S&P’s Warning: America at Risk!

Just for a moment … let’s travel back in time to the year 1860.

The northern and western states of the United States of America have elected Abraham Lincoln to the Presidency. The southern states, determined to protect the economic institution of human slavery, vow to raise an army and attack the federal forces as soon as Lincoln is sworn in, thereby splitting America in two and plunging it into the bloodiest conflict imaginable.

Was Lincoln’s election the most significant event in the United States in 1860? If you were living through that year, you would undoubtedly believe so. But historians who believe in the butterfly effect often note that seemingly obscure people and their ostensibly trivial activities can eventually change the world.

Consider Henry Poor, for instance. Few noticed when he, as the brother of railroad magnate John Poor, became the editor of the American Railroad Journal in 1849. And even fewer purchased his first book, an industry text entitled History of Railroads and Canals in the United States, when it was published in 1860.

Indeed, unless you were a railroad or canal historian, you were probably far more interested in the progress of the Union Army than in the path of Poor’s career. Nevertheless, Poor’s book was sufficiently successful to refocus him on a career in investment data analysis, leading him to launch the company now known as Standard & Poor’s, today’s leader in the investment ratings business.

The AAA Rating: No Risk!

How important is the investment ratings system of Standard & Poor’s, as well as the similar systems of its competitors Moody’s and Fitch? One may argue that the entire American economy, and perhaps the global economy as well, rely on the public’s trust in these systems.

For instance, investors who wish to lend money to non-financial corporations that are considered “no risk” would rely on S&P’s recommendation to buy the bonds of ADP, Johnson & Johnson, Microsoft, and ExxonMobil. Why these particular firms? Because S&P asserts that these are the only four American corporations that have maintained their cherished AAA investment ratings since the market crash of 2008.

For investors who wish to purchase the bonds of sovereign countries, S&P publishes ratings that assess the financial health of national governments. The strongest AAA rated country of them all has always been the United States, by far the world’s largest economy and the issuer of the dollar, the world’s sole reserve currency. Last week, however, S&P unexpectedly alerted the world that it was seriously considering an unprecedented downgrade of America’s sterling AAA credit rating.

Structured By Cows

On April 18, S&P placed the United States on a “negative outlook,” the mildest form of alert that an organization — in this case, the federal government of the world’s most powerful nation — is facing fiscal pressures and might default on its debt obligations. Indeed, S&P was reacting to the possibility that President Obama and the United States Congress might fail to reach an agreement on reducing the federal budget deficit.

To be sure, a “negative outlook” is far from a “credit watch,” which is an announcement that a downgrade of a credit rating may be imminent. Nevertheless, the markets were stunned at S&P’s announcement last week, and investment indices plunged accordingly. Some pundits interpreted the dramatic event as a clear warning of the danger of American fiscal irresponsibility.

Others, though, have noted that S&P itself has made some highly questionable ratings decisions lately. The firm, after all, notoriously granted AAA ratings to numerous mortgage backed securities that later proved worthless. And a set of instant messages between S&P analysts that became public during a 2008 Congressional hearing embarrassed the firm; in one exchange of messages about an investment undergoing a review, an analyst protested “we should not be rating it” while another sardonically responded “we rate every deal … it could be structured by cows and we would rate it.”

Whom To Trust?

So whom, and what, should investors trust? The warning of an investment ratings firm that has been assessing the fiscal health of industries, firms, and nations since 1860? Or the historical strength of the world’s greatest economic power, a nation that has never defaulted on its obligations and that would most likely trigger a global financial panic if it would ever decide to do so?

It is indeed difficult to imagine America defaulting on its debts. Nevertheless, back in 1980, when Ronald Reagan won the presidency on a campaign platform that excoriated the growth of a national debt that had reached $900 billion, it would have been difficult to imagine that number exceeding $13.5 trillion in the year 2010.

Henry Poor himself, having lived through the era of the American Civil War, may not have been surprised that his namesake firm would question the creditworthiness of the government of the United States. For the contemporary investment community, though, last week’s negative outlook was truly an astonishing event.

Pension Plan Running Dry? Feed It a Glass of Scotch!

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?

Scotland’s Finest

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.