Pension schemes can sometimes be a bit of a mystery in a transaction situation. However they can also be one of the most financially significant aspects.

When undertaking a transaction it is vital to get clear and thorough pensions due diligence on the attaching defined benefit scheme, this will avoid discovering nasty surprises (such as "hidden" liabilities and costly risks) later down the line.

When seeking to acquire a business with a defined benefit pension scheme, any deficit in respect of past service or accrued liabilities should be treated as a debt-like item. There is a range of different actuarial bases (set of actuarial assumptions) that can be used to determine the debt in the pricing adjustment; the decision on which set of actuarial assumptions to use is not straightforward and should be considered carefully. The scheme's future service cost (in respect of current active members in the scheme and the cost implications of auto-enrolment) should be incorporated into the business projection model and is typically priced on the business' required rate of return.

The Pensions Regulator and the scheme trustees can sometimes play a significant role in the negotiations surrounding a transaction. Pre-agreeing a package of additional funding or security with them, to ensure that the scheme's security position is not detrimentally affected may be required.

Due Diligence

Due diligence of the pension scheme will usually be produced by both the purchaser and the vendor (except in hostile takeover situations), although they vary in nature according to the different needs of the two parties.

Vendor due diligence is likely to focus on a description of the benefits currently provided, a description of the membership profile and key financial information relating to the scheme such as current level of contributions, the disclosed accounting position and the latest funding valuation. The vendor would also usually make available a library of important scheme documentation for any would-be purchasers.

In contrast, purchaser due diligence focuses on identifying risks associated with the target's pension scheme. This will include an analysis of:

  • the key provisions contained within the target scheme's trust deed and rules;
  • an analysis of the appropriateness of the current investment strategy;
  • the actuarial valuation and accounting assumptions;
  • other risks inherent within the scheme such as the PPF levy and any possible means for risk mitigation. 

Furthermore, it will provide advice on the ultimate basis to be used to determine the pricing adjustment in respect of the scheme's past liabilities and will place a value on this debt under the various possible bases. It may also assess the debt triggered on the employer in the case of the wind-up of the pension scheme. Lastly, the purchaser may want to consider options regarding the level of benefits to be offered going forward and whether advice on this is required.

Given the potential for a pension scheme to be so significant, an initial high-level feasibility study for the purchaser can sometimes be useful as an efficient means of identifying any "deal breakers" at an early stage.

Pricing

There are a number of possible actuarial bases that can be used to value the debt in relation to a defined benefit pension scheme; these can include the accounting basis, the ongoing funding basis, an "economic" basis or a buy-out basis. These bases are just different measures used to place a single value on the liabilities of the pension scheme. In other words they contain the financial and demographic assumptions required to project out future cashflows and then discount them back to the present day.

The ultimate basis used for pricing purposes will depend on the relative negotiating powers of the purchaser and the vendor; for the purchaser it is important to balance producing a competitive bid versus deciding how much pension risk they are prepared to accept within the framework of the entire transaction.

These actuarial bases, in order of "strength" (although the first two may change places in some circumstances) are briefly summarised below:

The accounting basis

This is the basis that is used to measure the pension scheme liabilities disclosed on a company's balance sheet, under either UK or International accounting standards. The standards require the basis adopted to reflect the company's best estimate view of future experience although the projected cashflows are discounted with reference to the yield available on AA rated corporate bonds. The use of the accounting basis to price pension scheme debt implies that the purchaser is happy to accept some pension scheme risk.

AA rated corporate bonds are expected to outperform UK government gilt yields to reflect the increased credit and liquidity risks, thereby reducing the debt item. This may however be an acceptable level of investment risk for the purchaser to take as, depending on the scheme's investment strategy, it might not be an unreasonable level of out-performance to expect.

Before the 2008 credit crunch, when credit spreads were relatively moderate, this was the most common approach to determining the discount rate used in placing a value on pension scheme debt in a transaction.

