Let's take a look at thepath to fully terminate a pension plan in a M&A transaction andthe timing considerations for going down this road. (Photo:Shutterstock)

M&A transactions that involve defined benefit pension planscan be tricky. First, due diligence and pricing the risk associatedwith the plan can be difficult. Second, managing the plan after thetransaction can be complicated.

For many CFOs, the optimal answer would be to eliminate the planand not deal with a long-term, volatile liability on the books,distracting and often complicated plan administration and apotential cash drain for the organization.

This article looks at the path to fully terminate a pension planin a M&A transaction and the timing considerations for goingdown this road.

Background

Over the past 30 years, many corporations have moved away fromthe traditional defined benefit pension plan in favor of401(k)-style retirement plans. But just because a company that isbeing acquired is no longer offering pension benefits doesn't meanthat they don't still own pension plan liabilities in the form ofbenefits that they are paying to current, or will pay to future,retirees.

Many companies moved away from pension plans due to volatilityin balance sheet liabilities, P&L expense, and cashrequirements.

Pension liabilities behave very similarly to long-term bondswith a series of expected cash flows that could be payable fordecades. The liability is simply the present value of the futurebenefit payments, discounted back to today using high qualitycorporate bond yields (or variations of those yields depending onthe measurement).

These liabilities are backed by assets in a protected trust. Thedifference between those assets and the liabilities is a plan'sfunded status. That funded status is recognized on the corporatebalance sheet, determines the P&L cost, and is the basis forcalculating the required contributions to the trust.

In addition, there are administrative costs in maintaining apension plan including actuarial and investment services, audit,potentially recordkeeping, and premiums paid to the Pension BenefitGuarantee Corporation (PBGC) – all of which are ultimately paid bythe company.

Depending on how the pension trust assets are invested and howwell funded the liabilities are, there can be substantial swings infunded status creating undesirable changes to a company'sfinancials and demands on cash.

This can be particularly painful when there are marketcorrections that decrease the value of trust investments or whenthe discount rates used to value the liabilities decreasemeaningfully. Typically a 1% change in the discount rate can changeliabilities anywhere from 10% – 18% depending on a plan'scharacteristics. These rates have decreased approximately 1.25%since Q4 2018, increasing the value of a typical plan's liabilitiesby 15-20%.

Terminating a plan

The easiest way for a company to relieve itself of theuncertainty and potential liability of a pension plan is toterminate it. Terminating a plan typically involves offeringparticipants in the plan a cash-out of their annuity benefits and,for those that don't take the cash-out, transferring the remainingbenefits to an insurer to take on the liability and responsibilityto pay those benefits when due.

While that may seem straightforward, the termination processitself is prescribed by government regulations. These regulationsessentially mean that the termination is going to take anywherefrom 12-24 months to complete and involve various notices toparticipants including a detailed benefit statement showing howbenefits are  calculated, as well as filings withgovernment entities and eventually, audits.

To successfully terminate a plan requires preparation. Thismeans compiling data (which can be hard to come by), ensuring planadministration compliance (which can be tricky if there areissues), and funding the plan sufficiently (which can be costly andpotentially risky).

Dealing with a pension plan during M&A

Given that terminating a pension plan is lengthy process that isunlikely to be completed while a M&A transaction is underway,what can companies do to deal with the plan so that: 1) It doesn'tcause problems for the M&A transaction itself, and 2) It can beeventually successfully terminated?

Proper due diligence

Typically, buyers will rely on the seller's documentation of thepension plan for assessing the state of the plan.  It iscritical that the buyer and their representatives conduct athorough due diligence review of the materials.

Some of the key considerations include the following:

Are the assumptions being used to value liabilities appropriatefor acquisition purposes? Sponsors often use accounting assumptionsthat will dampen the liabilities on their balance sheet.

Are there hidden benefits that could kick in afteracquisition?  For instance, will the acquisition involveemployee turnover and does the plan have subsidized earlyretirement benefits? If so, liabilities could jump.

Is the plan's administration in good shape?  Forinstance, data backing up old accrued benefits is often buried in awarehouse; compiling this data in order to conduct a plantermination can be time consuming and expensive.

Funding and risk management

Once due diligence has been completed, the key factor for thepurchase price is any shortfall in the plan's trust assets comparedto the benefit liabilities. In many M&A deals, the overall sizeof the transaction is extremely large compared to the pensiondeficit.

Given that companies are often going to borrow some amount tofinance a transaction, they will want to consider adding an amountto fully fund the pension liabilities to the amount borrowed. Thisis especially true in today's low interest rateenvironment.  Assuming a pension deficit is akin to addingmore corporate debt.

The borrowing cost of many companies is lower than the effectivecost of maintaining a pension deficit, which is 7%-8%+ per year formost plans in today's environment. Companies can therefore pay off"expensive" and volatile pension "debt" with low cost, andpredictable, regular corporate debt.

The second consideration is that once the funding has beensecured, ensuring that the plan's funded status remains at 100% ona plan termination basis is critical. This can be done throughcustomized, liability driven investment strategies that minimizefunded status volatility.

This piece is of paramount importance given the time horizon fora plan termination. The last thing that you want to happen is tothink you are 100% funded but then due to a misalignment ininvestment strategy you find that when it's time to make theultimate payouts you have a shortfall once again.

Data and plan administration

Prior to terminating, it is important to get all potential planadministration and data elements in as clean a shape as possible.Plan administration involves ensuring 100% compliance with thevarious rules and regulations governing these types of plans.

Having an independent professional review the plan documentation(i.e., formal plan document, summary plan description, amendmentsand resolutions, forms) is a good first step. Depending on theoutcome of a review it may be necessary to file for certaincorrections. This is a step that cannot be overlooked withoutjeopardizing the eventual success of a plan termination.

Data has another aspect that can be challenging after a M&Atransaction. It is imperative that the right data be collected,especially on vested terminated participants (people who have leftemployment at the sponsoring company, but who are still owed abenefit from the plan that will be paid in the future).

Some data elements include the back-up data that was used indetermining accrued benefits. This data can sometimes be hard tocome by and it gets harder and harder to get a hold of the furtheraway from the M&A transaction.

In addition to the indicative benefit information, collectinginformation like addresses, job title/function, union/salaryindicators, etc. will help with the termination.

An eye on the end game

Pension plans in M&A transactions can be problematic if notdealt with properly. With an eye towards an end game, there is alot that a company can do to ensure that the pension liabilitiesthat they bring on board do not become a sore spot down theroad.

To do this requires the right due diligence and preparation –it's more than just quantifying the current financial position toget to a closing.

Michael Clark is a director and consultingactuary in River and Mercantile's Denver office.