Key Takeaways

  • The commercial real estate market faces significant headwinds such as tighter credit conditions, income pressure and elevated refinancing needs over the next two years.
  • In the US, while the risks are acute for owners of office properties, commercial real estate remains a diverse asset class and pockets of resilience can be found.
  • As investors seek to protect portfolios and capitalize on opportunities, it will be vital to monitor multiple near-term risks and potential global economic spillover effects.

Commercial real estate (CRE), the third-largest asset class after fixed income and equities, is under pressure. An aggressive rate tightening cycle by the US Federal Reserve (Fed) and other major central banks over the past year has fuelled concerns about the potential impact on the sector, given its reliance on debt and bank financing. This has been compounded by the prospect of further tightening in credit conditions resulting from recent stress among US regional banks, which are a key source of lending to owners.

The office market faces the greatest headwinds, underscored by several high profile CRE loan defaults hitting the headlines.1 Owners of office buildings are contending with structural challenges led by fundamental changes in the way we work since the pandemic. With more people working from home or on hybrid schedules, many companies are reducing their office space. In the US, this shift has contributed to a steady rise in office vacancy rates, particularly in central business districts. Owners of older buildings that lack amenities and sustainability credentials are finding it even harder to attract tenants.

Outside of office properties, however, the outlook for CRE is less downbeat. Industrial properties such as warehouses and logistics facilities have posted the strongest rent increases in the sector in recent years, though net operating income (NOI) growth may slow along with the economy. We believe that pockets of resilience can still be found in CRE despite the current challenges facing the sector, thanks in part to its diversity. In this article, we review the headwinds facing the US CRE market, examine where opportunities may be found and discuss key factors to consider when making investment decisions.

Stress is Building

 

The pressure on CRE has been created by a convergence of factors, including a sharp increase in interest rates, rising costs and reduced operating margins, income pressure, tighter financing needs and a wall of debt maturing over the next 18 months. These headwinds have put downward pressure on asset valuations and while the performance across CRE sectors is uneven, the oversupplied office market is presenting the most acute challenges.

Rate Sensitivity

The US CRE sector has become increasingly reliant in recent years on floating-rate debt, which has become more expensive following benchmark interest rate hikes by central banks. By contrast, the residential real estate market is comprised mostly of 30-year fixed-rate mortgages. Lenders often require floating-rate loans to be paired with interest rate caps tied to a benchmark such as the Secured Overnight Financing Rate (SOFR), although this still exposes borrowers to rate increases up to the strike rate. While most of these floating-rate loans are hedged to protect against rising rates, the duration of rate caps is generally shorter than the fully extended mortgage term. These hedges therefore need to be reset in order to exercise extension options, exposing borrowers to large capital outlays to reset the hedge, or the need to seek out refinancing in the current constrained environment.

The Share of Floating-Rate Loans in CMBS Portfolios has Risen in Recent Years.

Refinancing Needs

The imminent refinancing needs of CRE owners are another source of stress in the sector, with nearly $1.1 trillion worth of commercial mortgage loans expected to mature before the end of 2024, according to Goldman Sachs Global Investment Research. Given the balloon maturities common in commercial mortgages, many borrowers will have to refinance their existing loans at higher rates—assuming there is no dovish pivot by the Fed during this period.

Refinancing Needs

The imminent refinancing needs of CRE owners are another source of stress in the sector, with nearly $1.1 trillion worth of commercial mortgage loans expected to mature before the end of 2024, according to Goldman Sachs Global Investment Research. Given the balloon maturities common in commercial mortgages, many borrowers will have to refinance their existing loans at higher rates—assuming there is no dovish pivot by the Fed during this period.

Refinancing Needs are Elevated Over the Next Two Years

Tighter Credit

Deposits at small US banks—the dominant lenders to CRE—have decreased by nearly $250 billion since January 2023. This pressure will likely lead to a pullback in lending among some banks, including to the CRE market, reinforcing existing headwinds on the sector. Outside of banks, the securitization market has also slowed, with new issuance of commercial mortgage-backed securities (CMBS) falling sharply. The supply of conduit CMBS is down by 72% in the year to date compared with the same period in 2022. Single-asset/single-borrower CMBS have fallen by 85% and CRE collateralized loan obligations are down by 92%.2

Income Pressure

Downward pressure on net operating income (NOI) from declining rent growth, higher labor and materials costs and, in some sectors, rising vacancy rates, is a fourth source of stress for CRE. These issues are particularly acute in the office sector, while some other property types, such as industrial, are driven by more favorable fundamental dynamics. Overall, CRE borrowers have become exposed to a higher risk of a payment2 shock on their liabilities than households and non-financial corporations. The office sector faces uncertain long-term demand due to the continued popularity of remote and hybrid work among employees. US office utilization is down by 51% nationwide compared with the pre-pandemic period. Further, tenant demand has shifted toward newer buildings with better amenities and sustainability features. More than two-thirds of US offices were built before 1990 and the required repurposing and capital expenditure will weigh on NOI, at least in the near term.

The Decline in Occupancy Rates Has Been More Pronounced for Office Versus Other Types of Properties

Sources of Resilience

 

Credit Quality

Stringent lending standards over the past two decades suggest that the credit quality of CRE loans today is stronger than in the period preceding the savings and loan crisis of the 1980s and 1990s, and the global financial crisis of 2007-2008. Many loans that will mature in the next few years were originated at loan-to-value levels of 50% to 65%.3 This significant equity cushion suggests that the impact of lower valuations will be mostly felt by equity sponsors rather than holders of CRE debt including banks, insurers and investors in CMBS. CRE is highly diverse, comprising everything from offices in major cities to data centers and industrial warehouses in rural areas. The office sector faces headwinds, as discussed above, but it accounts for less than a third of all CRE. Elsewhere, the fundamentals are more encouraging. Rents for multifamily properties have come down, for example, but significant growth in the NOI of apartment buildings over the past two years has raised the bar for defaults. Industrial properties including warehouses and logistics facilities have seen strong rent growth in recent years, though the sector is cyclical so NOI growth may slow along with the economy.

Brick-and-mortar retail stores have been suffering for years from the rise of e-commerce, which accounted for 14.7% of total US retail sales in the fourth quarter of 2022, down from the peak reached in the early stages of the pandemic, but still a significant increase from the level of 5.4% in the same period a decade earlier.4 The default cycle has largely materialized, however, particularly for regional shopping malls. The lodging industry was hard hit by lockdown measures during the pandemic, and although business-oriented hotels have yet to fully recover, tourism-oriented hotels have benefited from a steady recovery in demand.

Overall, the fundamental strength of credit quality in CRE has kept delinquency rates in check. Given the sharp rise in interest rates over the past year and slowing economic growth, we expect delinquencies to trend higher from current low levels, but we believe the rise to remain largely concentrated in the office sector, while other sectors remain relatively resilient.

Loss Rates

The experience of the past two decades suggests that losses on CRE loans tend to materialize over a multi-year period, allowing investors to adapt and lowering the prospect of widespread defaults in the near term. Even after a recession, loss rates only tend to pick up after five to seven years. This lag is the result of several factors. First, the process between a default—when a borrower stops repaying debt—and the liquidation of collateral tends to be lengthy. Second, borrowers and lenders are incentivized to amend and extend loans, postponing the potential realization of losses. Finally, loan maturities and property leases are both spread out over several years. As a result, we believe the prospect of a large percentage of leases being rolled over (or not renewed) and loans maturing (or refinanced at higher rates) at the same time is limited. In the office sector, for example, multi-year leases are commonplace and firms cannot typically terminate leases early just because more of their staff are working remotely. Even if CRE defaults reach the scale seen during the global financial crisis—which is not our base-case expectation—we believe US regional banks and the broader financial sector should be able to absorb the losses provided the US economy holds steady. According to our bottom-up analysis, the total losses for US banks should amount to less than 10% of current Tier 1 capital and accumulate over four years.

