18th August 2016 Defined benefit pension schemes: should they stop you buying a business?
By Rosalind Connor, Partner, ARC Pensions Law.
Recent months may have led people to believe that buying a company with a defined pension scheme is about the most dangerous thing you could do, particularly if you want to avoid insolvency, or being called in front of a Parliamentary select committee, and being on the front pages of the papers for a couple of months.
Of course, there are plenty of businesses with defined benefit pension schemes which are not BHS or Tata Steel. Many of these are hugely profitable, and able to deal very comfortably with their pensions obligations. However, the question remains in the minds of many: is it possible to acquire a business with a defined benefit pension scheme risking without your own business?
As ever, it depends on the business, what you are buying and the state of the pension scheme. However, the mere existence of a defined benefit pension scheme should not stop you purchasing a business. It is simply a question of understanding what you are buying, what the liabilities are, and what the future risks might be.
It is perfectly possible to buy a business, even if by way of share purchase, without taking the pension scheme, but if the pension scheme is coming your way, this is not necessarily a deal breaker. It is, however, important to put in the time to ensure a full understanding of the pension liabilities.
Defined benefit pension schemes are challenging because the liabilities are uncertain, right up to the moment when the last beneficiary dies. As a result, no employer knows exactly the cost of the pension scheme, and how much money they will need to put in. An actuarial analysis can give a good indication, but it will never be absolutely certain. That said, businesses are used to uncertainty – businesses may for instance have risks of litigation, of change in regulation, or of errors in production that might lead to product recall and other losses. As with other risks, some degree of quantification is needed and this is where the analysis should start.
The mistake made by many purchasers is to look at the accounts of the company to assess the pension liability. There will be a figure representing the surplus or deficit in the pension scheme in the balance sheet, but this is not the figure that most businesses will want to consider. In practice, the businesses want to consider the cost of running the scheme in terms of the cashflow requirements, and perhaps the cost of getting rid of the scheme altogether. Neither of these costs is represented by the accounting entry, and in fact will be much more costly than the number in the accounts. For example, it is not unusual for the accounts to show a surplus in the scheme, suggesting that it is over-funded, but this rarely translates to cashflow and contributions will still be needed to the scheme.
The reason these figures can seem misleading is the very different bases used for the actuarial analysis between the accounts (carried out on a best estimate basis) and the valuation of the scheme used for cashflow obligations (carried out on a prudent basis). The cashflow figure is found in the scheme’s own triennial valuation, which is carried out by the scheme’s trustees and then agreed with the employer, and includes an agreement about how the employer will make contributions to deal with the probable shortfall.
Looking at the valuation will give a clear idea of the business’ current obligations to make contributions, but it has to be borne in mind that this is reviewed at least every three years. At best, the valuation will explain the next three years of cashflow, until the next valuation. Because the valuation is agreed with the trustees, it is hard to predict the future in monetary terms. However, a wise purchaser ensures that they meet the trustees in advance of signing up to any deal, to ensure that they develop a relationship and have some confidence that the negotiations on the valuation will not be impossible in future years.
In addition to the cost, taking on the pension scheme means being aware of the potential restrictions it may impose on the business. The obligations to pay into the pension scheme are generally only with the legal entity that is the scheme employer, but the Pensions Regulator has the power to widen those obligations to other group companies, shareholders and directors, particularly in circumstances where those parties have taken part in an action (or failure to act) which has either intended, or had the effect, of reducing the chances of the pension scheme being paid in full in the long run.
These circumstances may seem quite limited but in fact the Regulator’s powers are quite wide. The Regulator does not need to wait until problems with the pension scheme or with the business arise as a result of the action in question – in fact, the six year time limit from the action encourages it to act early. In addition, a wide range of normal, best practice corporate activities can easily fall into this category, such as a refinancing, a dividend, reduction of capital, a group reorganisation or M&A activity.
This in itself can discourage many businesses from taking on a defined benefit pension scheme. However, many businesses deal entirely effectively with this situation, mostly by having a good understanding of the issues. Being aware of the powers, and ensuring appropriate information flow to trustees (who are generally happy to be bound by tight confidentiality obligations) can ensure that, in practice, this does not curtail normal business activity. Businesses that are well-versed in this issue simply ensure that they take early advice, and rarely, if ever, does it prevent their business plan progressing as expected.
Of course, for some purchasers, the idea of taking on a defined benefit pension scheme, with its undefined costs and restrictions on corporate behaviour, is a step too far. In which case, the most important financial assessment should be the cost of getting rid of the pension scheme altogether. This is in fact a relatively certain figure – simply, the cost of purchasing annuity policies to provide the benefits for all the members of the scheme. So long as the benefits for members are correctly set out (a point that often needs significant checking), an insurer can provide a quote and the figure can be relatively clear as, for instance, an adjustment to the purchase price.
The practical problem with this approach is that the figure tends to be very large. Because the insurer is taking on very long term risks, the cost of annuities, particularly for those a long time from retirement, can be very high. In any event, the cost of termination is generally thought to be much greater than a capitalisation of the future cost of paying for the pensions on an ongoing basis. Unless the scheme relates to a small part of the business, it is rare for termination to be an appropriate solution on an acquisition, because a purchase price adjustment would be so large as to be impractical or even impossible for most circumstances.
However, pension liabilities can be understood, as with any other obligation. Purchasers that are willing to invest in understanding what they are buying are able assess this liability and risk alongside all the other business risks of acquisition. Appropriate pricing and business planning can ensure that a defined benefit pension scheme is no bar to successful acquisition activity.
This article was also published in Finance Digest and can be viewed here.
The views in this article are intended for general information purposes only and should not be used as a substitute for professional advice. ARC Pensions Law and the author(s) are not responsible for any direct or indirect result arising from any reliance placed on content, including any loss, and exclude liability to the full extent. Always seek appropriate legal advice from a suitably qualified lawyer before taking, or avoiding taking, any action. If you have any questions on the points raised in the above, please do not hesitate to get in touch.