Pension Provisions
Types of Pension Obligations
Pension provisions are established for specific pension obligations under which a company intends to grant future pension benefits to individual employees upon their reaching retirement age.
There are two types of pension obligations: A company pension can be granted by the company as a direct commitment (direct pension obligation), which in practice is likely the most common method of implementation. Alternatively, the company pension plan can also be provided through the involvement of another legal entity (indirect pension obligation, e.g., direct insurance policies, pension funds, or support funds).1
In the case of a direct pension obligation, the agreed-upon benefits are paid directly by the employer to the employee only upon the occurrence of the pension event. In contrast, indirect pension obligations typically result in contribution payments by the company beginning as early as the date the binding pension commitment is made to the employee, which end upon the occurrence of the pension event because the intermediary legal entity assumes responsibility for the pension benefits.
Accounting Treatment: Basis and Amount
Regardless of the implementation method, the pension obligation is related to the commercial sphere. In accordance with accounting standards, it is also reflected in the company’s external financial reporting. Under commercial law—with the exception of legacy commitments—direct pension obligations must be recognized as liabilities and are to be recorded as a provision for contingent liabilities in the amount of the expected benefit. Generally, it is assumed that the beneficiary earns their pension entitlement during their active employment with the company.
Consequently, the pension provision increases year after year until the pension becomes payable. These annual additions represent non-cash expenses in the respective period, the amount of which can be determined using various valuation methods (Projected Unit Credit Method, present value method, or partial value method). If there are assets that serve exclusively to settle liabilities arising from pension obligations (“plan assets”), these must be offset against the pension provision; in this case, only the net liability that the company must bear economically is shown on the balance sheet.
Under the German Commercial Code (HGB), contributions for indirect pension obligations constitute cash-based expenses in the period in which the premiums are paid by the company to the intermediary pension fund. The recognition of a pension reserve is generally not required for indirect pension obligations, provided the employer is not subject to a duty to make up the shortfall arising from subsidiary liability. A pension reserve may—but is not required to—be recognized in the amount of such a shortfall; there is a discretionary option to recognize this as a liability.
The recognition of pension provisions in the tax balance sheet is permitted only under Section 6a of the German Income Tax Act (EStG), which is subject to a number of special requirements under income tax law. International Financial Reporting Standards (IFRS) also contain extensive requirements for the recognition of pension obligations. Because IFRS is primarily relevant for capital market-oriented companies, but not for small and medium-sized enterprises (SMEs), the relevant standards will not be described here.
Challenges in the M&A Process
In the M&A process, the focus is typically on a potential funding shortfall. External accounting standards contain specific guidelines on how to measure pension provisions. These prescribed parameters can result in the amount of the provision reported on the balance sheet not corresponding to the actual benefit obligation that must be paid out when benefits become due. Such funding gaps, as well as liability risks and structuring options, are regularly the subject of discussion during contract negotiations.
In the case of SMEs, it is evident that many successors do not assume a pension commitment in favor of the former owner. The former owner’s retirement security may therefore be at risk if the sale price achieved is insufficient to cover his or her living expenses. Such a situation should therefore be addressed early on in succession planning.
A pension commitment can be interpreted economically as a loan from the employee to the employer. It can therefore generally be assumed that a pension provision replaces other interest-bearingdebt. When valuing a business, it is therefore important to ensure consistency in the derivation of financial surpluses, the various forms of debt financing, the calculation of the weighted average cost of capital, and, ultimately, the reconciliation to the equity value. It is also advisable to reflect existing funding shortfalls as a special item in the business valuation.