The Losses for Banks are Expected to be Manageable Provided the US Economy Holds Steady

Investment Opportunities

 

Private Credit

For private credit investors, the roughly $1.1 trillion of CRE loans due to mature before the end of 2024 creates immediate capital deployment opportunities. While demand for debt is growing, increased volatility and uncertainty have significantly reduced the supply of available credit from traditional lenders and public financing providers. As public markets have pulled back, the resulting supply-demand shift has created an opportunity for private lenders to negotiate higher pricing and more favorable structural protections with borrowers, as well as finance higher-quality assets that would have previously been capitalized by the public markets. Funding gaps between current levels of debt and what lenders are willing to refinance may also drive opportunities in structured financing as owners look for options to retain upside in performing assets.

Securitized Credit

CMBS typically consist of a pool of fixed-rate loans with terms of 5-10 years that are securitized and sold in the secondary market. The market in private-label CMBS stood at $729 billion outstanding at the end of 2022, and conduit CMBS made up about half of that total.5 Single-asset, single-borrower (SASB) conduit loans provide another opportunity for CRE exposure. These consist of a single large loan for a single property that is securitized and sold in the secondary market. SASB CMBS accounted for a third of the market at end-2022, with the remainder in collateralized loan obligations (CLOs). The office sector accounted for 28% of conduit CMBS, 24% of SASB CMBS and 15% of CRE CLOs. The underlying loans in CRE CLOs tend to have a floating rate and are typically linked to “transitional properties” such as multi-family assets under redevelopment/ re-tenanting to stabilize the asset. These assets tend to entail more active management, because loans can be added or removed during a specific reinvestment period, and CRE CLO managers tend to have more familiarity with underlying properties.

We expect many CRE borrowers to extend and modify existing loans to avoid stress. We are also reassured by improved credit quality in the CMBS asset class since the global financial crisis thanks to tighter underwriting standards, a tougher regulatory environment that introduced risk retention rules for CMBS issuers and affiliated parties, lower loan-to-value ratios, and higher interest coverage ratios. We are nevertheless alert to the ongoing pressure on NOI that could diminish borrowers’ willingness and ability to refinance or extend loans, particularly in stressed segments of the CRE market such as low-to mid-tier offices and brick-and-mortar retail properties. As a result, we favor risk in senior parts of the capital structure and exposure to high-quality property types. We expect CMBS transaction volumes to remain subdued overall and we anticipate some pockets of stress, but we think better credit standards since the global financial crisis combined with loan modification options will help to contain spillovers to the broader market beyond the structurally challenged office sector.

Corporate Credit

Banks are among the largest holders of US CRE debt, and investors have understandably grown mindful of potential losses on CRE loan exposure, particularly for the regional banks. Historically, banks have not disclosed property type exposure within their CRE loan portfolio, but in response to investor concerns, many provided more detail in Q1 2023 earnings reports. While certain regional banks may be exposed to losses on CRE loans (particularly in the office sector), we think the risk of widespread losses is curbed by relatively healthier fundamentals in other CRE property types and strong capital positions among larger banks. Further, we are reassured by the fact that all banks have access to Fed funding facilities, usage of which has recently moderated.

Banks Own Over Half of the CRE Loans Outstanding

Looking ahead, while we are alert to the risk of renewed banking sector stress, we also believe extraordinary policy interventions could limit contagion risk. That said, alongside the effects of a slowing economy we are closely monitoring the impact on bank profitability from rising deposit rates.6 During the last US hiking cycle, the increase in deposit rates relative to the rise in policy rates—also known as the deposit beta—was modest. Today, deposit rates remain low but are increasing at a faster pace than they did in the last cycle. This likely reflects the speed and scale of the hiking cycle which has made short-term money instruments and other interest-bearing assets more attractive relative to deposits. The ease with which deposits can move around at the tap of a smartphone app has also likely contributed to the stiffer competition faced by banks for deposits. Overall, a larger-than-expected increase in deposit betas could weigh on bank profitability, as higher deposit rates erode the margin between interest expenses and interest income, making this a key dynamic to monitor to assess the outlook for the sector.


Real Estate Investment Trusts

Market dislocation has increased dispersion of returns across property types, with public REITs trading at historic discounts to private market valuations. While the full effects of the US banking stress on real estate is still uncertain, we believe there remains some insulated pockets of opportunities for investors to gain exposure to REIT sectors where fundamentals remain strong, secular trends are supportive, and existing valuation discounts reflect attractive entry points.

For instance, life sciences office has been more insulated than traditional office space from work-from-home trends given the need for scientists to collaborate in person on the research and development of new drugs. Although higher financing costs have led to a slowdown in venture capital funding for life science companies and consequently lower absorption of space relative to the strong levels of the prior two years, we expect rents to remain relatively stable within most major life science clusters. Cell towers and data centers are also in strong positions and benefitting from the digitization of activities in many areas of the economy, with increasing demand for broadband connectivity and cloud data storage. Access to this property type is primarily through the public markets. As an example, more than 90% of cell towers in the US are owned by public tower REITs. The rollout of 5G and AI applications, as well as the internet of things (IoT) are two key tailwinds for these property types, which historically have enjoyed high barriers of entry.

Finally, we remain constructive on rent growth for the industrial sector over the next year, especially in gateway markets. We forecast strong demand for industrial real estate space will continue, which is supported by growing e-commerce penetration and an undersupply in logistics real estate in many of the key distribution hubs.

It is important to note that not all publicly traded REIT sectors will benefit from increased secular demand drivers. REITs that own standard commodity offices, as opposed to amenity-rich specialty office buildings, will be more impacted by the secular decline in demand due to disruption trends and refinancing headwinds, compared to the sectors mentioned above.

What We’re Watching

 

Non-Bank Lending and Spillovers to the Broader Economy

For almost two decades, loans to US businesses from non-bank lenders such as hedge funds, pension funds and insurance companies have exceeded loans from banks. As of the fourth quarter of 2022, about 40% of all non-corporate business loans were bank loans, down from a peak of 70% in 1983.7 If we assume that losses on CRE loans cause only banks to tighten lending standards, the impact on the US economy should be manageable and recession would likely be avoided. Given the increased dependence on non-bank lenders, however, we also need to consider the potential impact if they also tighten lending standards. For example, CRE loans account for about 11% of investments made by insurance companies.8 Losses on those loans relative to capital could be sizeable and lead insurers to scale back investments elsewhere. In a bearish scenario, where CRE sector stress also leads to tighter credit standards in non-bank lending, we think a recession is highly likely. More broadly, we continue to monitor spillovers to the broader economy from tighter standards for lending to CRE borrowers and are tracking data across stress in the broader financial sector, as well as monitoring financial conditions, consumer spending and confidence.

