Barely touched for 60 years, under State Treasurer Dale Folwell’s watch, North Carolina Retirement Systems has lowered its assumed rate of return for the principal pension fund three times since 2018. The consequences for the $114.3 billion plan’s 87 per cent funded status weighs particularly heavily on his shoulders.

“If I cared about my funded ratio, I wouldn’t lower my rate of return,” he says, speaking from the Retirement Systems’ Raleigh headquarters. “The second you lower your assumed rate of return the funding level drops. It could be 90 per cent funded, you lower the ARR, and the next morning it will be 88 per cent.”

Now at 6.5 per cent, each assumed notch lower makes the road back to being fully funded more arduous and challenging. Particularly given North Carolina is paying out more in benefits every month because of longer life expectancy and early retirement. “Lowering the assumed rate of return at the same time as funding the pension plan is really Herculean.”

The fund, he says, is stuck between a rock and a hard place. The outlook for returns ahead is increasingly bleak. And despite, like many US public pension funds, a recent spate of healthy returns bolstering the funded status,  over the long-term North Carolina’s past returns have failed to achieve their assumed rate of return, on average, for the last 20 years.

“Lowering the ARR has been recommended for over a decade but never done. Doing right is rarely wrong,” he says, coining a phrase that helped his resolve during difficult requests for more money with North Carolina’s General Assembly, councils, and cities in the form of employer contributions to make up the shortfall, alongside reduced benefits. “Every time you lower the assumed rate of return you have to ask your funders for money.”

Conserve, liberate and set free

Investment gains make up almost two thirds of the contributions going into the pension fund and although Folwell says he’s not generally one to blame or complain, he does point the finger at Fed interventions for the challenging investment environment. “In the Spring of 2020 we were all set to take advantage of fantastic investment opportunities, but then the Fed showed up and started betting against us.”

Today, he believes Fed largesse has fuelled the inflation crisis and led to too much money chasing too few assets. “They’ve put us in a situation where there is too much money on the street, and they’ve also created an employment crisis. I’m a conservative, my priority is to conserve, liberate and set free.”

The same free market beliefs inform Folwell’s frustration with the rise of shareholders intervening in corporate governance, particularly regarding climate change. Like other funds, North Carolina is in the process of reclaiming its voting powers from proxy advisors, taking back its ability to vote on corporate climate policy in accordance with the pension fund’s best economic interests.

“We don’t want our proxy to be used to promote policies that don’t have anything to do with our fiduciary responsibility; to use these assets and vote these assets in a way that is contrary to our fiduciary responsibilities is not something we are going to do anymore.” Elsewhere, he says that the rise of ESG has deflected from the importance of energy security and provided an excuse for investment managers to charge higher fees.

“We have recently learned that even the SEC is somewhat uncertain what ESG investment actually is,” he says in response to new rules being prepared by the Securities and Exchange Commission that will set standards for funds claiming to be ESG, sustainable, or low carbon.

Cash and short duration fixed income

North Carolina currently has a high allocation to cash and the shortest duration on its fixed income allocation ever, positioned to snap up assets that bring safety and value to the plan. Folwell’s strategy is to keep investments simple, prioritising “fat crayon” deals that jump off the paper, and make much of North Carolina’s sole fiduciary model. “If we decide to do something, we can act quickly.” He also says the plan benefits from not being a forced seller, able to hold onto assets to their maturity in fixed income if they fall below investment grade.

Continuity is another characteristic of the fund that Folwell believes will lend a competitive advantage in the months ahead. It’s encapsulated in North Carolina’s two CIOs (Christopher Morris and Jeff Smith) each with decade-long careers in the Department of State Treasurer, bringing a status quo and consistency to strategy that was absent in the years before Folwell took the helm when North Carolina ploughed through seven CIOs in 14 years.

Their constant presence avoids the churn of personnel and assets that often accompanies fresh blood and new ideas, he says. “A new CIO would say I don’t want this manager I want that one; my priority has always been to focus on the stability of the plan and the people who work here.”

Fees

Low returns make fee savings even more crucial. Around $17 billion in US equities is now managed internally, and over the last six years North Carolina has saved $650 million in Wall Street fees.  Some of the fund’s most successful investments have been side car allocations in distressed debt that in some instances have not had any fees or profit sharing attached, he says. “Don’t assume managers don’t want to work with you for lower fees; take advantage of the totality of your investments.” North Carolina’s private equity portfolio generated a total return of 58.5 per cent for the last fiscal year.

