Substantial recent financial media focus has been lavished on subprime mortgages, credit derivative bets on a decline in the residential housing market, flash crashes in the stock market, bank insolvencies, major corporate bankruptcies, and sovereign debt defaults. They have paid less attention and provided less insight into the perilous state of pension funds.
Both public and private pension funds face an emerging crisis. We need to examine some disturbing trends in both sectors.
New Jersey Pension Fund Crisis
In No Garden-Variety Pension Crisis, Andrew Briggs asks hard questions about the funding of New Jersey’s public pension plans. If the state used private sector pension accounting, the underfunding would rise from an already horrendous $46b to a mindboggling $170b. This deficit is more than five times the 2011 $29.4b state budget.
The real question is, when will the plan run out of money? Assuming the plan can earn 8%, which may be an aggressive assumption in the current environment, the plan would run out of money in 2019. However, NJ has increased its risk profile for the fund. The state has moved 60% of its pension assets into riskier alternative investments, such as hedge funds and private equity. Thus, there is a 25% chance the fund can run out of money as early as 2017.
The article concludes that NJ is not alone. Connecticut, Indiana, Illinois and other states are due to run out of money before the end of the decade. (See Bailout Nation Lives: Revisited, a Short Update).
Diageo
And while we are worried about risky funding strategies utilizing hedge funds and private equity, pension funding creativity reaches new heights with a plan by the Diageo Corporation. This beverage conglomerate intends to “fund” its plan with more than 2 million barrels of scotch whiskey.
Diageo said … it would transfer ownership of £430 million, or $645 million, worth of whiskey to a pension funding partnership. Diageo employees would not receive their pensions in whiskey rather than cash, but the move does give them a guarantee that they would not walk away empty-handed should the company default.
“A pension funding partnership will be formed, which will hold maturing whiskey spirit as assets,” ….
As part of the deal, Diageo agreed to pay the pension partnership £25 million a year as it sells the recently distilled whiskey once it matures after three years and replaces it with new stock. The agreement would expire after 15 years, at which point Diageo would buy back the whiskey, which comes from distilleries such [as] sic Oban on the west coast of Scotland. See Diageo Uses Scotch to Plug Gap in Pension Plan.
I personally love Diageo products. Talisker, Lagavulin, Oban and others are some of the finest whiskies in the world. See Tis’ the Season for Deflation and Update on Deflation. In my prior posts on Diageo, I pointed out that some of their premium products were in dramatic price decline. Now it becomes clear that weak pricing power and pension underfunding for Diageo are connected. If Diageo had pricing power, it would have sufficient profits to fund its pension plan with cash. In a deflationary world, should their pension plan beneficiaries hope to count on the future price of scotch whiskey in order to receive their benefits?
GM, A Cautionary Tale
We have seen innovate funding techniques before. In 1993, GM asked federal pension regulators to approve an innovative plan to meet a $24b pension deficit.
Under the plan announced today, GM would contribute shares of its class E common stock to the pension plan. The value of that stock is tied to the performance of a wholly owned subsidiary, Electronic Data Systems. Its closing price today on the New York Stock Exchange was $31; based on that price, the total value of the contribution would be $5.7 billion. See G.M.Acts to Secure Pension Using Stock.
Regulators acceded to the GM request. The rest is economic history: GM recently went bankrupt, and the plans remain massively underfunded.
Poverty Follows Financial Innovation
In its time of pension deficit, Diageo is not the only creative funder. The UK is rife with new schemes:
The British supermarket chain J Sainsbury said earlier this year it would transfer property into a pension vehicle, while Whitbread agreed to hand over a share in its portfolio of restaurants and hotels. The investment firm Man Group moved some hedge fund assets into a trust as a security for its British pension plan in March.
“We’re seeing a huge growth in the use of non-cash funding,” Marc Hommel, leader of the pensions practice at PricewaterhouseCoopers in London, said. “There are big pension deficits and sponsors are cash-strapped. These mechanisms provide security for the pension plans in exchange for less cash.” See Diageo Uses Scotch to Plug Gap in Pension Plan.
Mr. Hommel probably did not intend to be humorous, but one must ask whether these new methods of providing “security” make the funds more or less secure. I would submit that when one has to innovate and pull financial “rabbits out of the hat” both equity holders and pensioners of these companies face a lot more risk. And so do we, the taxpayers and funders of our enormous public pension funds and guarantors of private pensions through the Pension Benefit Guaranty Corporation.
In this current age of funding gimmicks, maybe we should refer to pensions as a social insecurity system.
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- Awash in Legacy Costs
- Tis’ the Season for Deflation
- What are the Unintended Consequences of Low Interest Rates?
- The Failure of Extrapolation
- Bailout Nation Lives
Tags: Diageo, GM, New Jersey state pension fund, pension funding, scotch
