As our global markets shudder on the precipice of a recessionary double dip, pension plans around the world are staggering under the weight of immense investment risk.
Plan fiduciaries have spent decades managing the risks of short term asset valuation corrections, which are normally addressed by reallocating funds and buying on dips for limited periods of time. They are also familiar with the risks posed by long term secular bear markets, which are customarily addressed by adjusting risk tolerance levels and benefit formulas gradually.
But in today’s volatile environment, fiduciaries are confronting the perfect storm of twin declines in short term asset valuation levels and long term growth trends. Some innovative firms, such as the premium drinks firm Diageo, have decided to confront these challenges in extremely unusual ways.
A Triple Whammy
To be sure, the devastating impact of asset valuation and growth trend declines on investment risk is further complicated by the specter of soaring demographic risk. In other words, plan fiduciaries are watching their current and projected asset values decline at the very moment when their baby boom employees are retiring and applying for pension benefits.
So how should pension sponsors address this situation? For starters, they should certainly avoid withdrawing plan funds to finance their own needs, as entities like the State of New York have done. Instead, they should focus on assessing the scopes of their deficits by prudently reducing their long term growth rate assumptions, and by estimating the true gaps between their current asset values and their future liabilities.
But then how should these organizational sponsors, many of whom are themselves facing cash flow shortfalls, plug their pension plan funding gaps? Must these organizations necessarily slash retirement benefits and risk alienating their already frazzled and insecure work forces? And what if federal pension laws constrain their abilities to take such actions?
Last week, Diageo decided to respond to these challenges with an innovative approach to managing the investment risk of its employee pension plan. Instead of plugging the gap between investment assets and benefit liabilities with cash or cash equivalents, it donated two million barrels of aging whiskey — Johnny Walker whiskey from Scotland — to their plan instead!
The barrels didn’t actually move at all; they remained in their Diageo storage areas, although ownership title was transferred to the pension plan. Diageo promised to sell the barrels as the whiskey reaches maturity, transferring the cash proceeds to the pension plan as they are collected over time. In fact, Diageo even promised to repurchase its ownership interest in the partnership that will manage the transactions after fifteen years.
At first glance, one might not perceive much incremental risk in this innovative approach to pension plan management. After all, isn’t Diageo’s continuing ability to fund its pension plan dependent on its revenue stream from liquor sales any way? Although this is indeed true, by transferring inventory directly into the plan, Diageo cleverly managed to transfer much of its diversification risk onto the backs of its pension plan beneficiaries as well.
Asset Diversification, Risk, and Return
Had Diageo chosen the traditional approach of transferring cash and cash equivalents to its pension plan, its fiduciaries would have undoubtedly invested the proceeds in a customary array of diversified investments. Just as individual investors in 401(k) plans are routinely warned against placing all of their funds in their employers’ equity securities, pension plan fiduciaries are likewise warned against placing the bulk of their fund assets in single asset classes.
Diageo’s two million barrel pension contribution, though, was not even diversified across its own collection of spirit, wine, and beer brands. It was wholly concentrated on a single brand and product at a single stage of the manufacturing process, i.e. on Johnny Walker whiskey at a maturing (but not yet fully matured) stage.
So what might happen to Diageo’s pension plan if whiskey drinkers gravitate to the Jack Daniel’s brand and away from Johnny Walker? Or if Diageo itself decides to promote its Smirnoff vodka, Guinness beer, Captain Morgan rum, or Tanqueray gin drinks products more heavily than its Johnny Walker whiskey product? The pension plan’s inventory asset would undoubtedly decline in value, creating yet another gap between asset valuations and plan obligations.
Governance Risk, Too!
As if investment risk and diversification risk aren’t sufficiently worrisome concerns for fiduciaries, governance risk applies to Diageo’s situation as well. A fundamental principle of pension plan management, and of the federal government’s regulations, requires that plans be legally distinct entities, with governing boards that are focused on the interests of beneficiaries instead of the interests of employer sponsors.
Once Diageo’s pension plan fiduciaries agreed to accept plan contributions in the form of whiskey barrels instead of cash and cash equivalents, they essentially placed themselves in the drinks business instead of focusing solely on the retirement benefits business. Although their plan does remain a legally distinct entity, its convergence of business interests with those of its sponsoring firm opens the door to potential governance conflicts of interest as well.