Pension plan sponsors have been facing ongoing difficulty with defined benefit pension plans due to persistently low interest rates and volatile capital markets along with changing accounting standards. While it is unlikely that pension plan issues will break a corporate deal, it is an important consideration when valuing an enterprise and considering what future obligations may exist.
A recent report by Mercer estimates that only one in twenty defined benefit pension plans were fully funded as of December 31, 2012.1 Furthermore, the Office of the Superintendent of Financial Institutions (OSFI) had over 125 pension plans on its "watch list," a list of pension plans that give rise to serious concerns based on their financial condition. This number is considerably higher than the 49 plans that were on the list at the end of March, 2011.2
REGULATORY FRAMEWORK FOR PENSION PLANS
Although Canadian companies are not required to offer a pension plan to their employees, many larger employers do offer some sort of plan. Once they do so, the employer will be subject to rules under the applicable benefits standards legislation.
These rules require that the benefit be funded through a trust or insurance contract. These rules also impose strict funding requirements on a plan and a requirement for periodic actuarial valuations, which determine if the plan is in a surplus or deficit position. Deficits must be funded over time, although pension plans in deficit may be given relief to extend the length of time over which to amortize their deficit. It may also be possible for pension plan sponsors to provide a letter of credit in lieu of a contribution to provide for certain liabilities.
TYPES OF PENSION PLANS
The two main types of pension plans are defined benefit ("DB") or defined contribution ("DC") plans, although pension plans that are a hybrid of the two can also exist. In the context of M&A transactions, it will generally be DB plans that will cause the greatest concern in respect of funding issues.
As the name implies, in a DB plan, the employer promises the employee a specific pension benefit. It then becomes the employer's responsibility to ensure that sufficient assets are available in the pension fund to pay the promised retirement benefit. The rest of this note deals with DB plans.
FINANCIAL CONSIDERATIONS
Purchasers and sellers should engage in careful due diligence relating to DB plans since these plans may have funding issues, which in turn can affect the value of the target company or create unexpected future obligations. While due diligence is usually considered a purchaser's concern, it is also a seller's concern when pension plans are involved as the seller needs to verify the accuracy of any representations it makes, and valuations if it is offering a discount in purchase price.
Due diligence should include a detailed analysis of corporate and pension fund financial statements and actuarial reports. It may be necessary to get updated actuarial valuations as pension rules allow for the filing of reports up to 3 years apart, so it is possible that a report may not accurately capture the current status of a pension plan, especially in a time of volatile capital markets and interest rates. Furthermore, it is important for both parties to understand if any funding relief has already been granted. For example, if a company has been allowed to amortize the deficit over a longer period of time or is using letters of credit to fund deficits, future obligations could be more onerous than they appear. Even if a pension plan is fully funded or in surplus, there is also no guarantee that the plan will remain in this position.
PURCHASE OPTIONS AND PENSION PLAN IMPLICATIONS
If the target company has a pension plan, there are different ways a purchaser can structure the deal, each with its own advantages and disadvantages. Purchasers and sellers will both want to avoid being left with an underfunded pension plan after the deal is complete, so parties should consider what kind of trade-offs will need to be made under each option.
Share Purchase
A share purchase deal is the least complex structure for dealing with pension plans. In a share purchase, the purchaser acquires the target enterprise as a whole, which means that the purchaser will assume all of the target's assets and liabilities, including the pension plan. This means that the purchaser has to fulfill the funding requirements and obligations of the plan, which can be onerous, especially if the plan is in deficit.
Asset Purchase
An asset purchase can be complex, because the purchaser can choose which assets and liabilities it wishes to purchase and which to leave behind. This can result in a purchaser offering no pension plan, a pension plan for future service (plan freeze), a purchaser assuming the seller's plan or a transfer of pension assets and liabilities. Each of these options is discussed below.
No pension plan
This can be an attractive option for a purchaser if the target company has a pension plan that is in deficit. In this situation, the pension liabilities would remain with the seller. However, there are certain consequences that may arise as a result. For example, because the purchaser is not providing a pension plan, the regulator could order a wind-up of the pension plan. This would result in cost consequences since it would lead to "grow in" rights for some employees. Furthermore, employment law claims could arise if employment in the successor company is not considered to be substantially similar. For the seller, this is usually not an attractive option since they would be left with all the pension obligations.
Pension plan for future service (plan freeze)
This type of structure allows the seller to avoid the wind-up issues associated with not providing a plan and allows the purchaser to avoid pension liability for an underfunded seller plan. The seller would be responsible for pre-purchase service and related deficits and the purchaser would be responsible for post-sale service. The purchaser can either create a new plan for the transferred employees or enrol them in an existing plan.
There is a concern that employees would be disadvantaged if the seller's benefits were calculated based on career or final average earnings because, once enrolled in the purchaser's plan, the benefits under the seller's plan would be based on earnings only to the date of sale and would not account for increases in salary. To make up for this, a wrap-around arrangement can be negotiated, which would recognize the credited service with the seller's plan when calculating the benefits under the purchaser's plan.
A wind-up issue can still arise if, after the transaction, the purchaser terminates the new plan. The regulator could require that the seller's plan also be wound up and this would result in the consequences mentioned above.
Purchaser adopts seller's pension plan "as-is"
This is similar to what occurs in a share deal. The purchaser assumes the seller's pension plan including all assets and liabilities. The same concerns as discussed in a share purchase deal would apply.
Full or partial transfer of assets
In a transfer, the purchaser assumes pension liability (and related assets) for the active members of the pension plan and thus avoids the wrap-around problems and issues with future wind-ups of the plan. The remaining obligations remain in the seller's plan. This type of structure can be a complicated and time consuming option as it requires detailed actuarial calculations and regulatory approval for the transfer of assets.
If the transferred pension liabilities exceed the related assets, the purchaser will usually require a discount in the purchase price. Conversely, if the assets exceed the liabilities the seller will usually require compensation.
CONCLUSION
While pension plan issues are rarely on the forefront of M&A transactions, they can have significant effect on the purchase price or future obligations of an enterprise. While a deal can be structured in a way to help mitigate these effects, it is important that information on these plans be obtained early on in the due diligence process and that expert pension advice is sought to ensure that there will be no surprises during negotiations or after the deal is completed.
Footnotes
1 Mercer, Press Release, "2012 spares battered Canadian pension plans" (2 January 2013).
2 Tara Perkins, "Regulator puts more private pension plans on watch list" The Globe and Mail (7 January 2013).
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