While other assumptions in the accounting basis are usually stripped of explicit margins of prudence, the purchaser may want to negotiate for some margins of prudence to be incorporated back into the ultimate basis used for pricing.

The ongoing funding basis

The Scheme Specific Funding basis will be different for different pension schemes. The Pensions Regulator requires for this to be determined according to "prudent principles" but does not prescribe a definition of prudence. It should also reflect the strength of the sponsoring employer's covenant. This is discussed further in the Scheme funding section.

This basis will usually reflect the actual asset allocation of the scheme, and will allow for expected out-performance of return-seeking asset classes over bonds. Clearly holding a large proportion of equities that are reflected in the Scheme Funding assumptions works in the vendor's favour (i.e. it reduces the pension scheme liabilities), despite the greater attaching investment risk.

In recent years however, there has been a trend for schemes to move away from return-seeking or growth asset classes to less risky bonds. Maturing pension schemes leading to less risky investment strategies coupled with margins of prudence incorporated in the other actuarial assumptions have meant that this measure of pension scheme debt is now likely to be higher than on the accounting basis. Since the credit crunch it has become more common for pricing to end up somewhere between the accounting basis and the ongoing funding basis, or even in some circumstances on a more prudent basis than the ongoing funding basis.

The economic basis

An economic basis will in most cases lead to a higher liability value than the Scheme Funding basis as it allows for pension scheme liabilities to be discounted on a yield that - in theory - would be obtained on risk-free matching asset classes. In other words this is the yield that would be obtained from assets that have the same term, nature and currency, and are expected to behave in the same way, as the liabilities. Typically UK government fixed and index-linked bonds (gilts) are used to derive the financial assumptions. The mortality assumption may be dictated by terms being offered by insurance companies or banks in longevity-linked contracts. 

In reality it will be impossible to adopt a strategy that exactly matches the liabilities in this way, so there will still be some residual risk accepted by the purchaser. For example, pension increases are often capped and collared, and can be linked to CPI rather than RPI, so it can also be difficult to achieve a perfect match here through index-linked bonds.

It is important to note that, unless a scheme's assets are moved into these types of matching asset classes, then the sponsor could still be exposed to significant investment risk. This is discussed further in the Investment section.

The buy-out basis

A buy-out basis theoretically removes all pension scheme risk from the transaction. It represents the price that could be paid to an insurance company to take on the obligations of the scheme and for the trustees to extinguish their liability. This basis is not likely to allow for much (if any) investment risk and will also incorporate additional margins for insurance company profits and expenses. For further information on buy-outs see our Buy-out section.

It is relatively unusual to price the pension scheme on this basis therefore using it is likely to result in an uncompetitive bid.

A buy-out estimate will often be quoted in the actuarial valuation report. This figure should be used with caution as it is very difficult to replicate insurers pricing bases and they can vary considerably from scheme to scheme and over time. Therefore, actuaries will often use broad brush rules of thumb to derive this figure which is only a disclosure item in the report. Obtaining and ultimately securing the liabilities with an insurance company can be a lengthy process so there will be some residual risk that the basis used does not match what is available in the market place when the benefits are ultimately secured.

Post Transaction

Following the completion of a transaction, there are a variety of options that can be used to minimise the pension scheme liabilities. Techniques to reduce and re-shape liabilities, which have the effect of improving the funding level and reducing the inherent risks, include enhanced transfer value exercises, pension increase exchange exercises and early retirement exercises. These can be implemented in the short term so that the pension debt is minimised if a future exit strategy is being planned.

There are also a number of means by which investment risk can be reduced, often without increasing the anticipated cost to the sponsor. This can be carried out by better diversifying the return-seeking assets and implementing funding-based de-risking triggers whereby funding levels are monitored and return-seeking assets such as equities moved into less risky matching assets at opportune times (according to the sponsor's de-risking objectives). Where schemes are sufficiently well funded, benefits can be purchased with an insurance company (either through 'buy-in' or 'buy-out' annuity policies).