Welcome to the first part of our series looking at the key pension issues corporate lawyers need to be aware of when advising clients.
Issue 1 – Dealing with Underfunded Pension Schemes in a Corporate Transaction
Our first critical issue to watch out for is an underfunded final salary pension scheme liability as part of any corporate transaction. That is where the pension scheme assets are inadequate to meet its liabilities.
Where you are acting on behalf of the purchaser you will want to ensure that they do not inherit a seller’s or a seller’s subsidiary company’s pension liability which is not factored into the purchase price. Where you are acting on behalf of the seller you will want to avoid any such debt eroding the value obtained from the sale. If unfunded liabilities are not detected and addressed during the sale process, it could also lead to an unpleasant surprise for both you and your insurers.
Let’s take an example of the sale of a subsidiary (“the target company”) from a group of companies, which is a participating employer in a multi-employer final salary scheme, and assess what to look out for.
Why Is This an Issue?
There are several ways in which the liability of a pension scheme can be calculated. Sections 75 and 75A of the Pensions Act 1995 (as amended) provides that in certain circumstances (such as a company leaving a multi-employer scheme) debt on the participating employer is triggered in the most expensive way – known as “the annuity buy out basis”. It provides that the debt is calculated in the final salary scheme by assuming that insurance company annuities are purchased for all scheme beneficiaries, and then the total assets of the scheme are deducted from the annuity cost.
In some cases, the debt will be very substantial in comparison to the company’s overall transactional value. For example, British Airways is sometimes referred to as a pension scheme with an airline attached because of the size of the pension scheme deficit compared to its profit and loss account.
This issue is a particular risk because neither side wants to take on the additional liability and the exact amount of debt is unlikely to be known at completion as it is only triggered when the relevant participating employer actually leaves a final salary scheme on completion of a sale and then needs to be calculated. There can be liability attached to a target company simply by reason of it being connected or associated with another company, for example, the seller which operates a defined benefit scheme.
Be Careful in your Due Diligence
When completing the due diligence process always ensure that the scheme rules are carefully examined to determine whether the scheme is a final salary arrangement. What may appear to be a money purchase arrangement may in fact be deemed to be on a final salary basis – it is often far from clear. This could be because there is an employer underpin granted in relation to the benefits, the full extent of the scheme rules are not examined, or indeed the scheme actually has two sections – one money purchase and one final salary. This is a complex area and it’s critical to make sure the rules are correctly assessed. Another area in due diligence is to establish whether the target has ever been associated or connected with a sponsor of a defined benefit scheme.
Avoiding or Reducing my Client’s Exposure on a Sale – Use an Apportionment Agreement
One strategy to avoid or reduce exposure to such unfunded pension debt whichever side you represent in a sale is to make use of an apportionment agreement. Under such an agreement, the seller may agree with the target company to take on its liability so that the seller pays higher contributions over a period of time to fund the target company’s deficit, on what is known as the “ongoing basis”. Their agreement may also require the target to fund the scheme up to a certain level on completion so that the buyer’s group does not have to.
The “ongoing basis” means that pensions are paid when people reach retirement. Therefore, there is no need to fully fund the scheme now for those who have not reached retirement, and no need to buy expensive annuities for the beneficiaries. Utilising the ongoing basis is therefore much cheaper than an annuity buy-out basis for the seller.
It follows that once the buyer has determined that the seller must take on these unfunded liabilities as a key deal term, the seller will have a keen interest in ensuring that the apportionment agreement requires funding from the Group on the most affordable basis, having the least possible impact on its balance sheet and cash flow.
Under an apportionment agreement, if the seller takes on the target company’s pension liability in advance of completion of the transaction, the target is left with no debt for section 75 purposes when it leaves the scheme.
Is an Apportionment Agreement a Simple Exercise?
Not necessarily, there are 4 different types of apportionment agreement and advice will be needed to select the right one. This includes the trustees who will need actuarial advice on the size of any deficit, and accountancy advice on the respective solvency of the different companies, as any agreement will be between the scheme trustees, seller and target company. Trustees will need satisfying that the seller’s covenant is at least as strong as the target before releasing the target of liability. The negotiations take time and this needs to be taken into account in the exchange of contracts and completion timetable. Be aware that the trustees may demand some form of cash or other collateral in return to signing up to an apportionment agreement.
Are there any Other Aspects I Should be Aware of?
Another issue to consider is whether the buyer wants the apportionment agreement approved by the Pension Regulator so that they have the assurance that there is no risk of future action against them. The Regulator has extensive powers to make what are known as “contribution notices” and “financial support directions” up to the annuity buy-out deficit if it feels its guidance has not been adequately followed. Obtaining such approval can take many weeks or even months, and any application to the Pensions Regulator needs to be made as early on in the negotiation process as possible.
How Can We Help?
Abbiss Cadres has a unique service model incorporating all the expertise needed to help you manage the complexities of your client’s employment and people issues. As well as pension solicitors, our team includes employment, immigration, tax, compensation and benefits, and global mobility specialists. We have extensive experience of working alongside a variety of corporate law teams, from the world’s largest to domestic firms, to deliver an integrated service to their clients.
If you would like advice on how we can help you with this or another other employment-related issue get in touch.
In the next part of our series, we will look at corporate restructuring and liabilities within pension schemes.
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By Gary Cullen LL.M., BA Solicitor, Partner Abbiss Cadres LLP