Some problems can be solved by tossing large amounts of liquid at them. Throwing water at a fire, for example. Noah’s flood, perhaps. And now, if all goes well, Diageo’s pension deficit will be added to the list.
Diageo, the London-based alcoholic beverage giant, has adopted an innovative strategy that is becoming increasingly popular in the United Kingdom: funding pension obligations with non-cash assets. The company has announced that it will reduce its pension plan’s deficit by contributing £430 million ($645 million) worth of immature whisky. That’s enough to fill about 180 Olympic swimming pools.
Though this technique is still rare, it is already garnering international attention. Companies worldwide are looking for ways to reduce pension deficits for their defined benefit plans. Using assets like real estate, or whisky, allows them to satisfy contribution obligations at a time when cash flow is tight. At least that’s the theory.
Diageo plans to buy back the whisky from the pension fund once it reaches its three-year maturity mark, replacing it with new immature spirits. The maturing whisky is expected to generate annual income of £25 million for the pension fund. The arrangement will continue for 15 years, at which time the company will buy back all of the remaining booze. The pension plan will keep the profits from the 15-year venture and the company will regain its whisky.
But what happens if something goes wrong and Diageo is unable to convert its literally liquid assets to figuratively liquid ones? Will retirees receive part of their monthly pensions in Johnny Walker Blue? If so, would they mind?
It’s easy to see how this creative solution could eventually snowball. Museums could promise their employees a one-month loan of a Picasso. Cattle companies might offer retirees a third of a cow with their monthly check. J Sainsbury PLC, a leading U.K. grocery chain, put up its own property as a pledge. One day, some lucky employee could own aisle four and its attendant clean-ups.
Joking aside, these arrangements raise some serious concerns. For one thing, who determines how much the contributed asset is worth (and therefore how much of the company’s pension obligation is satisfied by the contribution)? If the company provides the value for its own contributed asset, there is a conflict of interest, because the employer has a financial incentive to claim a high value that could shortchange the pension fund.
Even if the company hires an independent fiduciary to conduct the valuation, the ultimate power may still lie with the company, given the uneven power dynamic involved in such a transaction. The plan trustee (often a company employee) is required to act in the best interest of its pensioners, but it is difficult to remain impartial in such a situation.
American companies should also be wary of potential violations of the Employee Retirement Income Security Act (ERISA). In-kind contributions (as non-cash asset contributions are often called) can be handled legally, but they require caution and close attention. Depending on the type of asset involved and the exact details of the proposed contribution, a company may need to seek a waiver of prohibited transaction rules from the U.S. Department of Labor. Most importantly, ERISA requires that in-kind contributions be adequately diversified. An exemption exists for the transfer of “qualifying employer real property,” but ERISA stipulates that the property must consist of several parcels that are “dispersed geographically” and that each have more than one possible use.
Immature whisky doesn’t present much opportunity for diversification. Between the limited ability to diversify and the potential for self-dealing, a move like Diageo’s could be difficult, if not impossible, for a U.S. company attempting a similar strategy.
Pensioners should also be skeptical of non-cash contributions if they substantially increase the pension plan’s exposure to risk. In 2003, the Department of Labor allowed Northwest Airlines to contribute stock in its Pinnacle Airlines subsidiary to meet pension obligations. This was unusual as Pinnacle shares were not publicly traded, and because both Northwest and Pinnacle were part of an airline industry that faced major difficulties following the 9/11 terrorist attacks. The contribution directly increased the pension fund’s exposure to the airline industry’s risks.
Cash-strapped companies are looking for creative ways to keep their businesses afloat while keeping their promises to current and former employees. But unless those companies truly have sufficient resources, something will have to give. We can applaud such creative thinking, but non-cash contributions come with risks and complications, some obvious and some less so.
Here’s to the hope that Diageo employees don’t wake up with a nasty financial hangover if their pension plan’s whisky investment goes sour.