Headwinds are building for the CRE market. A challenging environment is set to persist in the year ahead, with most pressure likely to apply to the office sector. However, investors should be mindful that CRE remains a diverse asset class. Not all property is created equal, and some segments are better placed to navigate a difficult backdrop than others. To protect portfolios and capitalize on opportunities, we believe it will be vital for investors to monitor near-term risks and identify pockets of resilience where they can be found.

Important Information

1Goldman Sachs Global Investment Research: Guide to CRE Office Debt: Mapping exposures and analyzing property performance. As of April 17, 2023.

 

2Goldman Sachs Global Investment Research. CRE: Will This Time Be Different?” Goldman Sachs Global Investment Research. As of April 10, 2023.

 

3CMBS Weekly: Deconstructing and Demystifying US CRE Exposure,” BofA Global Research. As of April 21, 2023.

 

4 “Quarterly Retail E-Commerce Sales, 4th Quarter 2012,” U.S. Census Bureau press release. As of February 15, 2013.

 

5 “CMBS Weekly: Deconstructing and Demystifying US CRE Exposure,” BofA Global Research. As of April 21, 2023.

 

6 Goldman Sachs Global Investment Research, “Global Economics Analyst The Lending and Growth Hit From Higher Deposit Rates”. As of  April 5, 2023.

 

7Goldman Sachs Global Investment Research, “US Economics Analyst: Small Banks, Small Business, and the Geography of Lending,”. As of April 10, 2023.

 

8US Federal Reserve, Autonomous and Goldman Sachs Asset Management Multi-Asset Solutions. As of March 31, 2023.

 

Disclosures

 

Risk Considerations

 

Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price.  The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

 

When interest rates increase, fixed income securities will generally decline in value. Fluctuations in interest rates may also affect the yield and liquidity of fixed income securities.

 

Mortgage-related and other asset-backed securities are subject to credit/default, interest rate and certain additional risks, including extension risk (i.e., in periods of rising interest rates, issuers may pay principal later than expected) and prepayment risk (i.e., in periods of declining interest rates, issuers may pay principal more quickly than expected, causing the strategy to reinvest proceeds at lower prevailing interest rates).

 

An investment in Real Estate Investment Trusts (“REITs”) involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITs whose underlying properties are focused in a particular industry or geographic region are also subject to risks affecting such industries and regions. The securities of REITs involve greater risks than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements because of interest rate changes, economic conditions, tax code adjustments, and other factors.

 

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The possibility of a recession is “still pretty high”, according to PSP Investments’ chief investment officer, Eduard van Gelderen, with that prospect driving investigations into the most impacted asset classes if that eventuated.

“It’s a very delicate situation in the next three years, and we’re looking into the impact that would have on the portfolio,” he says. “We still believe the probably of a recession is still pretty high over the next two years.”

It’s one of a handful of projects the PSP investment team is looking at over the next 12 months as it comes off a stellar year despite the market upheaval.

Increasingly important to the way the portfolio is managed is the aim of minimising and mitigating the risk of a deficit in the plan, van Gelderen says.

Portfolio testing is centred around returns but also negative scenarios that could impact the portfolio and more specifically create a deficit, and subsequently how the portfolio could be positioned to mitigate that.

The fund manages currency hedging at a total fund level, hedging a group of five currencies that behave similarly to the Canadian dollar. Currency added 5.8 per cent to the total portfolio for the year making it the fourth biggest contributor behind infrastructure, private credit, and natural resources.

“The US dollar is important for us, especially when markets take a nose dive,” he says. “Our annual return of 4.4 per cent is pretty good given the circumstances and currency hedging contributed to that.”

The fund continues to focus on risk management and building portfolio resilience.

“With risk people think about market volatility, but we think about it differently,” he says.

The risk of a deficit, and funding risk, is important to the fund, which in turn gives the investment team very different indicators for the portfolio.

“We need to think about the government adding to contributions if there is a deficit, so we look at funding risk not market risk and this gives us very different signals,” he says. “We look at cashflows. As long as positions generate good solid cashflows, the market valuation is not that important to us. Cash generation is more important than the volatility.”

Van Gelderen says PSP’s portfolio is well positioned, and despite the volatility in capital markets, the cashflows generated from real assets are providing protection.

Infrastructure, which makes up 12 per cent of the C$247 billion portfolio, was the fund’s best performer in the financial year results just released.

“With the real assets we have a cashflow focus and look at whether the deals we do are generating an appropriate cashflow we are looking for. One of the reason the asset classes did so well last year in infrastructure and private credit is because the deals have solid cashflow generations. And in infrastructure there is an inflation path through in those deals. That is an important to us.”

In the past year the infrastructure investments generated C$4.6 billion of income, and an increase in assets of C$5.9 billion, with C$1.6 billion of that attributable to currency gains.

Core to the management of the portfolio is the risk tolerance of the Canadian government, PSP’s sponsor, and how each asset class and currencies play a role in managing that risk tolerance.

“Our mandate is not just about maximising returns, there is clearly a risk element to it.”

Focusing on the long term

PSP has outperformed its reference portfolio over the past decade with a 10-year net annualised return of 9.2 per cent versus the reference portfolio of 7.4 per cent. It’s also outperformed on a five-year (7.9 per cent versus 5.5 per cent) and one-year (4.4 per cent versus 0.2 per cent) time frame.

Looking forward van Gelderen is emphasising “more and more we are a long-term investor”.

“The long term is what we find important not the short term,” he says. “We try to stay away from market timing as much as possible. In reality it is never successful, investors are always late and make a lot of transaction costs.”

PSP reviews its policy portfolio every year, with changes driven by the dynamics of asset classes or a change in the risk tolerance of the sponsor.

Van Gelderen thinks the policy mix will remain stable this year and there won’t be any big changes but there are two issues under discussion: the impact of a recession on asset classes; and the impact of climate change on different asset classes over the long term.

The fund also has a dynamic asset allocation process that looks closer at the economic cycle.

“If inflation remains high and more sticky than we hope it will have a massive impact on the liability side of our portfolio. If it remains more sticky then we might move more towards our inflation hedging strategies, that is something we are currently looking into.”

In September last year PSP appointed a new chief executive, Deborah Orida. And in that time the team has made some changes to the team and organisation. From an investment sense there will be more emphasis on the difference between the alpha and beta generating activities, and portfolio completion driven by an internal trading team to create passive exposures.

The fund is split 50:50 between private and public assets with the private asset classes given great freedom to pick the best deals across regions and sectors.

“But by doing it that way they might not follow the country or sector asset allocation for the policy portfolio, so to hedge that gap we have the completion portfolios and tat will be something we emphasise a bit more,” van Gelderen says. “From a risk point of view we can see whether the total portfolio is moving in line with the view of the reference portfolio.”

Talking to Top1000funds.com in an interview following the fund’s “town hall” meeting van Gelderen emphasised the impact of new CEO, Orida.

“She is directing the organisation in a certain way and clearly on the agenda is the culture of PSP,” he says.  “She keeps emphasising our role at PSP and the importance of what we do. People working for the Canadian government do an important job for Canada and we need to support them to be able to retire. Our social licence to operate is front of mind for her and the culture she is creating. And this is important internally, there is a purpose for why we do our jobs.”

The best way to tap alpha investing in the energy transition is to buy assets in high carbon-emitting sectors and help them green, a major pension fund’s investment committee has heard.

Mark Carney, vice chair of Brookfield Asset Management and Head of Transition Investing at the manager, a guest speaker at a recent CalPERS investment committee meeting, said an asset’s emissions will be inextricably tied to financial performance in the years ahead, already visible in how low emitting companies within a sector currently trade at a premium.

