Defined benefit pension liabilities can play a big part in merger talks, says Sarah Coles
In December 2008, a potential merger between Qantas and British Airways collapsed, with BA’s £1.7 billion defined benefit (DB) pension liability cited as a major reason. This was perhaps unsurprising, given that BA’s pension liabilities were more than twice the market value of its business.
But a pension does not have to be that huge to affect merger plans. The key is for both parties to understand the liabilities, for the price to reflect them accurately, and to devise a strategy for the pension and its liabilities both pre- and post-merger.
The first step is to understand the liabilities. Philip Baker, senior consultant at Towers Watson, says: “The buyer is taking on responsibility for existing pension promises to current members, deferred members and pensioners. It needs to understand the cost of these promises.”
Scheme valuations tend to be carried out every three years, so a buyer may need to get an up-to-date actuarial valuation, which may inform the ratios of the merged group.
But a typical actuarial valuation under the rules of accounting standards FRS17/IAS19 is only one approach, and is likely to produce the lowest valuation of liabilities. Baker adds: “The buyer is also interested in the cash funding measure how much cash goes into the plan and how much it may have to put in in future. Or there is the buy-out measure, the cost of securing all the liabilities with an insurance company. This is often the largest number a buyer looks at.”
The valuation measure does not have to be agreed between the two parties. The buyer simply considers the figures during the valuation, and uses the different valuations in negotiations over price.
The price also needs to take into account any unpaid contributions and any regulatory concerns. The Pensions Regulator can intervene if it believes it is less likely that pension liabilities will be paid in full after the merger. It is common practice for buyers to seek approval from the regulator in advance to avoid potential problems. For the seller, this may mean the regulator insists on a payment into the scheme, which is usually deducted from the sale price. The regulator could also put the brakes on the merger.
There are various options for getting transaction-ready. Terry Simmons, partner and head of pensions at Ernst and Young, says: “Employers can close a DB scheme to new members and future accruals. This will remove uncertainty.”
A seller can also reduce the liabilities through an enhanced transfer value exercise or pension increase swaps. Baker says: “Benefits professionals can add a great deal by getting involved early in the transaction.”
After a merger, there is no requirement to replicate a DB pension scheme for staff transferred into the new organisation. The Transfer of Undertakings (Protection of Employment) regulations protect salaries and benefits, but do not insist on the continuation of a DB pension plan. Baker adds: “The strategy needs revisiting so it matches the new employer’s objectives.”
The role of the trustees is to protect members’ interests. The crucial issue is the employer covenant. Philip Baker, senior consultant at Towers Watson, says: “Trustees need to appreciate how strong the employer covenant is before the transaction and after.”
If the covenant is weakened, trustees may require steps to be taken, such as cash payments, letters of credit, fixed or floating charges, or improving trustees’ powers.
If they do not have sufficient financial understanding to assess the covenant, the regulator expects them to seek advice. The selling employer can help by ensuring all relevant information is supplied to trustees in a clear format. Baker says: “Employers will want dialogue with trustees to explain the rationale for the business.”
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