Folwell is adamant that having just one person in charge of the US’s ninth-biggest pension fund in a sole fiduciary model, long seen as outdated in terms of governance, is preferable to a board-supervised structure. His belief in continuity and persistence in a changing and challenging world holds firm. “We are in the cheque delivery business. At the end of the day, somebody has got to make government work.”

For years Central Bank bond buying has supressed the volatility on which hedge funds thrive. At Finnish pension fund Ilmarinen hedge funds are back in favour, particularly volatility, momentum, and macro strategies that don’t correlate to equities.  

Ilmarinen, the €60 billion Finnish pension insurer founded in 1961, is benefiting from an increased allocation to hedge funds. In recent years, Ilmarinen has grown its allocation to externally managed hedge funds from 1 per cent to around 6-7 per cent, particularly focusing on strategies that don’t correlate with listed equities including different types of volatility, momentum, and macro strategies.

“Some of these have a reasonably low or even negative correlation with equity markets,” says Mikko Mursula, chief investment officer and deputy chief executive at Ilmarinen, explaining that as the environment turns hawkish; inflation edges higher, money policy tightens and investors weigh the risk of recession, active strategies that can navigate asset class volatility appeal.

Mursula doesn’t consider hedge funds a separate asset class, arguing that the wide variety of managers and strategies make it difficult to place the allocation in a single bucket. Alongside the external allocation, Ilmarinen also runs an internally managed hedge fund allocation, although Mursula declines to disclose its size.

Selective approach

In another approach, Ilmarinen is focused on diversification and selective investment in preparation for markedly different performances ahead across countries and sectors and impacting both credit and equity markets. He is also keenly aware of the impact of a probable recession on corporate earnings and margins: investing in companies with strong balance sheets, cashflows and transparent dividends is a priority.

“In recent years, it hasn’t really mattered what sector or equities have been in your portfolio. Going forward, this won’t be the case.”

He believes analysts’ estimates that have current corporate earnings growth at between 6-8 per cent are too high given the level of inflation and its forecast impact on global growth and corporate health.

“Average US and European corporate profit margins are near historical highs. Companies are producing very high earnings numbers and if we are heading into a recession these will obviously fall. We just don’t know how much the cut will be.”

Selection at Ilmarinen will also involve steering away from companies and sectors with high levels of leverage. “As rates go higher and credit spreads widen, corporates with high levels of leverage are going to struggle more going forward,” he says. “It is crystal clear that companies, and countries, will need to pay more for their bonds and loans; there will be pressure on margins.”

Heavily indebted European countries like Italy and Greece with vast public sector debt are most vulnerable. “Reading between the lines of the recent ECB meeting, discussions about debt in Italy have already started.”

He is also wary of countries and corporates most exposed to the grain and energy crisis triggered by Russia’s invasion of Ukraine. “The negative impacts of war in Ukraine will hit Europe more than the US,” he says, attributing the 8 per cent fall in the euro versus the dollar from the start of the year (notwithstanding the interest rate differential) as a key sign of European travails.

Positively, he believes that the energy crisis will spur Europe’s transition to green energy sources away from Russian oil and gas. “In the long run I am not worried; the transition will continue and some of these projects will be launched sooner than we thought because Europe needs to get rid of its dependence on Russian oil and gas.”

Roadmaps

Ilmarinen, which targets a net zero portfolio by 2035, has created roadmaps to net zero for its listed equity and domestic real estate portfolios already. By the end of this year, it aims to have completed roadmaps for its corporate bond and foreign real estate allocations that will also include interim targets, actions, and monitoring criteria. “The single biggest challenge decarbonizing the portfolio is how best to evolve methodologies and frameworks and ensuring enough high value data about your portfolio for all asset classes. It requires more and more resources just to follow the latest evolutions.”

Once these two new roadmaps are in place, attention will turn to other sub asset classes including the whole external manager portfolio across equity, fixed income, infrastructure, and private equity.