“Nothing succeeds like success, and value creation will bring imitation,” Carney said.

“Being low carbon is a determinant of companies and countries competitiveness. We will increasingly see this over time.”

Carney dates his epiphany on the opportunity and risk of climate change to when he was Governor of the Bank of England between 2013-2020. Overseeing the Lloyds insurance market, in the grip of rising inflation-adjusted insurance costs due to extreme weather events, plus a steady rise in uninsured losses, opened his eyes to the climate risk coming down the track.

Investors will find the best returns from investing “where the emissions are” and supporting assets transition. He counselled against divestment from heavily emitting industries, arguing it would result in shutting down core parts of the economy in too large an economic adjustment.

A belief already integral in CalPERS approach to sustainability. CalPERS (and CalSTRS) recently voted against a Californian bill that would prohibit the fund from making new investments in fossil fuel companies and would also require both pension funds to divest existing fossil fuel company investments on or before July 2030. “CalPERS does not believe that mandatory fossil fuel divestment is an effective solution to the reduction of greenhouse gas emissions,” said the fund in a statement.

With less than ten years remaining in the global carbon budget (the amount of carbon the world can produce to keep within a temperature threshold) investors need to support heavily emitting industries reduce their emissions. And Carney said the need for capital amongst high emitting industries is paramount.

Many companies are in a transition trap, unable to tap public markets to invest in the transition, and paying large dividends to shareholders. This offers an opportunity for investors like CalPERS, although he said the pension fund would have to commit to owning those high emissions until they started to fall.

He told board members that investors are increasingly committed to asking companies for their transition plans. And the fact that many corporates are only beginning their journey, offers investors even more of an opportunity.

Local opportunities

Investors have other opportunities to tap transition alpha. It is also possible to generate alpha by investing in local solutions, a crucial element of progress. This could include local investment in a new electricity system that transports clean energy, suggested Carney. “Three quarters of our emissions are traceable back to energy. The issue is getting that energy clean.”

In another strategy, CalPERS could consider carving out a specific transition strategy like Canada’s OTPP and Singapore’s Temasek. Both these investors are investing where the emissions are, going “above and beyond” the core opportunity. “The dynamic around getting capital to climate solutions is starting to kick in,” he said.

Above all, Carney urged board members to recognise the scale of the trend ahead. “Clean energy investment is tripling,” he said, adding that the risk of not acting is manifest in every corner of the portfolio.

Risks include property exposed to climate change in the real estate allocation, and investments in companies that have not adjusted their business model to a green economy. He said investors should “pick and choose” investments in fossil fuel groups, mindful of stranded assets and fossil fuel groups paying out more cash flow as dividends or debt repurchases versus spending on investment. “Are they building up expertise? Some of them are,” he said.

Macro risk

Carney told the board that the transition also holds macro significance that carries implications for the portfolio. Transition investment will impact the rate of inflation; the speed of economic growth, job creation and, in Carney’s view, medium- and long-term interest rates. Rates will track higher because of the multi-decade investment boom in the energy transition ahead. This will have ramifications for portfolio construction, managing risk and fixed income portfolios, he warned. “These are considerations to take into account.”

In contrast to the last two decades, investment will rise relative to GDP. He added that the transition to a clean economy will affect every industry, and is on a scale of the industrial revolution but at a speed akin to the digital transformation, taking place over the next quarter of a century.

Regulation will accelerate the transition. Witness policy in Europe where the EU has agreed to ban the sale of new petrol and diesel cars from 2035. “The impact on investment in electric vehicles was almost immediate,” he said. “It drives activity.”

“What happens when California puts in regulation to get emissions down? It’s a big change and old economic models will become uneconomic.” He said that TCFD will become the global standard in climate disclosure and noted that countries the world over are starting to act with purpose.

Countries’ policies to limit emissions to less than 2.5 degrees are progressing, and combined these commitments are getting close to where we need to be. “The expectation is these commitments will tighten,” he said.

Policy will drive the transition via a combination of regulation and subsidies, or support through the tax system like America’s Inflation Reduction Act (IRA) which provides large tax incentives for energy and climate change measures. A national carbon tax is unlikely. Not many jurisdictions have introduced a carbon tax and the coverage is uneven. “The rest of the world is responding to this by trying to level up to IRA as much as possible.”

Other factors are also speeding up the transition. Reshoring trends mean companies relocating production facilities in new jurisdictions have are keenly focused on where their energy is coming from.  “There is no point locking in emissions when they move,” said Carney. Geopolitical risk has also hastened the transition, visible in Europe accelerating the energy transition since Russia invaded Ukraine.

A Just Transition

Acting early and investing in transition opportunities now will help support a Just Transition. As a financial market participant, CalPERS is engaged with what is happening to the community and workers tied to its assets.

Investors can support workers but sighting new facilities in the same place as legacy infrastructure.

Access to raw materials like copper and lithium is a choke point. But he said the west is now focused on this and new resources will be developed. Exploration of these materials is a small component of the overall cost of the transition. “The transition will throw up challenges and we will focus on addressing them,” he said.

BT Pension Scheme Management, the executive arm of the £47 billion ($59.8 billion) BT Pension Scheme (BTPS), believes it has a solution for the United Kingdom’s mature defined benefit pension schemes, buffeted by complex investment risks and dependent on external support from a fragmented landscape of service providers.

Under its new name Brightwell, and in a model visible in regions like Canada, other institutions can now tap into BTPS’ investment expertise and manager relationships in a mutually beneficial partnership that will also boost assets under management as BTPS continues on its own de-risking journey.

The £1 billion DB arm of the EE Pension Scheme has already signed up and Morten Nilsson, Brightwell’s chief executive officer, notes steady enthusiasm since the April launch.

Perhaps Brightwell’s most compelling service comes in its promise of a coherent, single approach to pension management. Schemes will be able to replace a noisy cohort of actuarial, investment, fiduciary and covenant advisors, plus multiple asset managers, with a single operation.

“We think holistically, and Brightwell can bring all this together under one roof,” he says. “At BTPS we start from our funded position and work through to our liabilities and our covenant and our investment strategy, bringing it all together.”

Nilsson believes multiple service providers create value leakage that is detrimental to pension funds, and although many fiduciary and asset managers argue they are selling solutions they are mostly focused on pushing products.

“There is an acknowledgement from all our peers of the need for something different,” he says. “The challenge is trying to offer something different in a way that the market understands.”

Reducing managers is central to Brightwell’s approach and has been a key seam of strategy at BTPS over the years where the fund has deliberately consolidated its managers into fewer, deeper relationships. These relationships can now be used to offer deals and investment opportunities to others, he says.

Multiple relationships leave many funds struggling to get value for money from their managers and risks pension funds having mandates that are not fully aligned with what they are trying to achieve, he continues.

Nilsson won’t be drawn on Brightwell’s target for assets under management, insisting it is not a volume game. Rather, Brightwell’s guiding rationale is persuading pension funds to work together rather than go through intermediaries and tap into the operational benefits that come with sharing resources.

“This is an opportunity to see how we can work with like minded schemes and find solutions,” he says. “We live in very uncertain times where DB funds need to manage their journey plans. Most schemes are in their end game discussions about what they are trying to achieve.”

