Merger and acquisition (M&A) transactions that involvedefined-benefit pension plans can be tricky fortwo reasons: First, due diligence and pricing the risk associatedwith the plan can be difficult. And second, managing the plan afterthe transaction can be complicated.

For many CFOs, the optimal answer would be to eliminate the planto avoid dealing with a long-term, volatile liability on the books;distracting and often complicated plan administration; and apotential cash drain for the organization.

Over the past 30 years, many businesses have moved away from thetraditional defined-benefit pension plan in favor of 401(k)-styledefined-contribution retirement plans. But just because a companythat is being acquired is no longer offering pension benefitsdoesn't mean that they don't still own pension plan liabilities inthe form of benefits that they are paying to current, or will payto future, retirees.

Many companies moved away from pension plans due tovolatility in balance sheet liabilities, P&L expense, and cashrequirements. Pension liabilities behave very similarly tolong-term bonds, with a series of expected cash flows that could bepayable for decades. The liability is simply the present value ofthe future benefit payments, discounted back to today usinghigh-quality corporate bond yields (or variations of those yieldsdepending on the measurement). These liabilities are backed byassets in a protected trust.

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

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

Terminating the Plan

The easiest way for a company to relieve itself of theuncertainty and potential liability of a pension plan is toterminate it. Terminating a plan typically involves offeringparticipants in the plan a cash-out of their annuity benefits and,for those that don't take the cash-out, transferring the remainingbenefits to an insurer to take on the liability and responsibilityto pay those benefits when due.

While that may seem straightforward, the termination processitself is prescribed by government regulations. These regulationsessentially mean that the termination is going to take anywherefrom 12 to 24 months to complete, and will involve various noticesto participants, including a detailed benefit statement showing howbenefits are calculated, as well as filings with governmententities and, eventually, audits.

Successfully terminating a plan requires preparation. This meanscompiling data (which can be hard to come by), ensuring planadministration compliance (which can be tricky if there areissues), and funding the plan sufficiently (which can be costly andpotentially risky).

Given that terminating a pension plan is lengthy process that isunlikely 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 isacquiring so that, first, the plan doesn't cause problems for theM&A transaction itself, and second, it can eventually beterminated?

Proper Due Diligence

Typically, buyers will rely on the seller's documentation toassess the state of the pension plan. It is critical that the buyerand its representatives conduct a thorough due diligence review ofthose materials. Key considerations include answering thesequestions:

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

Funding and Risk Management

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

Taking on a pension deficit is akin to adding more corporatedebt, and the borrowing cost for many companies is lower than theeffective cost of maintaining a pension deficit, which for mostplans today is 7 to 8 percent, or more. Companies can therefore payoff "expensive" and volatile pension "debt" with low-cost, andpredictable, regular corporate debt. This is especially true intoday's low interest rate environment.

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

Data and Plan Administration

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

Having an independent professional review the plan documentation(e.g., formal plan document, summary plan description, amendmentsand resolutions, forms) is a good first step. Depending on theoutcome of the review, filing for certain corrections may benecessary. This is a step that cannot be overlooked withoutjeopardizing the eventual success of a plan termination.

See also:

• The Importance of a Treasury AcquisitionStrategy
• 5 Drivers of Success in M&A
• Risk Management Pitfalls in Mergers andAcquisitions

Another aspect of data management that can be challenging afteran M&A transaction is the imperative that the right data becollected, especially on vested terminated participants (people whohave left employment at the sponsoring company but are still owed abenefit from the plan that will be paid in the future). Backup datathat is used to determine accrued benefits can sometimes be hard tocome by, and it will likely get harder and harder to find overtime, once the M&A transaction is complete. In addition to theindicative benefit information, collecting information likeaddresses, job title/function, union/salary indicators, etc. willhelp with the termination.

An Eye on the Endgame

Pension plans can be problematic in M&A transactions if notdealt with properly. With an eye toward the endgame, treasury andfinance professionals can take meaningful steps to ensure that thepension liabilities an acquisition is bringing on board do notbecome a sore spot down the road.

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

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

From: BenefitsPro