Avoiding the pension trap

To the untutored eye, mergers and acquisitions is an irrepressibly glamourous business, conjuring up images of shoals of Michael Douglas clones finning through the City.

Fairy tale marriages and the collapse of corporate bastions grab headlines. But the figures at stake in the administrative nitty-gritty that goes into putting a big deal together are just as newsworthy.

One area that can be financially calamitous if the backroom boys don’t do their stuff is the transfer of company pensions. Issues can come up that even the seller does not fully appreciate. Future costs are very often different from historic figures shown in company or management accounts, particularly for a new pension scheme which gets a transfer payment from the existing one.

Number crunching

And the sums involved may be huge (costs of over 10% of payroll are common) – funds built up in a pension scheme can easily exceed the annual payroll cost.

Acquiring a business where employees have final salary pension promises puts future profitability at very real risk. One MBO team which bought out its division of a major UK plc saved about u700,000 – 10% of the purchase price – at an estimated P/E of 14:1 by getting pensions experts to crunch the numbers before agreeing the deal.

The prospective new company had a payroll of u1m and around 80 employees, all members of the group’s final salary pension scheme which offered the sort of benefits typical of big company practice.

Also fairly typical was the fact that surplus was being used to subsidise costs, running historically at around u50,000 a year. Due diligence showed that the true long-term employer cost of the benefits was about double (ie u100,000 a year).

The MBO team expected to set up a similar scheme which would accept a transfer of the pensions benefits built up in the past.

It was clear from initial negotiations that the seller would not pass over any surplus so the new pension scheme would immediately cost the MBO team an extra u50,000 a year.

Faced with full knowledge of the likely outcome, the MBO team had to pull back from providing similar benefits and, instead, agreed to put in a money purchase scheme.

The greater cost predictability was more suitable for their future circumstances and company contribution levels were set at u50,000 pa. This reduced employees’ benefit expectations but it did achieve the aim of controlling company costs.

It illustrates very clearly pitfall number one: how costs can increase because a surplus is not transferred. Fortunately, expert advice brought the issues out before promises were made to the seller, the employees or the financial backers, so an orderly change to money purchase was possible and nasty future profit surprises were averted.

An incomplete assessment can affect the success of the purchase as a whole. It is important to realise that costs can increase even when a surplus is transferred, as in the case of one US company which was proposing to buy a subsidiary of a UK plc. The acquisition price was expected to be about u20m. The seller was keen for the deal but wanted to ensure that the employees’ final salary pension rights continued and was prepared to transfer surplus from its own fund (or top up the transfer amount if the trustees would not transfer surplus) to the buyer’s new scheme.

The seller even stated that the company pension cost would not change after the purchase. Initially, once again, it all looked pretty straightforward.

There were about 400 employees with a pensionable payroll of u5m. Company pension costs were reported as u150,000 pa and the expected transfer amount to a new scheme was about u11.5m (in value equal to over 50% of the purchase price for the business).

Unfortunately, the seller was not aware of the full implications of future pension funding. The existing scheme had not equalised benefits for men and women; valuations did not fully allow for pension increases which were expected to go on being paid from surpluses; and if company costs were to be kept down, it meant an end to a long period of reduced employee contributions.

In total it would have taken a transfer payment of u15m to maintain future company costs at the same level, and not the u11.5m that was offered at first.

Future costs should never be automatically assumed to equal past costs, nor should actuarial valuations always be taken at face value because it is important to understand the effect of all the assumptions made.

Fortunately, detailed negotiations lead to an acceptable solution.

The seller agreed to end the employees’ contribution reduction, thus giving the bad news themselves and not leaving it to the buyer. The buyer agreed to an expected annual future pension cost of u250,000 in return for a u2m reduction to the purchase price.

So careful due diligence and negotiation avoided a potential hidden cost of u3.5m (17.5% of the initial purchase price) and left the buyer with a realistic and sustainable assessment of the future pension spend.

Additional costs

You cannot avoid additional costs just by deciding to wind up a pension scheme either. Earlier this year, an entrepreneur was considering buying a privately-owned UK company.

As a result of the u9m transaction, one of the directors was expected to leave the target company. It operated a final salary pension scheme for directors and staff, and offered personal pensions to other employees.

The latest valuation of the scheme was a little out of date but showed that, on an ongoing basis, there was a small deficit of assets compared to liabilities of u40,000. The company was paying annual contributions of u140,000 in line with the actuary’s advice.

The buyer wanted to wind up the pension scheme and replace it with improved personal pensions for the remaining staff and other employees. The outgoing director was in his 50s and would be expected to retire and draw his pension.

Everything seemed fairly simple and the costs well contained.

However, investigations showed that the directors had promises to retire early on unreduced pensions. The actuary hadn’t valued these rights in his report as, on an ongoing basis, there was no reason to believe that the directors would retire before the age of 60.

What’s more, their salaries had grown faster than expected since the valuation: as is very common in current financial conditions, the cost of buying out the benefits with annuities was much higher than the reserves held in the pension scheme. So the deficit would have grown to around u200,000 on a wind-up at the time of the purchase investigations.

Armed with this information, the buyer was able to negotiate reduced early retirement benefits for the two directors who were staying on as a quid pro quo for the improved profit-sharing and option schemes he was going to introduce to incentivise them to improve the performance of the business.

The buyer was also in a position to factor the likely extra pension costs into his assessment of the business’s value when agreeing a price for it.

These real life problems all demonstrate the financial complexity of final salary pension schemes. And there are many other issues to address: the Pensions Act 1995 makes pension increases compulsory and will add to the cost of many pension schemes.

When buying a business where employees are members of a final salary pension scheme, it really is important to take specialist advice. Only then can you be armed with all the information needed to assess the likely real future pension costs.

Without help it is very easy to lose substantial sums of money – a surefire and very unpleasant way of grabbing the headlines.

Moray Sharp is an actuary and partner with Lane Clark & Peacock and specialises in pensions advice to companies considering mergers and acquisitions.