Sponsors

Nilsson also believes that Brightwell offers a compelling solution for corporates. Under a buyout model, de-risking DB funds offload tens of billions of pounds of liabilities to insurers who promise to pay employees’ retirement payments at a fixed level.

As schemes seek to complete a transaction with an insurer, they move out of riskier assets such as equities and into bonds.

Nilsson says a buyout is not an option for BTPS given the fund’s size, and capacity in the market. But he also believes corporate sponsors risk losing money in this kind of transaction. He questions the rationale of such large value transfers of returns and surplus from a pension scheme to an insurance company when pension funds could stay in control, benefiting their sponsor.

“A buyout is expected to lead to double digit returns for insurance companies. Buyouts also mean you are taking money away from sponsors that could otherwise be invested in the UK economy – or wherever they operate.”

In a reflection of employers’ concerns that the surplus will be trapped in schemes as funding levels improve, Brightwell has set up a vehicle whereby a pension surplus can be given back to the corporate sponsor.

Integration

Brightwell won’t pool or merge client fund assets like the LGPS model and the team will work with different trustee boards. The DB section of the EE Pension Scheme has outsourced its CIO function, but Nilsson says a larger scheme might equally benefit from having its own CIO and internal team.

Either way, client funds will be able to tap into BTPS’ own investment office in a virtual extension of their own team, accessing Brightwell’s expertise to find the best solutions, design mandates, select managers and implement strategy.

Brightwell will approach investment through the lens of understanding client funds’ funding position, liabilities, how longevity hedging fits with investment strategy and the best way to lock down cash flows on that journey, tailored and specific to them but which will also reveal alignment between BTPS’ objectives.

Cash flows

Brightwell will pay particular attention to how client funds can maximize and lock in cash flows better, providing certainty on what flows they are trying to match. Part of this involves ensuring funds tap a healthy illiquidity premium for their illiquid assets (an allocation which, for many pension funds, has growth relative to their size since last year) and are able to sell illiquid assets in the secondary market.

“Depending on their cash flows, the asset mix for many DB funds has become more illiquid and this is now a central focus area,” he says.

The UK government is banging the drum for pension funds to invest more domestically, but Nilsson says BTPS is already heavily invested in the UK – and wants to be. Closed DB schemes will never want to hold large amounts of local venture investments because it doesn’t fit with their maturity profile but BTPS offsets this by increasing exposure to the UK through investments in corporate credit, direct lending, infrastructure, and income generating property.

“DB and DC funds are different,” he continues. “If you are a 20-year-old saver in a DC scheme you have lots of capacity for risk and should grab it, but the DB sector is different. The government is eyeing trillions of pounds in DB schemes to invest at home. We have appetite to invest in income generating local assets, but high risk illiquid investments wouldn’t suit these schemes.”

Brightwell will also help client funds invest in the transition, supported by BTPS’s expertise where prize transition assets include King’s Cross station, “a brown asset that is now net zero and has also made a tonne of money.”

“UK pension funds also hold a lot of gilts. If the government transitions and helps pension funds achieve their net zero goals with the right return that is perfect,” he concludes.

 

After years of waiting, AP7, Sweden’s SEK 900 billion ($84 billion) DC state pension plan, has just completed an inaugural investment in real estate, marking a leap forward on the road to building a strategy that is less correlated to the equity market.

New regulations in place since the beginning of the year finally permit AP7 to invest up to 20 per cent (up from 10 per cent) of its assets in alternative, illiquid investments. A new allocation to infrastructure and targets to double private equity are in the offing following the fund dipping a first toe in real estate with a stake in a multi-use development in Stockholm.

“We have asked for this for a long time. If you manage investments with a time horizon of 40 to 60 years and 100 per cent of the fund is required to have daily liquidity, of course it will cost you in returns,”  says Johan Florén, chief ESG and communication officer at the fund.

The move is indicative of the gradual evolution of strategy at the fund which has had to adopt a creative approach to diversification because of its regulatory confines. It’s main life cycle product comprises a small allocation to fixed income (primarily Swedish exposure) with all the remainder in equity in a full throttle approach.

The majority of the equity exposure is in a global market cap ACWI allocation where diversification comes via stakes in some 3,000 global companies spread across all sectors and regions. Over the years AP7 has added diversification via paring back on global equity, introducing some factor exposure and increasing the allocation to small cap, emerging markets and a private equity allocation, explains Florén.

“This was our strategy to diversify the portfolio and reduce risk,” he says. “We reduced the global equity portfolio with the aim of lowering volatility a little, but also keeping returns at the same level. We hoped the risk adjusted return would improve.” Between 2010–2022 the equity fund has returned 415 per cent compared to 5.5 per cent returns in the fixed income allocation. The equity fund made a –9.9 per cent loss in 2022

Less leverage

The ability to diversify will also impact AP7’s use of leverage, accelerating a strategy to gradually reduce leverage over the years. At the end of 2022, the net equity market exposure amounted to 115.5 percent of the fund capital, in contrast to earlier periods of much higher leverage. In 2010 AP7 applied 50 per cent leverage to the equity portfolio and Florén  says the fund now targets leverage of around 25 per cent over the long term. “We have gradually taken it down,” he says.

The ability to invest more in illiquid assets also supports AP7’s sustainability ambitions. The lifting of restrictions will allow the fund to boost its allocation to green real estate and infrastructure.

AP7 has changed its own internal regulations to allow it to invest more in green bonds, highly rated state-owned companies and supranationals like the world Bank and EIB. Investments in green bonds increased to SEK 9.2 billion ($0.87 billion) in 2022, corresponding to 10 per cent of AP7’s fixed income portfolio with a target to increase this to 50 per cent by 2025. These types of bonds yield slightly higher returns than Swedish government bonds, partly because they are not as liquid.

Under its sustainability strategy,  AP7 has also began work on a new transition portfolio, targeting this portfolio account for 10 per cent of the equity fund by 2025. The actively managed allocation seeks to increase holdings in certain companies compared to the index. The idea is that the increased weighting and focus via an active ownership and increased stake will boost corporate transition.

“We are more likely to do good as active owners in a company with high emissions that has a longer transition ahead of them, than in a company that is already best in class,” says Carl Fredrik Pollack, responsible for sustainability integration in asset management.

Illiquid implementation

AP7 still hasn’t finalised processes around implementation and how best to access more illiquid assets, continues Florén.  Its first investment involved partnering with AMF in a joint venture.

“This is definitely one way we will do it,” he says. “But there is no final decision and we are looking at different ways.”

AP7 will likely approach infrastructure investment it in the same way as private equity – aka investing small amounts over a long period of time to avoid concentrating risk in a particular life cycle. “It can be hard to have high quality investments if you invest a lot quickly,” he says. “We will do it over a number of years, step by step.”

He also sounds the possibility of AP7 going into the secondary market to get more diversification over time. Although AP7 can invest up to 20 per cent of its assets in illiquid investments Floren says the fund will likely invest between 15-20 per cent over a number of years.

“Everyone is very enthusiastic about it and we don’t see any big risks since we don’t have a strict timetable. We are looking for good opportunities and will take it step by step.”

Costs

AP7’s outsourcing strategy means the internal team design strategy but select managers to deliver. “We look for the best there is when we do our procurement, in particular around asset management.” Although he says the fund might need to slightly boost its headcount to invest more in alternatives, there are no plans to abandon its outsourcing philosophy and hire a new team.

