Region of myths and misinformation
Many of us had hoped that the emergence in Europe of common accounting standards for pensions (IAS19 or FRS17 in the UK) would have made pension transaction work easier for both buyers and sellers. In some respects it has, establishing a common frame of reference to measure deficits (surplus seems to be a word no longer in common English usage) and at least making the starting point for negotiations easier. However problems remain, and in many transactions pensions are still a key issue. Of course, from a seller’s perspective there are never any real problems, as demonstrated by the phrases we often hear them say….
“The pension scheme is fully funded”
So what can this mean in practice? At one extreme, it can mean the opposite of what you might expect. In one German private equity transaction these words were used to describe a large book reserve scheme (a book reserve scheme is an unfunded arrangement where the liability is recognised on the accounts but is not funded by assets). This was not a mistake; the seller genuinely believed the existence of a book reserve in the accounts meant the benefits were “funded”. The seller took a while to convince that a book reserve represented a liability, not an asset. Needless to say, the seller’s price expectations for the business were not met.
Similar problems can arise in relation to unfunded arrangements in many European countries. Outside Germany these most frequently arise in relation to executive or management benefits which may be promised but not funded. Also in Italy and France for instance, end-of-career payment provisions are held on the balance sheet (or should be – governance and reporting are not always perfect, see below).
But the problems over interpretation of the phrase “the pension scheme is fully funded” are not restricted to unfunded schemes. In the Netherlands, for instance, 100% funded might look superficially reasonable, but there is a legal requirement to fund up to 105% and, over time, to increase this to around 130% to meet local standards. So in the Netherlands a plan can be 100% funded and require substantially more cash at the same time!
In the UK there are now so many funding standards that even a skilled actuary could risk losing count… and there are more to come. There is the old minimum funding requirement (MFR), now discredited but still in use. The fact that a scheme is 100% funded on this basis is only really of academic interest. The trustees’ chosen funding basis in any particular case is more useful, since it explains where current contribution rates come from. However, there is a great deal of flexibility over the assumptions used and 100% funded on this basis does not have great value in transactions since the Pensions Regulator (and the trustees) may well ask for more money as a condition of regulatory clearance.
The regulator has indicated that most transactions will be approved if a scheme is 100% funded on an accounting basis (under FRS 17). But followers of the Ericsson/Marconi deal, where an additional payment into escrow of £500m was required, will know that even this is not always sufficient to meet the regulator’s or the trustees’ needs.
New funding rules to replace the MFR have yet to be issued in the UK at the time of writing, but when they arrive they are likely to remain flexible. In the meantime, the regulator has already indicated that, among other things, it will look at FRS 17 funding, coverage for the Pension Protection Fund (PPF) liabilities and annuity buy-out funding when consider the adequacy of scheme funding.
So while the phrase “the scheme is fully funded” might mean the opposite of what you might expect in Germany, it is just as difficult to translate into something with clear meaning in the Netherlands or the UK!
“We don’t have any pensions”
Of course there are cases where the seller is correct in making this statement. In my experience, particularly of complex multinational deals, these are a minority as there are usually some underlying liabilities. In these cases, poor internal reporting and low levels of knowledge and governance by the seller can be addressed by buyers with high-quality due diligence or sound warranties and indemnities (preferably both).
Rather than looking purely at pensions, buyers should consider other long-term liabilities which need to be assessed actuarially and accounted for appropriately. These include:
q Early retirement plans or bridging pensions (for instance in the Netherlands, Belgium and Germany);
q Phased early retirement plans where the employee continues to work part time (in Germany);
q Leaving service and retirement payments (in France and Italy);
q Post retirement medical and life cover (in several countries);
q Disability benefits ;
q Career milestone payments (such as jubilee payments in Germany).
It is amazing how often these payments are overlooked, often because of flexible local reporting standards and poor head office governance or accounting processes. And they can be material; in one recent corporate deal non-pensions issues such as termination indemnities in various countries accounted for nearly 10% of the purchase price. In another medium-sized transaction, the actuarial value of disability benefits in Finland, unreported at parent company level, amounted to €10m and impacted significantly on the purchase price
“Our pensions are all defined contribution”
Defined benefit (DB) pensions are the problem. This is because the company is promising a benefit and the company takes the risks involved in providing it. In contrast, defined contribution (DC) pensions are easy. The employee takes the risks, so there is no need for the buyer to beware. Right? Not always.
