Diageo uses Scotch to plug pension deficit

Most people would rather not think about their pension. There are more immediate financial problems and retirement is on the far horizon.

But pensions are a thorny topic; the public sector’s pension liabilities are one of the causes of the present financial malaise and most companies cannot afford to be as generous as they used to be.

Even Diageo faces an £862 million deficit in its pension fund, but it has come up with a novel way of plugging it.

Diageo is one of the dwindling number of companies still offering its employees a guaranteed annual sum for life in retirement based on service and earnings.

Most have switched to a less generous fixed annual contribution to a personal pension pot that must be used to buy an annuity on retirement. The change has been brought about largely by accountancy rules that require companies to fund deficits rather than plug any gap out of continuing cash flow. That can put enormous pressure on balance sheets, especially if the value of existing pension fund investments has been eroded by the financial crisis of the past couple of years.

A valuation of its liabilities last year required Diageo to come up with a 10-year plan to fund its deficit; the £50m a year it had been paying was insufficient. Now the £862m hole is inconvenient, but not a problem.

For instance, it is less than a year’s free cash flow. But equally, Diageo would rather use as much of its profits as possible to invest in the business and to benefit shareholders. So the company is plugging the deficit by using the increasing value of maturing Scotch.

It is forming a 15-year partnership with the pension fund and has paid £197m into the fund. Now “new made spirit”, which is under three years old and thus not yet saleable, is being pledged as collateral to the partnership.

In total it is worth £500m. Diageo has the option to purchase maturing spirit when it is three years old and replace it with newly distilled Scotch to keep the value constant.  

In addition, the company will pay £25m a year into the pension fund, which, with the £25m estimated increase in the value of the spirit, will replace the £50m annual payment it has been making to date.

All well and good while demand for Scotch is growing, but what happens if the market nose-dives, as it did for, say, Cognac in the 1990s? Will the pension fund trustees be left with an ocean of spirit on their hands and insufficient funds to pay pensioners? No. For a start, such a massive downturn is extremely unlikely but to cover the improbable eventuality Diageo is putting £338m into escrow (held by a third party). That will be used if the deficit is not reduced as expected over the next 10 years.

And if the scheme works well and the deficit is reduced as planned, the pension fund trustees can sell their share of the partnership back to Diageo for up to a maximum of £450m at the end of the deal.  

It’s a winner for both sides. Employees can look forward to a guaranteed pension and shareholders to the company’s continuing prosperity. How come? Because the partnership will be consolidated into Diageo’s accounts. Clever.

Finance on Friday, 9.07.10