Do pensions make a business untouchable?

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Rosalind Connor of ARC Pensions Law writes that for some years now defined benefit pension arrangements have dogged sales and acquisitions, and buyers have been increasingly alarmed at enormous liabilities and demands for payments that can infect the broader groups and directors.  As recent news suggests, pensions are high profile and the loss of pensions can risk public vilification for those involved.

With all this, it seems astonishing that anyone invests in a business with a UK defined benefit pension scheme.  Yet, plenty of these 6,000 plus businesses are bought and sold every year.

On the whole, this isn’t due to foolhardiness – in fact, in general, those looking at buying or otherwise investing in these businesses are better informed than ever.  Transactions with a defined benefit pension scheme can run quite smoothly, so long as three simple rules are followed.

The first rule is to understand as much as possible about the funding of the scheme.  Defined benefit pensions promise a certain pension on retirement funded from its assets, with any shortfall made good by the employer.  The shortfall calculation assesses whether the present assets will be sufficient in the future to buy the earned pensions on retirement.  The contingencies and assumptions in this calculation is where the uncertainty arises.

The real shortfall, to quote Donald Rumsfeld, is a “known unknown”: you know that it exists but not what it is.  Every shortfall number is simply an estimate and none of them is, probably, correct.  However, businesses deal with uncertainties all the time – demand for products and services, litigation risks, supplier failure, the Brexit vote – and still manage to survive.  The pensions shortfall is no different, as long as the different calculations are understood.  The most important numbers are the present cashflow cost (the scheme funding basis under the valuation) and the cost of getting rid of the scheme (the buyout basis, which is the biggest number often quoted in the press).  So long as these are understood and appropriately analysed, the buyer can appreciate the sort of liability being taken on.

The second rule is to try to engage with the trustees of the pension scheme as early as possible.  This can be challenging, as trustees often include staff members and even ex-employees who work for competitors.  That said, trustees generally sign stringent confidentiality agreements and are very nervous about breaching confidentiality.

The trustees of a pension scheme can be very helpful in a transaction – they can provide comfort about the future valuations and hence cashflow, and can help (if needed) smooth the path with employees.  They can also be very difficult people to be fighting – they can provide unwelcome publicity, involve the Pensions Regulator in long debates about the business and, in some cases, make demands for one-off payments.  Sellers have learnt the importance of ensuring that trustees are on side, and are willing to present a positive view to a buyer; buyers are rightly wary when the trustees are out of bounds before signing.

The third rule is to consider the Pensions Regulator.  The Regulator came into being under the Pensions Act 2004, which was passed with legislation bringing in civil partners and banning hunting, and was every bit as controversial as those acts.  This was because it allowed the Regulator, under certain circumstances, to impose pension liabilities outside the liable company, on group companies, shareholders and directors, with a look-back period of up to six years.  Buying a group with a defined benefit pension scheme, could mean infecting the whole group with demands to fund the pension scheme. Except it won’t, not really.

Unsurprisingly, the Regulator can only use these powers in limited circumstances and, just as importantly, tends to use them as a last resort.  Proper and sensible engagement with trustees and, where appropriate, the Regulator itself ensures most businesses do not find themselves subject to these powers.

However, the powers are there. It is important to understand them and when they can be used.  On occasion, the transaction itself might risk Regulator action and more often, future restructuring and refinancing plans can make the group vulnerable.  Avoiding this risk may mean adjusting plans or providing funding or security to the pension scheme, and it is worth thinking this through in advance to ensure that the future business plans are still practical and profitable.

Pensions can undoubtedly be costly and unpredictable, but it is increasingly rare for businesses to be caught out in these transactions.  So long as there is proper due diligence, and an appropriate consideration of the future, pensions can simply be another part of the transaction analysis.

Rosalind Connor is a Partner at ARC Pensions Law LLP

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