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. That 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.

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 Guarantee Corporation (PBGC) – all of which are ultimately paid by the company.

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 cash.

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

Terminating a 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 12-24 months to complete and 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.

To successfully terminate 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).

Dealing with a pension plan during M&A

Given that terminating a pension plan is lengthy process that is unlikely to be completed while a M&A transaction is underway, what can companies do to deal with the plan so that: 1) It doesn't cause problems for the M&A transaction itself, and 2) It can be eventually successfully terminated?

Proper due diligence

Typically, buyers will rely on the seller's documentation of the pension plan for assessing the state of the plan.  It is critical that the buyer and their representatives conduct a thorough due diligence review of the materials.

Some of the key considerations include the following:

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.

Are there hidden benefits that could kick in after acquisition?  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 factor for the purchase price is any shortfall in the plan's trust assets compared to the benefit liabilities. In many M&A deals, the overall size of the transaction is extremely large compared to the pension deficit.

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

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

The second consideration is that once the funding has been secured, ensuring that the plan's funded status remains at 100% on a plan termination basis is critical. This can be done through customized, liability driven investment strategies that minimize funded status volatility.

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

Data and plan administration

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

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

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

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

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 end game

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

To do this requires the right 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.