Pension Obligations within Corporate Transactions
By Andrew Vaughan & Gavin Markham
Posted: 26th September 2012 12:21Whether buying, selling or restructuring a business, pension schemes are likely to play a significant role within a corporate transaction. Failure to fully understand the complex pension issues could end up being very costly, result in time delays or even become a potential deal-breaker. Recent economic experience means that the vast majority of pension schemes are in a deficit position, adding to the financial impact of pensions in the overall context of the transaction.
Given their respective powers and responsibilities, key aspects of the process for the Company are how it approaches the Trustees of the pension schemes involved in the transaction, and also engagement of the Pensions Regulator where appropriate. Based on past experience, a proactive employer approach typically underpins the successful management of the pension issues.
Primary Financial Implications
Having a detailed picture of both the future service pension benefits and any past service commitments is a vital starting point for the Company in any transaction. The extent to which an entity may be taking on responsibility for funding a past service deficit will be an important factor in the transaction pricing. A thorough due diligence process around pensions is needed to avoid any pitfalls, including the more obvious financial ones of understating the past service liabilities or misunderstanding the future service benefit obligations. Under a sale or purchase, for practical reasons the due diligence may be structured as a two stage process; the first stage a preliminary assessment to help identify any potential deal blockers and the second stage a more detailed analysis for negotiation purposes.
In practice, there is a range of different valuation bases (i.e. actuarial assumptions) which can be used to determine the impact of any pension deficit and future service costs on a corporate transaction. The Company needs to understand the primary financial pension risks associated with future investment returns, interest rates, inflation and longevity. Analysis of the potential impact of these on future Company costs and cash flow profiles gives the Company a quantitative assessment of the potential risks and volatility it may be exposed to following the transaction. The valuation basis ultimately adopted by a purchaser is heavily influenced by the Company’s attitude towards these pension risks, the relative size of the pension scheme and the strength of the Company’s negotiating position within the transaction. In particular, in a genuine bid situation the purchaser may need to balance any views on pension pricing with the need to submit a competitive offer.
Where employers are being restructured or sold, a careful eye needs to be kept on any Section 75 implications. Triggered by the withdrawal of an employer from a scheme, a statutory Section 75 debt represents the departing employers share of the scheme deficit calculated using an insurance company type valuation basis – typically significantly more prudent than a scheme’s normal funding valuation. Depending on the particular history of the scheme, Section 75 debts can be extremely large relative to both the scheme’s ongoing funding position and the current size of the employer. The Section 75 issues may therefore need to be managed by seeking suitable agreement with the Trustees, however, this agreement is likely to depend on the Trustees’ degree of comfort with the overall agreed position.
Engagement With The Trustees
It is generally beneficial for the Company to engage the Trustees early on in the process, using confidentiality agreements as necessary. In line with the broader regulatory direction, Trustees are increasingly seeking independent advice on the impact of the transaction on the employer covenant - the ability and willingness of the Company to support the pension scheme. Readily engaging with the Trustees and anticipating their likely reaction to the changes, particularly where there is any material weakening of the employer covenant, will help the company position negotiations about any appropriate mitigation. Mitigation can be provided in a number of ways, for example, additional or accelerated funding for the pension scheme or the provision of some form of contingent asset. As part of any negotiations, the Company will want to ensure that the Trustees response to the transaction remains proportionate and in particular does not put the employer’s access to capital or their future cash flows at risk.
Possible Regulatory Intervention
The Company needs to be mindful of the powers of the Pensions Regulator, collectively known as the “moral hazard” provisions. These are intended to provide protection in the situation where the supporting employers provide insufficient security for the pension schemes or the transaction changes weaken the ability of the employer to meet its pension obligations. Depending on the specific circumstances of the transaction, the Pensions Regulator has the ability to impose a “Contribution Notice” - requiring cash contributions from related companies, or a “Financial Support Direction” - requiring the financial support of other employers in the group. The parties to the transaction may need to consider the relative merits of applying for Clearance from the Pensions Regulator, which if granted provides certainty that the “moral hazard” provisions will not be applied.
Broader Transaction Considerations
In the case of a purchase, the Company may consider whether the pension benefits being provided will remain appropriate following the transaction. A new benefit design may be desirable for cost or risk management purposes, or simply to harmonise the benefits with their existing pension arrangements. Effective handling of the employee relations issues will play an important role if any benefit changes are to be made, especially if there is strong union representation amongst the workforce.
Subject to the support of the Trustees, the Company will also need to decide whether it wishes to pursue any de-risking of the pension schemes. The nature of any de-risking activity will be influenced by the future intentions for the purchased business. There is a wide range of potential de-risking actions, which can be broadly categorised as being linked to investment strategy, settlement options (i.e. securing of benefits with an insurer) or liability management exercises. While the current market conditions may mean that a particular de-risking action is not deemed feasible, the Company may seek that the scheme implements suitable processes and triggers to take advantage of future favourable changes.
Given the pensions complexities associated with a corporate transaction, it is vital for companies to obtain expert advice early on in the transaction process to achieve the best outcomes for the Company.
Andrew Vaughan joined Barnett Waddingham LLP as a Partner in October 2011. He provides advice to corporate clients on a variety of issues including pension scheme funding, scheme design, M&A transactions, risk reduction exercises and accounting matters. Prior to joining Barnett Waddingham he was a Senior/Worldwide Partner at Mercer. He is currently Chairman of the Association of Consulting Actuaries and Chair of the International Association of Actuaries. He qualified as an actuary in 1989.
Andrew has over 28 years’ experience in the pensions industry throughout which he has been advising corporate and trustee clients on actuarial and related matters – typically FTSE 100 (or equivalent) organisations and major multinationals. At Mercer he also had responsibility for sales and business development for the UK actuarial business as part of their UK management team.
Andrew can be contacted by phone +44 020 7776 2200 on or alternatively via email at Andrew.Vaughan@Barnett-Waddingham.co.uk
Gavin Markham is an associate in Barnett Waddingham’s corporate consulting practice. He has over 15 years’ experience of advising multi-national companies on pensions issues including corporate transactions, both as a consultant and working within a FTSE 100 company.
Gavin can be contacted by phone +44 020 7776 2200 on or alternatively via email at Gavin.Markham@Barnett-Waddingham.co.uk
Barnett Waddingham LLP is the UK’s largest independent firm of actuaries, administrators and consultants. The firm works with Corporates, Trustees and Individuals in both the private and public sector, offering clear advice and a full range of professional advice including trustee consulting, employer pensions advice, pension management and administration, investment strategy, public sector pensions, risk benefits, life and general insurance consulting as well as the provision of SIPPs, SSASs and specialist executive pension plans’.
The firm has grown steadily since its inception in 1989. There are currently 55 partners and over 550 staff, based in 7 locations around the UK (Amersham, Bromsgrove, Cheltenham, Glasgow, Leeds, Liverpool and London). Barnett Waddingham is also the UK representative of NORACS (North American Actuarial Consulting Services) and EURACS (European Actuarial Consulting Services).