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As the global financial markets adjust to a more volatile and uncertain environment, worldwide M&A activity continues, albeit at a slower pace, as consolidation occurs in certain sectors and falling share prices make acquisitions more attractive.1 Cross-border mergers, acquisitions and other transactions have increased markedly in recent years, more than tripling from some $400 billion in 2003 to almost $2 trillion in 2007.2 And during 2008, cross-border activity comprised almost 40 percent of all worldwide deal activity.3
One result of this activity and the deterioration in the financial condition of pension funds is an increased focus on pension and related benefits issues. Local market regulation makes managing these issues difficult, and the picture is further complicated by global investment markets and widespread underfunding of defined benefit pension schemes. Management teams – including human resource professionals, financial executives and CEOs – need to deal effectively with complex retirement provisions around the world. They also need to focus on the impact of investment markets on deal pricing and ongoing integration success.
It is important to note that with the current extreme volatility in the investment markets, there potentially could be dramatic increases in contribution requirements for defined benefit plans in 2009. These increases, resulting from recent financial market declines, may well impose significant unanticipated cash demands on businesses at a time of limited availability of capital, unusually tight credit markets and a challenging business climate overall. This will need to be factored in to business plans of buyers and sellers alike.4
This article aims to set out the process for managing the retirement benefit implications in cross-border transactions.
A look at the general employment environment across the globe is a good place to begin. One of the more revealing contrasts is highlighted when the US market is compared to the rest of the world (Exhibit 2 on page 5 identifies some key employment conditions inside and outside of the US). For example, in the US the majority of benefits are employer-sponsored and not mandatory; outside the US, health benefits and other benefits tend to be either government-provided or mandatory. Also in the US, changes in the terms and conditions of employment or benefit plans can often be made by companies unilaterally. This is not usually the case in Europe, South America and elsewhere.
Global differences only compound the fact that there are many financial considerations to be taken into account when evaluating the impact of pensions and related benefits in an M&A transaction.
Organizations must keep in mind the need for consistent communication with employees and take into consideration the respective organizational cultures of the entities that they are acquiring. So changes to pension and benefit strategies are best developed within the context of the desired organizational culture.
Any buyer in a cross-border M&A transaction should always undertake the following key activities with regard to retirement benefits:
Those who regularly assess the financial elements of a deal will be aware that the financial treatment of defined benefit pension and similar post-employment benefit liabilities can differ significantly from country to country.
For example, under the tax valuation rules for German pension plans (which are also often used for German accounting requirements), future pay increase projections are disallowed, although international accounting standards (IAS, FRS and FAS) typically require an allowance for future pay increases. This difference in treatment clearly has a material impact on the liability value.
There are also differences between formal plan rules and typical practices. In Brazil, for example, benefits referred to as the “leaving service benefit,” or FGTS,5 are uplifted or enriched for employees who are made redundant – this practice is also applied in some cases to normal retirements or those leaving the company for other reasons. When looking at a Brazilian company, it is important to look at the past history of such uplifts, as this can create an expectation that the uplift will continue to be applied in non-redundancy cases.
Also, early retirement provisions in many countries – for example inthe UK –may be discretionary.However, if in practice such benefits have been granted for many years, they may have become a constructive obligation for the company, and changing past practice may be difficult.
Other regulatory controls can also govern pricing and risk. For example, in 2005 the UK Pensions Regulator established a process whereby companies can apply in advance for “clearance” for certain corporate events. Obtaining a clearance statement from the Regulator is a voluntary process for those considering corporate transactions involving companies with underfunded defined benefit pension schemes.6
But a clearance statement is not an approval of a transaction such as an acquisition or a merger; rather, it gives assurance that the UK Pensions Regulator will not use its anti-avoidance powers in relation to that transaction. (These could include, for example, directing the employer or its parent company to provide additional financing for the pension plan.)
Initially, most companies used this clearance process, and the benefit was assurance that the Regulator would not come back at a later date in relation to the matter that had been cleared. The quid pro quo for this protection was typically more cash paid into the pension scheme. Over the past year, however, an increasing number of companies have opted to forgo clearance to avoid paying extra funds into their pension schemes. Revised clearance guidance has recently been published (with the aim of providing greater certainty for companies), and it will be interesting to observe its effect on transactions.
In another UK regulatory example, all defined benefit pension plans are subject to Section 75 of the Pensions Act 1995. This legislation (supplemented by regulations) stipulates that when part of a pension plan is terminated, the employer is liable to fund that part of the plan fully so that all members’ benefits can be bought out in full with an insurance company.7 7 (This is similar at a high level to the situation in the US when a company withdraws from a multi-employer plan.) A Section 75 debt can typically be triggered on the sale of a company’s shares when there is another company left with the seller who keeps the pension plan. It requires a cash payment to the seller’s pension plan to cover the shortfall for the part of the plan related to the company that was sold.
To help put Section 75 debt into context, consider the following. In a recent deal, the accounting deficit shown in the latest accounts of a company was UK£100 million. Deal completion would have triggered a cash payment of UK£500 million, or five times the original deficit. The reason for this is that the assets in the plan amounted to several billion pounds, and small changes in actuarial assumptions had a large impact on liability values. Having said that, competition in the buyout market increased markedly over the first half of 2008, which significantly reduced buyout costs with a knock-on reduction in Section 75 debts. In the later part of 2008, the buyout market experienced some signs of weakening as the credit crunch deepened. As a result, buyout firms are becoming increasingly selective over quoting for business, which makes actually buying out pension benefits more challenging than in the recent past. Irrespective of this, Section 75 debts are often large and remain a barrier to some transactions involving the UK.
