that you can communicate your head off, but if people aren't listening -- You think what you're saying is very clear, but it's not answering the questions that people want to know about, then you're not really communicating. I just recently read a book about super communicating and they talk about how some people-- like I'll be explaining something in a rational fact-based way, but people are asking questions out of emotion, and if I'm not really addressing their emotion, then I'm not really communicating with them.

We're working with our communication staff to improve our communication and really just to try to make sure that what we're saying people are hearing and understanding, and not just throwing it out there and assuming that we've done our job. We have a responsibility to make sure that what we're communicating is clear and addresses the questions people have.

Giordano: Andrew, in reading your letter and your annual report, we know you've worked hard with the board to diversify your portfolio. I'm very curious to know particularly which strategies are working really well in the current economic climate, especially through the ESG lens that you are required to put things through. What are your return targets for the portfolio, just for review purposes?

Palmer: We have a 6.8% actuarial target because that's what we expect to make over long periods of time, 20-year periods of time. That's our long-term target. I guess I'll merit the two questions. We have what we call a theme team and they're out trying to find things that would be falling through the cracks or are the next thing. A lot of our investing, and particularly in private funds, are re-upping with the same people whom we've invested with before because they've had a good track record. Largely, they do the same thing.

We find that as we speak to them, they do the same thing, but they do it in a little bit different way. They didn't use to talk about climate risk, but now most of our managers, when we talk to them about what they're doing, what their business plans are, almost invariably they have some metric in there that they're trying to make that company more sustainable as part of their value creation. They didn't use to do that, now they do that, but we're not investing in a fund that's focused on the ESG piece, we're investing in more traditional funds.

We've found a few things. One that we've been excited about and overlaps here is investing in California Carbon Credits, which is in our-- We didn't have a place for it, we had to figure out what to do with it because it didn't fit, it's not really a credit portfolio, it's not really a private equity portfolio. We had to really figure out how to make that investment. It basically is the-- People pay for carbon credits as they're still building out green power. To the extent they still need to burn fossil fuels, they have to have these permits. That's someplace we have found both profitable and aligned with the energy transition, and we're working to find more things like that.

Giordano: Just wondering what sleeve you put that in the asset allocation.

Palmer: We wound up putting that in commodities. We don't have a commodities allocation, we don't have a target for commodities, but we have the flexibility to use commodities. Essentially, it's a price on carbon, which I would say is a commodity. We decided to put it in that place and really benchmark it. How does it do relative to our 6.8? Because that's taking money from the whole rest of the portfolio to put it here. We want to make sure it's going to generate that return. Hopefully, we do that, and so far we've been doing very well.

Arora: We've already spoken about the things that worked pretty well for you and strategies that worked well. What would you say were the biggest challenges? Basically, just what are the biggest challenges that you're facing? How did you overcome them?

Palmer: I guess we talked a bit already about the challenges, which has been mostly about communication. One of the challenges I guess we've had, and I guess I haven't really overcome it yet, is to look into the portfolio and see what risks we actually have. We use a aggregate risk tool called Aladdin, which is a fantastic product. We have to populate it with all our holdings. That's a difficult thing to do, especially to do it in real time. We have private equity holdings. We have hedge fund holdings. We're in mutual funds.

Getting all that data together to just understand what we own, and then finding metrics that we can use that we believe are credible to, once we have all that data, look at the risk inside the portfolio, that's been a big hurdle. I think we're just about there because we've been working with Aladdin for two or three years to build that out. That's just identifying the issue, identifying that what we really want to do is figure out what the risks are in the portfolio and where they're concentrated. If there's a company that's a lion's share of that, we should be talking to them about the risks that they're presenting to our beneficiaries and trying to understand how they're addressing that in the future. Maybe we need to find a better or a different investment that doesn't have the same risk profile.

Giordano: Regarding risk profiles, I'm wondering where energy investments fit in that ESG lens and what your approach is.

Palmer: Our approach is that there are risks, but like all risks come with a price. After COVID, when many companies were going out of business and energy prices were low and energy stocks were cheap, the risk of stranded assets was very low at that point because they'd already had suffered it. From a portfolio management perspective, even though we believe that they have climate risk, the risk to the portfolio was not owning them because we should own them.