Similarly, Floren says the fund is determined to keep its investment costs low. Management fees for the AP7 equity fund (0.05 per cent) and the fixed income fund (0.04 per cent) remain unchanged in 2023, in line with policy.

“It’s well known that these investments can be more costly, but we are not going to raise fees and 5 basis points in the equity fund will remain. This fee is a clear condition that we must consider – cost efficiency will remain a priority even in new assets.”

The attempts by multiple Republican states to restrict where US pension funds can invest is symptomatic of bad governance. Top1000funds.com takes a deep dive into the quagmire of US state pension funds to assess the impact of partisan politics on the ability of CIOs to do their jobs. The analysis highlights the need for improved practices around delegated authority to prevent the politicisation of investments. 

So much has been written about the rise and fall of ESG investing. But as an active participant in the global investment industry, and a non-American, it is extraordinary to observe the grandstanding efforts by US politicians, collapsing their vote-grabbing job functions with their roles as stewards of long-term capital.  

The obvious and stark mismatch between the two-year political cycle and the long-term nature of pension investing is at the core of this problem, which also highlights the ignorance of the politically elected in managing pension assets. It’s no wonder best-practice pension management is complicated and difficult to attain. 

The convoluted governance structures of US state pension funds, where elected officials are also trustees of the pension money and in some cases the sole trustee, is the complicating issue. And according to some governance experts, it’s the source of the problem. 

The anti-ESG movement has been played out through comical headlines and quotes, one example being Montana’s Attorney General Austin Knudsen: “Montana’s a northern state. It gets really, really cold. We can’t heat our homes with rainbows and fairy dust.” But the impact is being felt by the investment staff whose jobs are to maximise the best financial outcomes for the beneficiaries of the pension funds whose money they manage.  

The now-famous Montana letter, signed by 21 state Attorneys General and sent to 53 of America’s largest fund managers and financial institutions, argues that the investment industry is following liberal principles of woke capitalism for illegitimate reasons and contravention of fiduciary duty.  

According to Roger Urwin, one of the world’s leading investment governance experts, their fundamental thesis is a strawman fallacy.  

“It is the knocking down of an investment thesis that hasn’t been put forward in the first place,” he says. “But it is symptomatic of something we should respect in the investment industry that is that the politicisation of investments has become a systemic risk.” 

The biggest risk is the legitimacy of the pension fund mission. 

 Shooting a moving target 

The problem with the investment industry arguing either side of the ESG war is the fight is not about investments. 

“My problem with the ESG wars is it’s like looking into the sun, that’s how stupid it is,” says David Wood, senior researcher at the Social Innovation and Change Initiative at Harvard Kennedy School, who has educated many pension fund trustees through the Initiative for Responsible Investment at the Kennedy School.  

“My problem with the ESG wars is it’s like
looking into the sun, that’s how stupid it is.” 

 “What is the point of talking about the ESG wars as an investment style when it’s not what has motivated the attack?” Wood says. 

It can be difficult to understand the arguments. One example of the complexities is in the state of Oklahoma which according to US Energy Secretary Jennifer Granholm is already the fourth-largest generator of renewable energy of all the 50 US states, with enough wind, solar, and energy storage capacity to power all of the state’s households, two times over. While it’s traditionally been a big fossil fuel state, clearly clean energy is a big part of its future. 

And yet last month the state’s treasurer put together a list of 13 financial institutions that are prohibited from doing business with the state for engaging in “boycotts of fossil fuel companies” claiming the firms, including JP Morgan and BlackRock, were “beholden to social goals that override their fiduciary duties”. Both firms claimed the treasurer’s claims were baseless and their business practices were “not anti-free market” as claimed. 

By nature, politics is short term and pension investment is long term. Investment professionals at the helm of pension investment management are managing 40+ year financial liabilities to an accuracy of three decimal points. Exploring the complexity of how these two competing time horizons intertwine is difficult and complex. 

A Journal of Finance paper, Political representation and governance: evidence from the investment decisions of public pension funds, found that pension funds whose boards contain greater representation of state officials underperform. It explores three sources of poor decision-making by those state officials: control, corruption and confusion. Among other things, the paper says elected officials may be more inclined towards opportunistic behaviour arising from personal career concerns or the desire to attract political contributions. 

This is certainly the observation from many investment professionals Top1000funds.com spoke to for this article, who noted that the behaviour of the political-elected trustees on their state pension fund boards did not even consider beneficiaries’ interests as an afterthought. 

Many US public pension funds conduct their board meetings in public arenas. San Francisco City, for example, has public comment after every agenda item at its board meeting, and many public funds hire multiple lawyers just to deal with the Freedom of Information Act requests. 

There are many problems with this structure, not least of which is focus. It opens the arena to people with objectives at odds with the beneficiaries and distracts trustee focus. When a trustee is also an elected official it can veer even more off course. 

“Politics and investment don’t mix,” says Craig Slaughter, CEO and CIO of the $19 billion West Virginia Investment Management Board (IMB), a position he has held for three decades. 

He believes recent legislation introduced by West Virginia’s Republican administration to claw back direct control of the fund’s proxy vote marks the tip of an iceberg. Political interference in investment decision-making threatens the fiduciary independence of the retirement plan, he says.  [See: West Virginia CIO fears anti-ESG campaign threatens fiduciary duty]

The new legislation, coming into force in the next 15 months, will increase the level of scrutiny and impose potentially costly processes and hurdles in the proxy voting process. However, Slaughter’s main concern is that this legislation marks the first step on a road that could see the legislature tell the pension fund how to invest its assets. 

One day that could mean ordering divestment of fossil fuels by those that oppose investing in them, but right now he is more concerned the anti-ESG movement led by West Virginia’s cultural Republicans could start to dictate investment strategy that could include forcing investment in West Virginia’s fossil fuel industry. 

“At the IMB we don’t favour or disfavour fossil fuels, we just buy them if they are a good investment and if not, we don’t; but that may no longer be good enough. Whether pro-ESG or anti-ESG, the idea of using other peoples’ money to achieve a political purpose is offensive to me.” 

“Whether pro-ESG or anti-ESG, the idea of using other peoples’ money to achieve a political purpose is offensive to me.” 

The political hurly-burly is impacting state pension fund CIOs’ day jobs in a meaningful way. 

“From an investment perspective I’m trying to use every tool I can to make better investment decisions – any other CIO will say the same thing,” says Andrew Palmer, CIO of the $63 billion Maryland State Retirement and Pension System. “Politicians are taking the ESG bat and hitting each other with it. And that has made the life of people trying to make investment decisions more difficult.” 

“It turns out good risk management is important for banks; that is a governance thing. If you don’t have good safety for petroleum companies, there can be multiple-year impediments for that company. Every fundamental investor I know looks at these issues to make better decisions. That’s ESG. If CIOs think they can make more money by looking at ESG factors they will look at it,” he says. 

Chris Ailman, the long-time CIO of CalSTRS has been dealing with external pressures on investments for more than 25 years.  

“The average teacher works for 30 years and lives for another 30 after that so this money has a 30- to 60-year time horizon. When you think that long-term you think of all sorts of things beyond the balance sheet. You need a lot more information,” he says. “Whatever initials you want to use, these are long-term risks, and they should be disclosed by companies so we can make investment decisions. End of discussion. This is not about political outlook it’s an investment decision. I’ve never thought of them as political, and still don’t. But I am saddened by fact that people characterise words and suddenly make them good or bad.” 

