By Helen Draper, Partner at LCP
With a significant proportion of UK pension schemes in surplus does this mean that Defined Benefit (DB) pension schemes are an asset of UK Plc.
And if so, in an M&A scenario, how can a potential purchaser assess and unlock that value?
Is a new mindset now warranted.
The answers clearly depend on not only the measure of surplus (which I discussed in the blog What measures of pension scheme surplus does a CFO need to know), but also the specifics of the business and the pension scheme in question.
It may already be reasonable to start from the current pensions regulation and an existing surplus on a relevant measure and extrapolate to a view that the pension scheme is an asset of the business. Recent announcements give additional confidence to this belief.
However, there is uncertainty around how the value of the surplus can be realised, and careful judgement needs to be applied to the specific circumstances before coming to that conclusion. This includes:
Interrogation of the robustness of the surplus
Reviewing the scheme’s governing documentation, to understand to what extent the pension trustees have discretion over the use of surplus, and/or the ability to take action to stop a surplus being utilised, for example:
Is there a requirement or expectation to use surplus to pay benefit improvements.
In the scheme rules, under what circumstances can a payment to the sponsoring company be made.
Decisions on the plans for the pension scheme and indeed the business post transaction:
Trustees often see insurance buy-out as the ultimate endgame and may explicitly be targeting it, which can quickly dissolve a surplus on any other basis
Plans for the business may mean it makes sense to remove all pension risk in the period of ownership; for a private equity acquirer for example, this could facilitate selling a restructured business free of pensions after a certain time horizon.
These areas will determine whether and how a surplus can be accessed and should form a key part of due diligence in any corporate transaction.
The potential rewards are high and worth working for. There are already examples of businesses accessing surplus under the current regulatory regime. Pensions are now a potential asset rather than a liability.
Run-on with surplus used to pay Defined Contribution (DC) benefits
Schemes can be run-on after they have reached full funding at self-sufficiency level. Establishing a well-designed asset strategy that yields returns while managing the risks, means a surplus can be generated year-on-year which can then be used to pay contributions in respect of a company’s DC scheme. This effectively saves the business money (and generates profits) that otherwise would have been required to meet DC payments.
There are potential execution challenges around accessing the surplus in this way. The support of the trustees is needed, and securing this is likely to require giving them some additional assurances (for example security or a buffer) in addition to potentially sharing some of the additional value created with DB pension scheme members in the form of, say, a modest enhancement to annual pension increases.
This offers a potential route to derive value from surplus. Keeping the money 'in pensions' can be seen as improving employee equality from an inter-generational perspective and viewed positively by trustees (and need not attract a tax charge on refund of surplus). The ability to access potentially large pools of assets, and benefit from a relatively long-term investment time horizon (enabling investment in illiquid assets) can also be attractive to certain purchasers.
Target a surplus on the ultimate insurance buy-out of the scheme
An essential element of Due Diligence is to consider long term plans for the pension scheme, which often means getting to buy-out. In particular, can buy-out be achieved with investment returns over time or is a sponsor contribution likely to be required to get there. In our experience, detailed analysis, including a review of the buy-out position informed by current insurer pricing, and modelling that allows for the impact of members retiring (and so being priced on a more competitive basis) can often be a pleasant surprise for a potential purchaser.
There is also an opportunity to continue to run the pension scheme on once a buy-out is affordable. As members continue to reach retirement, the buy-out surplus would be expected to increase year-on-year even with a low-risk investment strategy.
In these circumstances, when the scheme comes to be ultimately secured with an insurer, there will be a cash surplus which, subject to the rules and tax (at the reduced rate of 25% from April this year) could be returned in whole or in part to the employer.
As regulations and practice emerge and surpluses persist, these routes to accessing surplus which we have already seen in a number of cases will become more commonplace and assigning a value to the potential to benefit from them more typical practice.
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