We believe our managers before that, they had been underweight energy stocks and they were focused on the ones that were doing better in terms of having a strong plan for energy transition. Because of the opportunity set that happened during COVID, we wound up moving more money into energy stocks. We don't like them. We believe that long-term they're going out of business because we'll be transitioning…they'll have to transition to other things.

We also believe that these large companies that have experience moving molecules will be helpful and understand the tools that we'll need to build to move hydrogen if we move to more of a hydrogen-based economy. They're also good at moving electrons, some of the large companies as well. We think they're part of the solution and we just need to make sure we have the right incentives to get them to move down that path.

Arora: Did your manager selection process change due to your ESG mandate?

Palmer: Our manager selection process has evolved. Mostly it's evolved because now we include ESG and diversity questions in just about everything we do. At our organization, as I mentioned, we review everything together and part of that is to make sure that we have consistent diligence practice across all the different asset classes.

When we talk about a potential new investment, we look at their company's ESG practices and the risk management. We are able to understand whether it's a above-normal risk investment and with above-average risk mitigation or it's a low-risk investment with average. We look at those things as a team and that practice has continued to evolve. Our next piece of that is to try to think more along a SASB route where we look at the industry and the key metrics that are most at risk for those industries and try to build those analysis of our opportunity set.

We're also managing a fair amount of our assets directly internally. So far, they've been managed passively, but to the extent we want to add some element of active management, we want to make sure that we have good practice around evaluating these risks.

Giordano: Which areas are you thinking about actively managing?

Palmer: Bonds and stocks would be the simple answer, but we have a big domestic bond portfolio and we have an international portfolio of stocks. We have a fair amount of it passive, it is managed and most of the passive things we do ourselves. We believe that there's a potential for modest and sort of enhanced index active management and we want to make sure that the enhancement includes making sure we are not taking risks that we would avoid if we focused on these ESG factors.

Arora: How are you assessing your managers in emerging markets through that ESG lens?

Palmer: That's a good question for a number of reasons. One is the data on ESG is not as robust for those companies as it is in the U.S., and so we really have a little bit less knowledge. Two, they tend to be dirtier industries. There's a lot of mining and extraction industries there, and so that is a challenge. We tend to benchmark them against their own industry, and we expect managers to be looking at that industry factor.

Overall, actually, we used to have a very high allocation to emerging market stocks. We've pared that back toward more of a market weight, and so that's reducing our footprint in higher impact sectors. That's reducing our risk there. Mostly that was done because we believe that the changes in China has made the return outlook lower and the risk higher, and they were such a big part of the emerging market index. In those economies, we couldn't figure out how to take China out without still having the risk. We just decided to reduce the allocation there.

Arora: In which regions are you invested right now?

Palmer: We invest globally, based on indices. We don't have big geographic biases or focuses. I would say in the emerging market space, we have tended to focus on Asia and less on Latin America and Africa because we found better investment opportunities there. We've been pulling back from Asia on the private side because of this China effect. We do think there are good opportunities in those countries. Obviously, India has been stepping up and taking up some of the investment dollars there. We're considering India and some of the other countries as well.

Giordano: Andrew, you're known for your ability to think ahead. People are starting to talk more and more about climate technologies. Are you invested in them? We could talk on a high level on those that you find most promising, how might they be reflected in your portfolio?

Palmer: Except for the carbon credit portfolio, we really don't have any dedicated platforms that are focusing on these things. I do think the opportunity is going to be in infrastructure. There's going to be a lot of dollars there. I participated in some groups that think about what has to happen for us to do this energy transition. There's a huge need for investing there.

I think the most exciting thing for us, and I think that's the most impactful, is investing in energy infrastructure, but more of a greenfield space than being the long term owner. One, I think the long term owner of a solar farm or a wind farm, the returns are relatively low. If you buy a wind farm and you hold it, you basically have to hold it for a long period of time. It's more of like a bond. If you buy one wind farm and our assets are growing, but if you buy one wind farm, you own it for a long time. It's only making a little bit of change in the carbon economy.

