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Corporate investors facing greater pensions risk
Whether investing or divesting an investment, private equity managers must be vigilant in accurately measuring the pensions risk tied to the deal. Andrew Conquest, a partner in Grant Thornton’s Pension Advisory team, outlines the current pressures of the pensions landscape and how these can affect an investor’s obligations in a reorganisation or disposal.
The pensions landscape
The financial press is awash with headlines concerning the so called ‘pensions crisis’. The paper headlines are fuelled by slow growth reports from the UK FTSE 100 paired with a UK pensions deficit on the accounting measure being close to £100bn, marking the highest deficit ever recorded. But when a more robust approach is applied (using gilt yields, rather than corporate AA bond rates) this figure would be more than double.
The wide variance between these two estimates highlights why most operators of defined benefit schemes are considering measures to mitigate pensions risk, with an increasing number closing schemes altogether. This is why potential investors need to be rigorous in their due diligence investigations into companies with a defined benefit obligation. However, when seeking to avoid these liabilities in a restructuring or altogether on an acquisition, there is limited scope, unless the employer is insolvent.
Acquisitions
In a defined benefit scheme, the risk of scheme assets not generating expected returns is borne by the employer, which can be faced with demands for significant increases in contributions. This can put a massive strain on businesses particularly in times of recession when revenues are under pressure.
In considering an investment in a corporate with a defined benefit scheme, potential investors need to be aware of the financial status of the scheme, the investment risks facing the fund, and the four main measures whereby future pensions liabilities are extrapolated. The main distinction between these measures is the degree of prudence that is applied in predicting future investment returns and how these are reflected in the discount rates used to calculate the present value of future pensions liabilities.
The main methods are:
| IAS 19 /FRS 17 |
Liabilities discounted by reference to AA rated corporate bonds. |
| Scheme specific funding- the funding target for schemes under the Pensions Act 2004 |
Schemes set their own funding target according to the strength of the employer covenant. Liabilities are discounted at rates decided upon by trustees on the advice of the scheme actuary. |
| Section 179 |
Liabilities are discounted at prescribed rates to estimate the cost of securing benefits under the compensation scheme operated by the Pensions Protection Fund. |
| Section 75 (buy-out) |
The cost of purchasing annuities from an insurance company in order to secure the members' benefits. |
It can be expected that vendors will promote the IAS19 or FRS 17 valuation as being the most appropriate for valuing a business, but this will depend on good investment returns on plan assets being achieved typically over an extended period of time. The risk of those investment returns not being achieved lies with a purchaser. A significant over-valuation of a business could result unless more prudent discount rate assumptions are used in assessing future pensions benefits.
Opportunities on a restructuring
The Pensions Act 2004 introduced moral hazard provisions, whereby contribution notices can be issued against persons who are connected to the employer (which can include individual directors and shareholders), if there is an act or a failure to act which prevents the recovery of the Section 75 debt (the buy-out debt).
It is often the case that structural re-organisations and re-financing initiatives are implemented following the completion of acquisitions, particularly those involving complex groups of companies and multi-employer schemes. The Pensions Regulator has recently issued a code of practice clarifying the circumstances in which a contribution notice can be issued. These include situations whereby sponsor support is removed or weakened, which might arise for instance if assets are transferred from a group company with an obligation to a scheme to one that does not, or if the group's assets are leveraged to generate finance for the acquisition.
 Even the seemingly straight forward issue of transferring employees from one company to another can cause difficulties. If an employment cessation event occurs - for instance if a company which participates in the scheme is left without employees - its share of the overall buy-out deficit could be triggered for payment resulting in a strain on the group's resources.
A voluntary clearance process is available to shareholders, directors and other connected parties if it is recognised that a corporate transaction could be financially detrimental to a scheme. The Pensions Regulator can issue a clearance statement confirming that conribution notices wtill not be issued against the applicants. However, clearance will generally only be granted if mitigation is offered to compensate the scheme for the financial detriment it will suffer as a consequence of the transaction.
Disposals
The statutory regime governing contribution notices and clearance also applies to divestments. However, Contribution Notices and Financial Support Directions - an alternative remedy available to The Pensions Regulator - can be issued post divestment. Whereas a Contribution Notice can be issued against an individual, a Financial Support Direction can generally only be issued against a company. We have acted for trustees who have successfully argued that a scheme should be compensated for the payment of exceptional dividends several years beforehand.
Since the inception of the Pension Protection Fund (PPF), many owners of businesses have argued that their operations would be viable, if they could avoid legacy pension obligations and the attendant levies and expenses for defined benefit schemes. A range of reconstruction plans have been devised in order to demonstrate that it is in the best interests of all stakeholders if the PPF were to assume responsibility for the members' benefits emphasising that a reconstruction will help to secure the jobs of the employees.
Only a few of these reconstruction schemes have been entertained by the PPF, which can operate only within statutory constraints.
Such plans are only approved if they meet strict criteria set down by the PPF:
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The insolvency of the employer is inevitable.
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The reconstruction provides for a demonstrably better outcome for the scheme than is likely to be achieved if the employer fails.
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The scheme is being treated equitably with other creditors.
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Equity in the new operator of the business is provided to the PPF (between 10% and 33% depending on the circumstances).
Options to avoid deferred pensions obligations limited
The depth and strength of the anti-avoidance legislation is now so great that the options to avoid the deferred pensions obligation of a target are very limited. This will undoubtedly act as a disincentive to investment and result in a greater number of insolvencies of companies, which can no longer support their legacy schemes.
| Andrew
is a partner, Pensions Advisory, at Grant Thornton and has specialised
in treating ailing businesses since 1974. He was responsible for
leading the firm's Recovery & Reorganisation practice in East
Anglia for over 20 years before moving to London in 2000 to head up the
London asset recovery and tracing team whilst playing a supporting role
in Cambridge. His current role involves UK and international
assignments in varying jurisdictions including the US, Ireland,
Argentina, Romania and Scandinavia. Andrew leads our Exit Strategy
product in London. He is also head of Recovery's haulage and
distribution specialism and is responsible for liaison with our general
practice team in the South East and Grant Thornton Dublin. |
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