Thirty per cent of the portfolio is  invested in fixed-income, 50 per cent in equities, 11 per cent in Real Estate and 9 per cent in other investments. Around a quarter of Ilmarinen’s pension assets are invested in Finland. In 2021, Ilmarinen’s investments returned 15.3 per cent, equivalent to €8.1 billion.

 

In his recent bestseller, Dutch journalist Rutger Bregman presents a reading of human history centered on kindness. It is the altruism of millions of people, rather than their self-interest, that has allowed humanity to survive crises and paved the way to its long-term success.

The same philosophy now applies to the financial sector. When asked, individuals consistently express the will to have their investments make a positive impact on the world. Individual investors are increasingly searching for ways to overcome climate change and the pandemic, notwithstanding a loss of trust in the institutions that govern our world. The ‘moral bankruptcy’ of our financial system thus does not reflect the values of the people whose money is invested. Rather, it is the result of financial intermediaries insufficiently reflecting the will of people.

We must therefore adopt a people-centered approach to sustainable finance that is grounded in the protection of three rights: the right of people to know how their money is spent (“right to know”), to be asked about their sustainability preferences (“right to guide”), and to not be misled by investment products and services with overstated sustainability credentials (“right to be protected”).

A people-centered approach to sustainable finance is likely to lead to a win-win scenario where the achievement of people’s rights and sustainability goals goes in hand in hand. This approach will empower people to manage their money in accordance with their values, while they seek to benefit from the value generated through sustainability-aligned investing.
Different regulatory approaches to protecting these rights have been proposed in the 2022 Financing for Sustainable Development Report, an annual report by United Nations departments and agencies on the state of sustainable finance.

Firstly, regulation can mandate increased transparency. Institutions managing funds on behalf of others currently disclose information on how their funds have been invested, yet the way they disclose sustainability-related information is largely left up to the discretion of the fund managers and is difficult to interpret for anyone.

Regulators could require fund managers to consistently disclose the environmental and social footprint of their clients’ portfolios in a meaningful format. Doing so would expose people to the relative (un)sustainability of their investments, empowering them to demand better of their managers.

Secondly, regulation can require pension funds and financial advisors to ask their beneficiaries and clients about their sustainability preferences. These preferences should subsequently be incorporated in the financial products and investment plans offered to them.

Today this happens too little, and, when it happens, the responses are not always reflected in the investment decisions by those managing their money.

Only 59 per cent of individual investors across 24 countries said their financial advisors discussed Environmental Social and Governance (ESG) investments with them. Meanwhile, 80 per cent of pension fund members in the United Kingdom wish for their pension to do some good. If more people were able to properly guide how their money is managed, trillions more would be directed towards sustainable investing.

Thirdly, investors are too often misled by or lured into sustainable investment products that are sustainable in name only. Regulation should protect people against deceptive practices. They can strengthen market integrity by establishing common norms and criteria for investment products to be labelled as sustainable. Regulators should also embrace ambitious sustainability frameworks, for instance using the Sustainable Development Goals (SDGs) as references for market norms.

However, norms can only be established if adequate information is available about investable assets. Companies should therefore disclose adequate information on their environmental and social impact to make this possible. Again, regulation is needed as it would be naïve to only rely on voluntary disclosure by corporates.

In short, by creating, or reinforcing, these three ‘rights’, policymakers have the opportunity to put people back at the center of investment decisions and in doing so increase the likelihood of achieving their sustainability goals.

Some jurisdictions are ahead. In the European Union, regulations have been updated to ensure that wealth and portfolio managers incorporate clients’ sustainability preferences in their recommendations, and thresholds have been set for the marketing of financial products as sustainable.

If a people-centered approach is pursued in more jurisdictions, humanity’s innate sense of kindness and cooperation will prevail and sustainable finance can deliver on its true potential for sustainable development.

Mathieu Verougstraete and Sander Glas work at the United Nations Department of Economic and Social Affairs.

 

For the first 10 years of Bridgewater’s existence it didn’t manage money. The fund manager, now regarded as the world’s biggest hedge fund, was built on its research, content and advisory expertise, with Ray Dalio, Bob Prince and the team working one-on-one with corporate executives and policy makers to help solve problems. And now, as asset owners increasingly look to managers for “partnerships” rather than transactional relationships, Bridgewater’s advisory capabilities are coming to the fore. In this environment there are many problems to be solved.