If you're in the part of the process that's creating wind farms, creating solar farms, creating green hydrogen plants, those types of things, and then you build them and sell them to a long term holder, you make a little bit more money. It's a little riskier, and that your dollars are making a huge impact. One of the things that came out of the study of how climate impacts our returns forecast made us realize that we needed to have more infrastructure. We've added allocation to infrastructure to the portfolio, and we've been building that out. That is one place where we are going to focus specific dollars on the energy transition. We think that's going to be exciting.

I think we'll be looking at more value added in opportunistic spaces there instead of core because we want this churn. We want the dollars to be going in, creating a low-carbon solution, and then repeating that over and over and over again, because we think, one, that's going to drive great returns, and we think it's the most impactful.

Giordano: Where, in your point of view, might you have to sacrifice returns for ESG investments?

Palmer: You may have to sacrifice returns if you're focused on the societal impact. We have not had a lot of money in solar farms and some of these things early because there was a small amount of capital going into projects.

At the beginning, as we started this transition, the first people in were the people who were mission-driven. They were less concerned about returns and more concerned about getting their dollars impacted there. As the investment in green technologies has grown almost exponentially, those people have– their capital has been used for the large part, they're in the market already, and now we have better return opportunities.

I think in the past, and if you're focused on some of the things that mission-driven people are doing, you may crowd out some good returns, but if you're doing large things that are really making a difference, you can still have great returns.

Giordano: Can you give us an example, like, you wouldn't do X, but you would do Y. If you could give us a high level comparison.

Palmer: I'm really not that interested in stabilized solar farms, just as an example, because I think they throw off a modest single digit yield, which is great and is probably low risk, but I have other things that are more liquid that corporate bonds, for example, are liquid and they throw off about the same amount of income. I think that's one place I would rather not do. I might be interested in solar farm developers with firm contracts to take the power at the other side because you get paid to take the construction risk and things like that. I think there are places to be involved even in the same assets, but playing a different role.

Giordano: Interesting. Is there anyone you're learning from or taking a note from, any thought leaders, other CIOs, blogs, books?

Palmer: Well, mostly my family. [chuckles] Yes, I've got a lot of family members who are very focused here. We have a lot of conversations at home. I do think there are some people who are really trying to think strategically about these issues and I do pay attention to them. I do have some of the European investors and I don't want to really name individual names here. I do talk to individual people outside and there are in Europe because they're a little bit-- have different fiduciary responsibilities. You can think about it a little bit more differently.

I have some education groups that are industry groups that I think provide good resources and good thinking here. I've been working with one of the large money center banks, has put together repeated conferences where they think about, "How do we actually affect this? What are the things that are standing in the way? How do we get the dollars in the right place?" I think those approaches are very common sense and they bring people together to solve problems. I do really appreciate those.

Giordano: How would the American election change things, do you think, if we shifted towards the right again, if Maryland would be put under some kind of constraint as far as their mandates or anything like that?

Andrew: The Department of Labor has-- under ERISA, provided guidance on what fiduciary duty means and what trustees can do in this regard. The standards have shifted back and forth. On the Obama administration, they promulgated a rule that basically said that trustees probably should include ESG as part of their fiduciary duties. Trump rolled that back and then Biden went halfway back. It's back and forth, and we see it in those type of regulations.

I don't think, regardless of the election, that the Maryland legislature would be taking a different path. Because we are so focused on how we use these things to make investment decisions and we are strictly adhering to our fiduciary responsibilities to the beneficiaries, I don't think it's going to change what we do. My goal has been to incorporate things in such a way that I can talk to people who are against it and demonstrate that what I'm doing makes sense from an investment perspective. I can talk to somebody who is an advocate for solving the social issues through pension dollars and explain how what we're doing is consistent with their objectives.

I think where we are, it probably makes nobody really happy, but it's something we can continue to do no matter who's in charge because we think it is really focused on our ultimate goal, which is the beneficiaries.

Giordano: Solidly in the middle.

Palmer: Leading from the middle. I think that's an old thing that might be new again.

Giordano: Andrew, we're very much looking forward to giving you a Strategy Award on April 30th in Washington, DC. I want to thank you today for sharing your wisdom with myself, and Muskan, and our community of allocators who are trying to get this right. Thank you.

Palmer: I appreciate the opportunity to speak about it. It's been a big part of what I've been doing here in the state of Maryland, and one of the things I'm proud of that we've been able to accomplish so much.