Indeed, Willis Towers Watson’s Roger Urwin says asset owners worldwide are trying to solve a financial equation, not solve something more pro-social or pro-environmental.  And yet it’s become a political issue. 

The governance conundrum

To understand best practice pension governance, it’s necessary to go back to 1980s Canada, where independence from the United Kingdom was fresh and KD Lang’s career was going gangbusters. 

In 1986, Keith Ambachtsheer was on a taskforce set up by the then-Treasurer of Ontario, Bob Nixon, to reform pension organisations. The resulting report “In whose interest?” recommended two ways public sector pension management could be improved: first, ensure pension deals were intergenerationally fair; and second, that arm’s-length pension organisations should be governed and managed as effective financial intermediaries with fiduciary mindsets. 

“If you are going to create a great pension system there has to be legitimacy and value for money. Governance is critical to both. You have to understand what arm’s-length means, and you have to understand good business to be effective,” Ambachtsheer says, adding clear delegated investment authority is a key feature. 

The outcome of the report, and the implementation of the governance principles it outlined, was the formation of Ontario Teachers’ Pension Plan which has returned more than 10 per cent a year since inception.  

“It can be done right,” Ambachtsheer, a Canadian himself, says. “I look south of the border and shake my head. There are a few US states that have people who understand the principles around what Peter Drucker said and create outcomes that are kind of OK, but they are a [clear] minority. The issue is at odds with the original principles of legitimacy and effectiveness.” 

Similarly, Willis Towers Watson’s Roger Urwin has spent his career advising asset owners on governance and organisational issues – notably Australia’s Future Fund and New Zealand Super, both recognised for their organisational acumen. 

He is working with USS and Sweden’s AP funds, and although he did some work with the CalPERS’ board some years ago setting up their investment beliefs, he has done limited recent work with US funds.  Urwin, whose work with Oxford’s Gordon Clark demonstrated there is a 100 to 200 basis points a year return attributable to good governance, says there are three universal rules of governance: pension funds are fiduciaries; they should be independent; and they should be run as professional organisations. 

“Those three principles take you a long way,” Urwin says. “It looks on the surface in the US as if both the fiduciary and independence principles are being challenged in some funds. 

“The fiduciary-duty principle has always started with a financial-first orientation, but essentially sustainability is one of the instruments to secure the financial mandate,” Urwin says. “Sustainability is instrumental to financial outcome. But not everything in sustainability is supportive to financial outcomes. Understanding where those things are inter-related is important.” 

In the US there are some examples of good governance and Utah’s John Skjervem, for example, cites the fund’s governance model as a critical support for his team’s decision making.  

Specifically, the URS board addresses investment matters in executive sessions which limit the “political grandstanding and virtue signalling” that Skjervem says is commonplace at many US public-plan board meetings.  

Skjervem says the URS governance shields the entire program from politics and “non-fiduciary” influences, allowing the team to focus exclusively on hunting for the best risk-adjusted returns without interruption or interference.  He believes this combination of delegated investment authority and multi-level fiduciary oversight is the program’s “secret sauce” and manifests as excellence in both portfolio construction and team culture. [See: Utah Retirement Systems: Why ESG is a waste of time]

But Utah is a rare case, and for the most part the governance of the state pension funds is complicated at best, embroiled in the political sphere. 

“Politicians shouldn’t get involved in the investment policies in pension plans that are properly set up at all,” says Amabachtsheer. “As soon as they put their fingers in, they are offside. One of the big breakthroughs in the Canadian model was that politicians are deathly afraid to meddle – and they should be.” 

“Politicians shouldn’t get involved in the investment policies in pension plans that are properly set up at all.” 

According to Ambachtsheer, turning retirement savings into wealth-producing capital is the narrative that is central to pension fund management. 

“The whole question should be what is the best way for pension funds to do that transformation process?” he says. “OTPP got that straight away. It forces a long horizon, and you understand the businesses you are investing in. If you are a knowledgeable investor, then of course you can call up those companies and ask them about what they are doing. It comes naturally if you have the right narrative. In the US there are some cases where funds have gone off road on that central narrative to a laughable extent.” 

If getting the foundational governance right wasn’t hard enough, now investment practice is moving from 2D investing with a focus on risk and return, to 3D which also incorporates real world impact. 

“It’s going to get more messy,” Urwin says.  

The Thinking Ahead Institute, which Urwin co-founded, encourages investors to look through a systemic lens incorporating social, technological, economic, environmental, political, legal and ethical issues which all have influences on the system in which investments operate. 

“The new phenomenon is the increased connectedness of these things which is speeding up change as well as increasing complexity,” Urwin says. 

Rob Bauer, Professor of Finance at Maastricht University has been studying ESG considerations for more than 20 years and agrees where societal issues and financial institutions there is complexity. He believes a lack of authenticity from product providers has added to the polarisation and politicisation of ESG issues in the US. 

“I needed 20 years to understand what we are talking about here, every day a piece of the puzzle is added,” he says. “Then suddenly these marketing organisations come through overnight and say they are experts on ESG.” 

“I needed 20 years to understand what we are talking about here, every day a piece of the puzzle is added. Then suddenly these marketing organisations come through overnight and say they are experts on ESG.” 

The most complicated governance relationships according to Bauer are where the boards delegate their proxy voting to firms such as BlackRock and Vanguard. 

“These organisations have commercial incentives, that are often conflicting. On one hand BlackRock is saying divest, but on the other hand Texas oil companies are clients of BlackRock. This says it all. How can these organisations engage when they have two different stances?” 

For Maastricht’s Bauer, who also advises many Dutch funds on ESG-related issues, it again comes back to governance.  

“Pension organisations set up investment beliefs and hire organisations to implement. But it’s more like they are wishing for an outcome so they set up beliefs consistent with that. But they have to test the beliefs regularly,” he says. “ESG is a container so broad and complicated, how do you measure preferences?”

Anger over proxy votes 

To get a sense of the level of grievance red-state investors feel about the misuse of their proxy vote, we spoke to to South Carolina State Treasurer Curtis Loftis, beginning his fourth term as sole trustee of the state’s $65 billion fund, the bulk of which is invested in a $41 billion portfolio and separate from the state’s $38.2 billion pension fund which is managed by the Retirement System Investment Commission (RSIC). Loftis insists asset managers fired the opening shots in the now-raging ESG war by misusing institutional investors proxy votes in the first place.    

Most of his anger is directed towards BlackRock, which was mandated to run a passive equity allocation in the state’s portfolio until Loftis began removing BlackRock mandates, most recently re-allocating a final $200 million tranche to Vanguard.  

BlackRock was using South Carolina’s proxy to mandate dramatic changes in energy use, employment practices and looking after stakeholder rather than shareholder interests and that didn’t represent the beliefs of the people of South Carolina, he says.  

“We’ve eradicated them from our portfolio,” he told Top1000funds.com. “BlackRock was voting contrary to our wishes. It’s as if I couldn’t vote and asked my best friend to vote Republican for me, but he voted Democrat, sealed it up and mailed it.”  

Loftis, who was retired for 10 years before he returned to work to take up the role as South Carolina’s banker, managing, investing, and retaining custody of the state’s assets, continues. “This is what happened on a massive scale and it’s appalling, and it fuels the conundrum we are now in today. It’s about getting these asset managers to vote the investment dollars we’ve given them in accordance with the beliefs of the people who own them.”  

“It’s as if I couldn’t vote and asked my best friend to vote Republican for me, but he voted Democrat.” 