“The key thing right now is that the problem set has changed,” says Kyle Delaney, the firm’s president and chief commercial officer (pictured middle). “Most people are starting to recognise the next 10-20 years are going to be very different from the last. This has required a re-thinking of everything relative to what people know and have experienced and is bringing into question things like how to be diversified, which is the most critical and essential thing we have in large part taken for granted in the last decade.”

Bridgewater is talking to clients at the foundational level about what their goals are and what needs to be done to achieve them because many investors are dealing with increased complexity and an environment they have never had to deal with in their investment careers.  Brian Lawlor, co-head of Americas in the client service department (pictured right), says the current environment has caused investors to re-think their investment beliefs and how they allocate risk in their portfolio.

“The focus for now is on advice, understanding their problems and helping clients work through those. We are sharing what we have done and our approach to problem solving,” Lawlor says.

Bridgewater’s research is focused on understanding how the world works and the impact on markets. An enormous amount of information is needed for that and having access to data is more important than ever.

Bridgewater: The technology provider

Established in 1975 by Dalio in a two-bedroom New York City apartment, the firm’s history was embedded in currency and interest rate advisory.

Risk management advice was at the foundation and remains an important tool both internally and now for clients as well. Problem solving internally at Bridgewater has centred around a robust risk management tool which is now available to clients to stress test their portfolios across different dimensions.

“Clients are recognising what is coming down the pipe in the investment environment but they have had a hard time modelling how those environments might impact their portfolio. Because we’ve gone back hundreds of years, and we’ve looked at all different kinds of episodes of inflation and conditions like stagflation, this helps them think through what they can do today to get ahead of that as efficiently as they possibly can,” Delaney says.

It’s an increasing part of the relationship with clients, Lawlor says, and Bridgewater is working on custom technology solutions for clients to allow them access to better insights into the macro environment where inflation, drawdowns, cybersecurity, and liquidity top the list of concerns for clients.

“We’re also thinking about other tools we can make available for our strategic partners,” Lawlor says, which is likely to include technology solutions for data integration.

Throughout the firm’s history problem solving for clients – originally around currency and risk management – has led to product not the other way around.

It’s one of the reasons the firm limits the number of clients it works with, growth is measured in mind share and an ability to help clients solve problems. Product may or may not come out of that.

“As we have gone through drawdowns the feedback we have had from clients is they value the partnership and the impact we can have across the entirety of the portfolio. That makes them feel like they want to work with us,” Delaney says. “We had a drawdown in the first quarter of 2020, which was quite painful, but the research we did at the time on Covid-19, inflation and low interest rates kept us even more relevant to the C-suite.”

Bob Prince, the co-chief investment officer (pictured left) who could also be described as co-chief problem solver, says one of the indicators of a successful relationship with clients is if “the top of the organisation brings their most important problems to you”.

Stagflation and what to do about it

Prince believes one of the most important problems for markets and for clients to understand at the moment is the prospect of stagflation and the implications for portfolios.

For a long time Bridgewater’s line has been that current inflation is not transitory but is a monetary inflation, something not seen in a long time.

“We’re not talking just about money supply, we’re talking about total credit and total spending and looking in a different way at how an economy works,” Prince says.

He says the current difference between the upward pressure on inflation and the downward pressure on growth relative to what is discounted in markets is the widest it has been in the past century.

The root cause of the expected stagflation, he says, is the excessive level of credit and money growth and until that is drained nothing will be fixed.

“We have to nurse our way out of this. Central bankers would probably not shrink the balance sheet as fast as this year and would need to work to raise the interest rate a little faster. The net of that would be a better blend of financial and real economy performance.”

In terms of investors’ allocations in such a market, Bridgewater recommends starting by looking at the environmental biases of assets to growth and inflation.

Investors should favour assets that benefit from inflation, like inflation-linked bonds. Equities, he says, perform badly in stagflationary environments and investors need to recognise that.

“In stagflationary environments equities have been the worst-performing assets, in line with their vulnerability to both falling growth and rising interest rates,” he says.

Solving problems requires innovation

At the last tightening in 2017 Prince recalls a CIO describing their concerns and the vulnerabilities they had in the environment.