In Switzerland, many companies provide what are known locally as DC plans. And they have all the appearance of DC plans: contributions are paid in, they are credited with investment returns and eventually used to buy an annuity. The only problem is that , firstly, there is a guaranteed rate of investment return and, secondly, the annuity rate at retirement is guaranteed. Sometimes these benefits are fully insured. However, in many cases they are provided by a company scheme, or a foundation. This means the company is taking some of the investment and mortality risks, and these schemes need to be treated as DB plans by acquirers, and accounted for as such. In a recent transaction a multi-million Swiss Franc purchase price adjustment was required despite there only being a DC plan.
Another key DC risk throughout Europe which is often overlooked relates to the contribution structure. Frequently DC plans have contribution scales which increase with age or service, or where the employer matches voluntary employee contributions. In each of these cases, costs may well increase as the workforce ages. Projections are required to make sure financial models are sound.
“The seller will keep the liabilities so there are no risks”
Often, this is a reasonable solution. However there can still be risks. For instance, under TUPE regulations in the UK, early retirement rights may well transfer as a matter of law, whatever the buyer or seller agree among themselves. The costs can be substantial, particularly if redundancies are envisaged.
There may also be ‘exit charges’. Again the UK is a good example. A debt against a withdrawing employer as a result of a company sale, calculated on an insurance buy-out basis, can be a substantial charge for which indemnification or alternative strategies are normally required.
Industrial relations can also be a barrier. If employees are to lose out as a result of leaving benefits behind (for instance because the pay link is broken) a buyer might find it has to provide some form of unforeseen compensation in pension or other forms. At best it might inherit a disgruntled workforce.
“Pensions have correctly been accounted for under FRS/IAS”
This is always a good starting point, but a buyer would be naïve to accept the figures without question. This is of course a key problem with public bids, where a potential buyer might have nothing more than the published accounts to work from. Among the many problems can be:
q Historic v acquisition accounting. Under IAS 19, deficits are not always recognised fully on the balance sheet but may be spread via the profit and loss account. At the point of acquisition, the deficit (which of course is there however it is accounted for) hits the balance sheet in full;
q Industry-wide schemes. In the Netherlands and Sweden, for instance, companies can contribute collectively to a centralised DB plan. Figures for individual companies are not available and, for this reason, the accounting standard allows plans to be treated as if they were DC for accounting purposes. A buyer will, of course, be taking on a DB liability but will face a complete lack of transparency over the liabilities and future costs. In many cases a deficit which would have shown up on a balance sheet for an individual scheme will be ‘invisible’ if the business participates in an industry-wide plan;
q Although the accounting standards are more prescriptive than, for instance, UK funding standards, there is still a great deal of latitude to choose assumptions. And while, with advice, a buyer can assess the quality of the disclosed assumptions (such as the discount rate used), there remains uncertainty over what is not reported. For instance, mortality assumptions need not be disclosed but in the UK the choice of mortality table used can make 15% difference to the liabilities (and a great deal more difference to the deficit). The degree of allowance for discretionary benefits, such as enhanced early retirement benefits in the UK or pension increases in the Netherlands, can make similar substantial differences. And in a slightly more esoteric case recently, the usual allowance for pay to increase with age and promotion was reversed ie the scheme allowed for pay to be reduced with age, so the disclosed liability was much lower.
The new accounting standards help rather than hinder the transaction process. However they are only a starting point, and there are many opportunities for buyers to slip up. Sellers have recognised the difficulties caused in transactions by inconsistent or incomplete pensions information, and an accelerating trend over the past few years has been to commission “vendor due diligence” whereby pension issues are fully researched and reviewed by the seller for presentation to potential buyers, avoiding many of the problems highlighted above.
Pensions have undeniably forced their way to the top of the agenda in corporate transactions, and both buyers and sellers must adapt to the new M&A landscape accordingly. Going into a deal armed with the requisite knowledge and understanding of pension liabilities will aid negotiations and pave the way for a smoother transaction.
Principal Stuart Benson is an actuary and M&A specialist within Mercer Human Resource Consulting’s international retirement business.