Many companies moved away from pension plans due to volatility in balance sheet liabilities, P&L expense, and cash requirements. Pension liabilities behave very similarly to long-term bonds, with a series of expected cash flows that could be payable for decades. The liability is simply the present value of the future benefit payments, discounted back to today using high-quality corporate bond yields (or variations of those yields depending on the measurement). These liabilities are backed by assets in a protected trust.

The difference between those assets and the liabilities is a plan's funded status. The funded status is recognized on the corporate balance sheet, determines the P&L cost, and is the basis for calculating the required contributions to the trust. Depending on how the pension trust assets are invested and how well-funded the liabilities are, there can be substantial swings in funded status, creating undesirable changes to a company's financials and demands on its cash. This can be particularly painful when market corrections are decreasing the value of trust investments or when the discount rates used to value a pension's liabilities decrease meaningfully. Typically, a 1 percent change in the discount rate can change liabilities anywhere from 10 to 18 percent, depending on characteristics of the plan. These rates have decreased approximately 1.25 percent since Q4/2018, increasing the value of the typical plan's liabilities by 15 to 20 percent.

In addition, there are administrative costs in maintaining a pension plan, including actuarial and investment services, audit, potentially recordkeeping, and premiums paid to the Pension Benefit Guaranty Corporation (PBGC). All of these expenses are ultimately paid by the company.

Terminating the Plan

The easiest way for a company to relieve itself of the uncertainty and potential liability of a pension plan is to terminate it. Terminating a plan typically involves offering participants in the plan a cash-out of their annuity benefits and, for those that don't take the cash-out, transferring the remaining benefits to an insurer to take on the liability and responsibility to pay those benefits when due.

While that may seem straightforward, the termination process itself is prescribed by government regulations. These regulations essentially mean that the termination is going to take anywhere from 12 to 24 months to complete, and will involve various notices to participants, including a detailed benefit statement showing how benefits are calculated, as well as filings with government entities and, eventually, audits.

Successfully terminating a plan requires preparation. This means compiling data (which can be hard to come by), ensuring plan administration compliance (which can be tricky if there are issues), and funding the plan sufficiently (which can be costly and potentially risky).

Given that terminating a pension plan is lengthy process that is unlikely to be completed while an M&A transaction is under way, what can a company do to deal with the plan of a company it is acquiring so that, first, the plan doesn't cause problems for the M&A transaction itself, and second, it can eventually be terminated?

Proper Due Diligence

Typically, buyers will rely on the seller's documentation to assess the state of the pension plan. It is critical that the buyer and its representatives conduct a thorough due diligence review of those materials. Key considerations include answering these questions:

• Are the assumptions being used to value liabilities appropriate for acquisition purposes? Sponsors often use accounting assumptions that will dampen the liabilities on their balance sheet.
• Does the plan include any hidden benefits for employees that could kick in after the acquisition closes? For instance, will the acquisition involve employee turnover, and does the plan have subsidized early retirement benefits? If so, liabilities could jump.
• Is the plan's administration in good shape? For instance, data backing up old accrued benefits is often buried in a warehouse; compiling this data in order to conduct a plan termination can be time-consuming and expensive.

Funding and Risk Management

Once due diligence has been completed, the key pension factor that impacts the M&A purchase price is the shortfall (if any) in funded status. In many M&A deals, the overall size of the transaction is extremely large compared with the pension deficit. As companies are often borrowing to finance the M&A transaction anyway, they may want to consider increasing that debt so they can fully fund the acquisition's pension liabilities.

Taking on a pension deficit is akin to adding more corporate debt, and the borrowing cost for many companies is lower than the effective cost of maintaining a pension deficit, which for most plans today is 7 to 8 percent, or more. Companies can therefore pay off "expensive" and volatile pension "debt" with low-cost, and predictable, regular corporate debt. This is especially true in today's low interest rate environment.

The second consideration for an acquirer assuming a legacy pension plan is that once the deal funding has been secured, ensuring that the plan's funded status remains at 100 percent is critical. This can be done through customized, liability-driven investment (LDI) strategies that minimize funded status volatility. This piece is of paramount importance given the time horizon for a plan termination. The last thing pension managers want to happen is to think the plan is 100 percent funded, only to find—when it's time to make the ultimate payouts—that there is again a shortfall due to a misalignment in investment strategy.

Data and Plan Administration

Prior to terminating a plan, the company needs to make sure all plan documentation and data elements are as clean as possible. This involves ensuring the plan is 100 percent compliant with the various rules and regulations governing defined-benefit plans.

Having an independent professional review the plan documentation (e.g., formal plan document, summary plan description, amendments and resolutions, forms) is a good first step. Depending on the outcome of the review, filing for certain corrections may be necessary. This is a step that cannot be overlooked without jeopardizing the eventual success of a plan termination.

See also:

• The Importance of a Treasury Acquisition Strategy
• 5 Drivers of Success in M&A
• Risk Management Pitfalls in Mergers and Acquisitions

Another aspect of data management that can be challenging after an M&A transaction is the imperative that the right data be collected, especially on vested terminated participants (people who have left employment at the sponsoring company but are still owed a benefit from the plan that will be paid in the future). Backup data that is used to determine accrued benefits can sometimes be hard to come by, and it will likely get harder and harder to find over time, once the M&A transaction is complete. In addition to the indicative benefit information, collecting information like addresses, job title/function, union/salary indicators, etc. will help with the termination.

An Eye on the Endgame

Pension plans can be problematic in M&A transactions if not dealt with properly. With an eye toward the endgame, treasury and finance professionals can take meaningful steps to ensure that the pension liabilities an acquisition is bringing on board do not become a sore spot down the road.

Accomplishing this requires due diligence and preparation—it's more than just quantifying the current financial position to get to a closing.

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

From: BenefitsPro