Talking to Loftis reveals that taking back control of the proxy voting process is being driven by a deeper grievance than just a belief that the vote was being used contrary to South Carolina’s Republican taxpayers’ beliefs. He believes ESG-minded proxy voting has infiltrated corporate America and is now triggering fundamental change for the worse. Take the gradual move away from shareholder to stakeholder primacy for example. In today’s new world of stakeholder capitalism, companies are beholden to their community, consumers, and special interest groups not just shareholders, yet he believes these groups shouldn’t be a company’s responsibility. “We have governments to keep stakeholders happy,” he says. “It’s tipping the financial house of America on its head in a process that hasn’t been sanctioned at the ballot box.” 

Loftis says the capital markets used to work well. Now a business wanting to raise money must comply with ESG and other non financial stipulations laid down by ratings agencies and banks that insist on a swathe of rules that do not represent conservative ideas. 

“It is difficult to raise capital if you don’t have a high ESG score,” he says, describing a new landscape where corporate America, a reliable conservative partner, is now in the grip of “a hard left ideology”. 

Perhaps the fact that ESG isn’t the result of a democratic process – and wouldn’t, he says, pass through Congress if presented – angers him most.  

“ESG is changing a country and culture but without having the government permission to do so,” he says.  “It’s created a veneer of governance that we don’t think is even legal.”  

The guardians of South Carolina’s pension assets managed by RSIC are also preparing for change. The ESG Pension Protection Act, passing through South Carolina’s legislative process and which Loftis expects to be ratified either this year or next, would require the retirement system consider only “pecuniary factors” when making investment decisions. Although this is consistent with the perspective RSIC currently takes when managing the portfolio, the bill also requires the state’s retirement system to exercise shareholder proxy rights for shares that are owned directly or indirectly on behalf of the system.  

Negotiations over the bill have required substantial involvement by chief executive of RSIC Michael Hitchcock.  

“I’ve spent a significant portion of my time over the past year working with the legislators on ESG legislation,” he says.  

A process during which, like other CIOs interviewed by Top1000funds.com, he articulated his biggest fear is an outcome that decreases the availability of investment opportunities in a way that impacts returns and leads to increased contributions. HIs goal has been to keep the focus on RSIC’s obligation to earn an investment return that helps fund benefit payments for the retirement system’s 600,000 beneficiaries. 

“We are not woke, or anti-woke,” he says. “We are anti-broke.”  

CIOS hitting back 

Florida’s Republican Governor and US Presidential hopeful Ron DeSantis, the anti-ESG camp’s biggest hitter, has signed into law a bill that prohibits and seeks to punish all ESG considerations in the state’s investment decision-making, spanning all state treasury and retirement plan funds. It requires Florida State Board of Administration, guardian of $232.5 billion including the $181 billion Florida Retirement System, to only make investments on pecuniary factors and prohibits, amongst a raft of other restrictions, banks integrating ESG factors into their lending criteria.   

DeSantis said the legislation would protect “hard working pensioners” against “woke” asset managers and “joyriding ideology” and said he believes Florida’s legislation, which follows on from Florida State Board of Administration divesting the state’s pension investments from BlackRock, will act as a blueprint for other states opposed to ESG, in a multi-state effort.  

“This governor is leading the fight and 20 other states are following his lead into battle,” says Florida’s chief financial officer Jimmy Patronis, who sits on the SBA board alongside DeSantis and Attorney General Ashley Moody as the three government-elected trustees. 

 But the idea that Florida’s sweeping legislation, backed by the campaign’s biggest beasts, signposts the rollout of similar legislation at other pension funds is not necessarily the case. CIOs are also hitting back.  

Like Alan Conroy executive director of $24.3 billion Kansas Public Employees Retirement System, whose testimony highlighting the potential impact on the pension fund contributed to legislators reducing the scope of Kansas’ Protection of Pensions and Businesses Against Ideological Interference Act. The final legislation still restricts ESG but addresses all concerns Conroy raised in testimony. Like the fact forced divestment from ESG-minded managers, restructuring the portfolio and hiring new managers could cost $3.6 billion over the next decade, impacting the already underfunded pension system. He warned that KPERS’s funded ratio could be lowered by 10 per cent due to the combined impact of lost assets due to divestment and increased liabilities due to lower future investment. 

Forced divestment from ESG-minded managers, restructuring the portfolio and hiring new managers could cost $3.6 billion over the next decade,

Other CIOs also complain if anti-ESG legislation in their states went through in its original format it would have a huge adverse impact on their investment organisations, including needing to fire managers, build bigger internal organisations or go passive – all of which have cost, resource and return implications.  

CIOs are also arguing that new proxy rules create an unnecessary layer of administrative complexity in structures that are already highly bureaucratic compared to global peers, that will make them less competitive with private market investments. 

“These requirements could also prevent the system from using commingled investment accounts that often provide a more efficient, low-cost way of investing trust fund assets,” KPERS’ Conroy told legislators. He also sounded a warning bell on new complexities around the term “fiduciary”.  

It’s a similar story in Nebraska, where Michael Walden-Newman, CIO at $40 billion Nebraska Investment Council has resisted an attempt by Nebraska state legislator to introduce legislation banning ESG investment that directly interfered with fiduciary duty.  

“I explained to legislators that Nebraska already states that the investment council is prohibited from making any investment if its primary purpose is for social or economic development benefit,” said Walden-Newman. “Also, that the members of the investment council board and I, as CIO, are fiduciaries under the law, and are bound by that fiduciary responsibility to ensure investments are made for the benefit of the members of the various retirement plans and the general taxpayers of Nebraska. The Legislature chose to not act on the legislation.” 

In Texas, where an anti-ESG bill went through the legislative process earlier this year but was not passed because it missed a key deadline, Amy Bishop the executive director of the $45 billion Texas County & District Retirement System (TCDRS) raised similar concerns with the Senate State Affairs Committee. She warned the proposed bill would impact the organisation’s “ability to maximize returns and have a financial impact on employers” adding the bill would keep the fund from “partnering with some of the best investment managers in the world”. She warned that adjusting the asset allocation could cost more than $6 billion over the next 10 years, causing employer contributions to double. 

How do you right the ship? 

The governance structures of US public plans were set up in the 1970s and are due for modernisation. 

55 per cent of the board members of US public sector pension funds are either appointed through some kind of election process or through ‘ex-officio’ status, requiring board membership by state or local officials. The number in Canadian and European pension funds is zero per cent.  

The important distinction, according to CalSTRS’ Ailman, is that these organisations are trusts set up for a specific benefit. 

 “These are trust funds and they needed to be treated that way. We don’t use that word enough and that’s why we’ve lost sight of it,” he says.

“Seeing trust funds being attacked by both sides of the aisle may be enough of a catalyst for us to make some change. These retirement plans are for multiple generations. I have 20-year-old teachers starting this fall and it’s their pension too. Elected officials want to make a statement and so why not use somebody else’s money? It’s too easy for them.” CIOs and their investment teams are money managers trapped inside the business model of a government entity. 

“These are trust funds and they needed to be treated that way. We don’t use that word enough and that’s why we’ve lost sight of it.” 

“That is costing us money,” Ailman says. “But even that is not enough to make people want to change the governance, because the people who will change it are the ones using it for personal gain. I can’t put my finger on what will cause it to change, but when it does it will spread like wildfire across the country.”