Bridgewater took on a project to help the client understand the environmental biases of their portfolio, it turns out they had a bias to do badly if there was a rise in inflation.

“If you have a vulnerability you are worried about in [the] near term you can either fix it permanently by shifting your allocation or you can make some moves tactically based on a view of where we are in the cycle,” Prince says. “I suggested some things but they came back and said they couldn’t do them well enough so I said maybe we could help them with that.”

This was a risk for Bridgewater as it meant taking a particular position for a certain environment, where traditionally its portfolios are unbiased and designed to do well in all markets.

“We took on the mandate but we could only do this type of thing where we have a great relationship. The portfolio was set up only to perform in down times so most of the time it would underperform. We spent six months with them building out a risk management plan and accurate expectations.

At the moment the manager is working with a client to re-orient an asset allocation that had a heavy equities bias and shift that towards using equities as an absolute return, more consistent, resilient allocation. That approach has now also been incorporated into the firm’s approach.

“We have had a lot of innovations over the years we just always thought primarily in terms of our best alpha and our best beta so when we come up with new insights and ways to make money we’ve chosen to add them to our alpha strategy rather than become a product shop,” Delaney says.

The transition to renewable energy will be “volatile and complicated” like other major transitions in history, and spikes in demand and pricing for coal, oil and gas are likely over the near term, according to an expert in global resources strategy from NinetyOne.

While the European move towards low-carbon and renewables has been accelerating in recent years, in hindsight inadequate time was spent on security of supply of existing non-renewable energy sources, according to Tom Nelson, portfolio manager of the global natural resources strategy of Ninety One, the global investment manager established in South Africa in 1991.

Speaking in a podcast conversation with Julia Newbould, managing editor at Conexus Financial, Nelson predicted Europe’s energy crisis would drive up pricing and demand for non-renewable energy sources around the world, and argued oil and gas companies with clear transition plans were likely to do “exceptionally well” in coming years.

The Russia-Ukraine conflict, in jeopardising Europe’s foundational supply of natural gas, had seen the rare collision of two historical events, Nelson said.

“It’s a very, very unusual coming together of these two events: an energy supply shock and an energy transition,” Nelson said. “We’ve seen energy supply shocks before, we’ve seen two energy transitions, we’ve never seen two collide.”

We are now living through the “third energy transition,” with the first being the shift during the 19th century from burning wood and biomass towards coal, and the second being the industrial revolution and the move towards oil and gas, Nelson said. The third is the move away from fossil fuels and hydrocarbons towards low-carbon and renewable energy sources.

These transitions are historically extremely volatile, with new supply sources and demand trends causing large price swings, and “we should expect volatile pricing through the transition,” Nelson said.

Energy transitions “tend to take a little bit longer than people expect,” typically between 30 and 50 years, although this transition may be expedited by the urgency of climate change, Nelson said. They also tend to be “more a case of an energy supply diversification, rather than an overnight revolution where the incumbent effectively gets jettisoned.”

“So we didn’t stop burning wood and biomass when we found coal,” Nelson said. “Neither, sadly, did we stop burning coal when we discovered oil and gas. And I think what we’re perhaps beginning to learn in real time is that the advent of the arrival of low-carbon and renewable energy sources will not mean that we simply stop burning oil, gas and coal overnight.”

As consensus forecasts are established on the displacement of old energy sources with new sources, central market players stop investing in new supply of old sources, making the system more vulnerable to supply shocks and disruptions, he said.

“That is one of the reasons why the recent price action, since the invasion of Ukraine, has been as pronounced and as dramatic as it has been,” Nelson said. “We simply don’t have the spare capacity, or the the buffer, if you like, to fall back on. The system was fairly stretched going into it.”

The Russia-Ukraine conflict and the clear urgency to move to reliable and dependable energy sources will likely accelerate the transition over the long term, but there will be adverse impacts in the shorter term, Nelson said, noting “you can’t take away 35-or-so percent of Europe’s natural gas and not create, in other parts of the energy matrix…heightened levels of demand for other things.”

“So we’re likely to see more coal burned in Europe in the very short term. We’re likely to see Europe become a very strong bidder, and probably the first port of call for global cargoes of liquefied natural gas.”

If gas supply that would have gone to Asia gets diverted to Europe, Asia is likely to also burn more coal in the short term, he said.