While it’s always important to understand the employees, their reward structure, and the interaction of any contracts or unions, initial analysis is often heavily focused on the financials. If the numbers don’t add up, then the logic for the deal may need to be reconsidered.
Focusing on the accounting numbers is made more difficult by the fact that pension assets are not always counted under the definition of “pension assets” in corporate accounts; they may be held or hidden elsewhere on the balance sheet. Examples are found in German reinsurance contracts, bond issues in Austria and US Rabbi trusts.
Outdated valuations of plan assets and liabilities are also commonplace. In Canada, in most provinces, complete actuarial valuations are typically required only once every three years for defined benefit pension plans.
It is important to remember that defined benefit plan portfolios are subject to market conditions that can reduce their asset values relative to liabilities in the weeks and months following a financial assessment.
Many savvy buyers deal with this problem by asking their advisers to periodically update pension figures to reflect changes in investment markets, thereby ensuring realistic valuations during price negotiations. In times of volatile investment markets, this can become even more important to get right.
Other employee benefit programs may be accounted for at the divisional or operational level as defined contribution-type plans, but at the corporate level as defined benefit plans. This can be attributed to historical reasons; full defined benefit accounting has not been required at the local level and, as such, the figures may not be subject to any full audit process.
Both before and after the deal is signed, buyers must carefully consider:
Executive benefits are sometimes hidden in separate plans not administered by, or even known to, the HR departments in local countries. These plans may only be accounted for in the parent company’s consolidated accounts. This is common practice in the US, Canada, Japan, Ireland and the UK, among other countries.
Defined contribution plans sometimes offer defined benefit features such as minimum guarantees on investment returns, as is the case in Switzerland. It is also important to assess whether the employer retains any risk for pensioners, as is almost always the case in Switzerland.
Dealmakers must also understand how to handle past service obligations as they move toward the post- closing phase. Regulations governing these obligations vary by jurisdiction.
In many countries it is between the buyer and seller to negotiate whether past service obligations remain with the seller’s plans or move over to the buyer’s plans. However, in a minority of countries, including Switzerland and Taiwan, under applicable law, past service obligations cannot remain with the seller and typically are transferred to a plan maintained by the buyer. In Germany, past obligations for the pensions of active employees almost always transfer with the buyer. In Canada, the matter is negotiated between the buyer and seller.
In the UK, a group of employees transferring out as a result of an acquisition is automatically vested in the seller’s pension plan (as an aside, this can leave employees with a lower benefit expectation if any benefit link to final pay is lost, which can create industrial relations challenges if not addressed).
In South Korea, under the statutory defined benefit severance pay system, it is not possible to leave benefits within a seller’s plan. In addition, employee relations challenges may arise if the transferring employees are paid their fully vested benefit in cash upon transfer of employment. This is because many South Koreans view the retention of salary-linked past service benefits as preferable to receiving a cash lump sum in respect of such benefits. The country’s generally risk-averse population (in an investment context) is clearly not confident of outperforming salary inflation in the investment markets. The multinational buyer, therefore, typically backdates service in its own plan to the date of hire with the seller, and seeks a corresponding asset transfer.
In Japan, past service obligations are typically transferred to the buyer’s plan. In some instances accrued benefits are paid out to employees as cash lump sums and the transferring employees join the buyer’s plan as new hires. In practice, the approach is a matter for negotiation between the buyer and seller. Certain short-term guarantees on future benefit levels may also be negotiated by the seller.
Termination indemnities (lump sum benefits payable on leaving the company) are another consideration. In some countries, including Italy and Mexico, upon closing the default position is that the buyer inherits the termination indemnity liability in respect of service with the seller. Other options are available but these will need to be discussed between the relevant parties in advance of completing the deal.
Mastering the challenges of complex pension and benefit requirements and liabilities will put you on the path to a profitable transaction. The outcome will be even better if the following steps are taken in advance of Day One:
In every M&A transaction, employees will want to know as soon as possible how their benefit programs will change or whether they will be the same as those provided in the past. Much will ride on these decisions; therefore, the analysis must quickly move from past to future - to the costs associated with the benefits strategy anticipated by the new organization. There are two main models to consider when establishing how your future benefits strategy will support the new business strategy going forward:
When constructing a timetable for benefits change, insured benefits – for example, life and medical insurance – should be a priority. A lack of continuing coverage after the deal is closed can create large costs if an employee should die or go on long-term disability while awaiting coverage. The buyer and seller should work together to ensure that appropriate coverage is put in place on Day One. Retirement plans, in contrast, can often be handled retrospectively, as long as all necessary agreements have been reached regarding past service obligations. The same goes for compensation and career programs; those can generally wait until after the closing as long as payroll dates are synchronized. This is not true of executive benefits. Buyers should lock in the leadership they need to effectively manage the business and achieve its strategic objectives by constructing appropriate retention, compensation and benefit packages.
Although the issues we have identified in cross-border transactions are challenging, dealmakers around the globe have demonstrated that these challenges are not insurmountable. Maximizing a deal’s success requires attention to due diligence, the ability to cope with geographic differences in employment conditions and, as we have counseled here, a solid understanding of the local market employment policies and regulations.
1, 2, 3 Thomson Reuters, Financial Advisors, Fourth Quarter 2008.
4 To learn more about the US issues, go to the special edition of Mercer's Retirement, Risk & Finance Perspective.
7 March 2008.TheLawyer.com, Section 75 Debts are Proving a Hard Nut to Crack for the Department of Work and Pensions.
Mastering pension and benefit issues beyond your borders
Adam Rosenberg, principal
+44 161 837 6556
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