Recent economic experience means that the majority of UK defined benefit pension schemes are underfunded, adding to the financial impact of pensions in the overall context of the transaction.

Most deals will be structured as a transfer of ownership of the shares of a company, or the transfer of the business of one company to another, or a combination of both. It is possible for a seller to pre-organise its pension liabilities to make a sale more attractive if a disposal is likely to occur in the future.

Early input from pension experts is vital for all parties to a transaction where pensions are an issue.

What pension liabilities does the target have? Due Diligence
There may on the face of it just be defined contribution liabilities, where the only employer duty is to pay contributions into an arrangement for the members. But watch out for legacy or grandfathered liabilities. Some defined contribution schemes contain guarantees which could turn out to be defined benefit and require funding if in deficit.

If there are defined benefit schemes, does the target participate in a group arrangement for a number of employers or will the transaction mean that the entire pension scheme or group schemes come across as part of a transfer of ownership of the target?

Is there a transfer under the Acquired Rights Directive and if so what are the pension responsibilities for the transferring employees? As a general rule, occupational pension scheme entitlements and other rights under the UK’s “Transfer of Undertaking” regulations (“TUPE”) do not transfer under TUPE where they relate to “old age”, “invalidity” or “survivors” benefits.

In the Beckmann case an employee made redundant by the buyer was entitled to an early retirement pension and other benefits. The ECJ held these redundancy payments could not be classified as “old age” benefits and they did pass to the new employer. The Martin case was similar except it related to special early retirement rights.

The recent case of Proctor provided some clarification in that the UK High Court decided that discretionary early retirement rights did pass to the buyer but only to the extent that the rights transferred were those that would be lost by the transfer, namely any enhanced rights over and above the basic pension payable from normal retirement age. The rest of the liability stayed with the seller. However there remain a number of uncertainties with this approach and valuing such liabilities for the purposes of pricing a deal is key.

In the UK employers now have to contribute to a pension for employees, previously this was voluntary. Companies where historically there has been little or no pension take up by employees may incur high extra costs as a result of mandatory employer contributions being introduced and this should be factored into the financial projections.

Proposed treatment in the transaction

a) Defined benefit schemes are acquired
If a defined benefit scheme is to be acquired as part of a deal then a buyer needs to understand the financial risks associated with the scheme such as future investment returns, interest rates, inflation and longevity to enable it to form a knowledgeable assessment of the potential risks and volatility it may be exposed to following the transaction.

The valuation basis ultimately adopted by a buyer will be based on its attitude towards these pension risks, the relative size of the pension scheme and the strength of the buyer’s negotiating position within the transaction. The buyer will need to consider the impact on future cash flows and the effect of the deal on the strength of the employer covenant. If the covenant is weakened by the transaction, then it is likely the pension scheme trustees will seek some form of mitigation to compensate for the weaker covenant such as a parent company guarantee, contingent asset or accelerated contributions. It is usual for the deal price to be adjusted to take account of any deficit in the scheme’s funding.

b) Target participates in a group defined benefit scheme
Where employers in a group scheme are being restructured or sold, there are likely to be “debt on the employer” implications. Triggered by the withdrawal of an employer from a scheme, a statutory debt under section 75 of the Pensions Act 1995 represents the departing employer’s share of the scheme deficit calculated as if the liabilities were being bought out by an insurance company (which is likely to exceed the on-going funding basis by a large margin).

This debt will have to be dealt with as part of the transaction and there are various methods of dealing with this so the buyer takes the employer “clean” of any such debt. e.g. the debt can be reallocated to another employer owned by the seller or arrangements can be made to put in place guarantees or the liabilities themselves can be apportioned to other employers. This is likely to need the consent of the pension scheme trustees and they should be included in the negotiations as early as possible.

Case Study
As part of a global acquisition, Group A looks to acquire the shares of a company in the UK which participates in a group pension scheme. Once acquired by Group A, the company, B will no longer be able to stay in the seller’s group pension scheme and a debt on the employer would then arise payable by B (but then in A’s ownership) The debt is assessed at £30mn. Company B is the only company participating in its section of the group scheme. A deal is struck whereby the pension scheme trustees admit a new company C owned by the seller into B’s section; the liabilities of B are transferred via an apportionment arrangement to C, thereby releasing B from any liability in respect of the £30mn. B then formally leaves the section, leaving C (still owned by the seller) with the pension liabilities going forward but with no debt triggered. The pension scheme trustees receive a special contribution of £2mn to facilitate the transaction, payable by the seller. B is then clean of any pension liability and can be sold to Group A. For overall protection, Group A secures a full indemnity from the seller in respect of any liabilities with respect to the pension arrangements formerly offered by B.

Role of the pension scheme trustees
It is generally helpful for the buyer and the seller to engage the trustees early on in the process, using confidentiality agreements where appropriate. Trustees are increasingly seeking independent advice on the impact of the transaction on the “employer covenant” - the ability and willingness of the employer to support the pension scheme. Liaising with the trustees will help the buyer in its negotiations about any appropriate mitigation to compensate for any weakening in the employer covenant. Mitigation can be provided in a number of ways, for example, extra funding for the pension scheme or the provision of some form of contingent asset or guarantee in favour of the trustees.

Role of the Pension Regulator
The Pensions Regulator has statutory powers in relation to pension schemes known as the “moral hazard” provisions. These are intended to be used in circumstances where the relevant employers are deemed unable to provide adequate security for the pension schemes or the effect of the transaction weakens the ability of the employer to meet its pension obligations. The Pensions Regulator can impose a “Financial Support Direction” - requiring financial support from related companies, or a “Contribution Notice” - requiring cash contributions from related companies. Parties to a deal can seek prior clearance from the Pensions Regulator that it will not exercise its powers to make any orders as a result of the transaction going ahead which will give the buyer comfort.

Seeking clearance can take time so an early decision to refer a transaction to the Pensions Regulator will be beneficial. It should be noted that the Pensions Regulator has power to “unpick” completed transactions.

Post transaction considerations
A buyer may conduct a review post transaction to decide whether the pension benefits being provided are appropriate. New provisions may be more suitable from a cost or risk perspective or to harmonize the benefits with the buyer’s existing pension arrangements. Statutory consultation with affected members is required for some changes (e.g. closing the scheme to future accrual of pension) and it is not possible to adversely affect the accrued rights of members to their pensions up to the date of any change. Industrial relations will need to be approached carefully, particularly if there are recognized Unions.

Winding up a scheme entirely will trigger a right for the pension scheme trustees to demand an amount equal to the combined employer debt into the scheme to enable the trustees to buy out all the liabilities with an insurer, which can be very costly.

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*) Anne Taylor is Director Corporate, Banking and Pensions, Pensions at DWF LLP.