Oil and gas companies that demonstrate clear, coherent transition plans, and even potentially become “solutions providers and, if you like, diversified energy companies of the future,” will do “exceptionally well,” he said, pointing to European oil and gas majors like BP, Shell, TotalEnergies and Equinor.

“The ability of us, as investors in these companies, to buy those stocks today on five, six, seven times earnings against a backdrop where a lot of people are not comfortable to own these names–that as active investors we can buy these companies, we can engage with the management teams, we can help them to drive this transition–we think that’s a tremendous opportunity,” Nelson said.

Longer term, demand for metals like lithium, copper, nickel and zinc will see structural tailwinds, driven by electrification and the energy system moving towards more metals-reliant energy sources such as wind and solar, he said.

At CalPERS’ latest performance, compensation and talent management meeting, committee members continued to discuss changes to the $500 billion pension fund’s compensation program to make it more competitive in attracting and retaining staff.  CalPERS’ efforts to modernise the process reflects a sector wide struggle as other institutional investors including the Teacher Retirement System of Texas and the $83.4 billion Alaska Permanent Fund Corp struggle to fill a swathe of investment positions.

Returning to the board with their latest revisions, compensation consultant Global Governance Advisors’ Peter Landers and Bradley Kelly offered more detail on how to evolve the pension fund’s compensation, building on an April presentation when Kelly warned that complacency is the kiss of death for any organisation, especially public pensions, in today’s tight recruitment market.

Among the measures are plans to widen the peer group of funds that CalPERS compares its compensation levels against to include larger private sector firms, and introduce salary packages that have more incentives attached including an annual incentive plan that focuses on total fund results.

Regular review

The determination and assessment of compensation at CalPERS can lag peer funds. Although reviews may not always lead to salary adjustments, they need to be more frequent and regular. In a worse-case example, committee members heard how the compensation for CalPERS’ chief actuary position wasn’t adjusted over a 14-year period.

“Avoid major delays; our recommendation is you set a regular scheduled assessment roughly every two years to make sure you stay aligned with the market,” said Kelly, a partner at GGA.

The committee also reflected on the importance of CalPERS aligning pay, and benchmarking its compensation, with investors with a similar half trillion dollar assets under management.

“Your fund is growing; you want to make sure you are constantly benchmarking against similar-sized organisations,” said Kelly, later adding that alignment helps ensure CalPERS hires people best positioned to understand the size and complexity of the portfolio.  The board also discussed the importance of ensuring the benchmarking process compares CalPERS to other public pension funds and public state agencies, not just the private sector in a blended peer group.

Internal vs external

The committee also heard how, in some cases, internal candidates had been discouraged from applying for positions because of a perception that external candidates are more highly valued. GGA recommended putting in place a fair, transparent and objective assessment that treats external and internal candidates the same.

Moreover, there is a perception that external candidates are hired at the upper end of pay bands while internal hires, coming into new positions from within the fund, tend to sit at lower compensation bands.

Competitive

Although CalPERS cannot compete with private sector compensation, the pension fund can retain talent by offering a compelling quality of life and purpose in a value-add package. For example, the board heard how New York State Common Retirement Fund has successfully hired a senior investment professional from BlackRock.

“People in the private sector look at these pension funds as an opportunity,” said Kelly.

Board member Theresa Taylor added: “For some, it’s all about the experience of wanting to work in a pension fund for the mission.”

Incentives

CalPERS is planning to introduce an annual incentive plan that focuses on total fund results for incentive eligible positions. For now, suggestions that incentives incorporate returns of the asset class in which an investment executive works are on hold.

Discussions on the importance of rewarding talent and meritocracy at CalPERS captured some of the challenges in its pay structure. For sure, people shouldn’t be rewarded just because; the organisation needs to ensure everyone gives their all every day and are not keeping their seat warm for guaranteed incentives.

Yet higher levels of pay based on merit opens the potential for large pay differences and disparities between executives and rank and file workers that could lead to attrition among these essential employees.

Last year CalPERS approved a plan to pay its new chief investment officer, Nicole Musicco, annual and long-term incentives as much as 100 per cent to 150 per cent of an annual base salary ($707,500) based on investment performance.

Approved proposals will come to the full board at a later date.