Posted by Jonathan M. Bergman, CFP®, EA
Some problems can be solved by tossing large amounts of liquid at them. Throwing water at a fire, for example. Noah’s flood, perhaps. And now, if all goes well, Diageo’s pension deficit will be added to the list.
Diageo, the London-based alcoholic beverage giant, has adopted an innovative strategy that is becoming increasingly popular in the United Kingdom: funding pension obligations with non-cash assets. The company has announced that it will reduce its pension plan’s deficit by contributing £430 million ($645 million) worth of immature whisky. That’s enough to fill about 180 Olympic swimming pools.
Though this technique is still rare, it is already garnering international attention. Companies worldwide are looking for ways to reduce pension deficits for their defined benefit plans. Using assets like real estate, or whisky, allows them to satisfy contribution obligations at a time when cash flow is tight. At least that’s the theory.
Diageo plans to buy back the whisky from the pension fund once it reaches its three-year maturity mark, replacing it with new immature spirits. The maturing whisky is expected to generate annual income of £25 million for the pension fund. The arrangement will continue for 15 years, at which time the company will buy back all of the remaining booze. The pension plan will keep the profits from the 15-year venture and the company will regain its whisky.
But what happens if something goes wrong and Diageo is unable to convert its literally liquid assets to figuratively liquid ones? Will retirees receive part of their monthly pensions in Johnny Walker Blue? If so, would they mind?
It’s easy to see how this creative solution could eventually snowball. Museums could promise their employees a one-month loan of a Picasso. Cattle companies might offer retirees a third of a cow with their monthly check. J Sainsbury PLC, a leading U.K. grocery chain, put up its own property as a pledge. One day, some lucky employee could own aisle four and its attendant clean-ups.
Joking aside, these arrangements raise some serious concerns. For one thing, who determines how much the contributed asset is worth (and therefore how much of the company’s pension obligation is satisfied by the contribution)? If the company provides the value for its own contributed asset, there is a conflict of interest, because the employer has a financial incentive to claim a high value that could shortchange the pension fund.
Even if the company hires an independent fiduciary to conduct the valuation, the ultimate power may still lie with the company, given the uneven power dynamic involved in such a transaction. The plan trustee (often a company employee) is required to act in the best interest of its pensioners, but it is difficult to remain impartial in such a situation.
American companies should also be wary of potential violations of the Employee Retirement Income Security Act (ERISA). In-kind contributions (as non-cash asset contributions are often called) can be handled legally, but they require caution and close attention. Depending on the type of asset involved and the exact details of the proposed contribution, a company may need to seek a waiver of prohibited transaction rules from the U.S. Department of Labor. Most importantly, ERISA requires that in-kind contributions be adequately diversified. An exemption exists for the transfer of “qualifying employer real property,” but ERISA stipulates that the property must consist of several parcels that are “dispersed geographically” and that each have more than one possible use.
Immature whisky doesn’t present much opportunity for diversification. Between the limited ability to diversify and the potential for self-dealing, a move like Diageo’s could be difficult, if not impossible, for a U.S. company attempting a similar strategy.
Pensioners should also be skeptical of non-cash contributions if they substantially increase the pension plan’s exposure to risk. In 2003, the Department of Labor allowed Northwest Airlines to contribute stock in its Pinnacle Airlines subsidiary to meet pension obligations. This was unusual as Pinnacle shares were not publicly traded, and because both Northwest and Pinnacle were part of an airline industry that faced major difficulties following the 9/11 terrorist attacks. The contribution directly increased the pension fund’s exposure to the airline industry’s risks.
Cash-strapped companies are looking for creative ways to keep their businesses afloat while keeping their promises to current and former employees. But unless those companies truly have sufficient resources, something will have to give. We can applaud such creative thinking, but non-cash contributions come with risks and complications, some obvious and some less so.
Here’s to the hope that Diageo employees don’t wake up with a nasty financial hangover if their pension plan’s whisky investment goes sour.
Related posts: