When one company acquires another, the acquired company’s pension obligations pose a serious hurdle. This is not only the case with large M&A transactions, such as the recent deal between GM and PSA.
According to experts, the assessment of pension provisions is particularly important when buying and selling medium-sized companies. This is partly because pension plans are often complicated or poorly structured. For example, not everyone knows that the amount of the pension provision to be recognized on the balance sheet must be recalculated as of each balance sheet date.
On the other hand, low interest rates are a sensitive issue. A study by Commerzbank revealed that small and medium-sized enterprises, in particular, face the risk of enormous shortfalls in their pension provisions due to low interest rates. This is especially true when insufficient assets have been set aside to cover pension commitments.
According to the study, half of all small and medium-sized enterprises with annual revenue ranging from zero to more than 50 million euros have entered into obligations toward their employees—yet more than half of these obligations are already inadequately covered by capital. According to the study, only 45 percent of the companies surveyed have set aside at least 75 percent of the required amount. By comparison, at 18 percent of the companies, less than one-fifth of the pension commitments are secured by provisions. For another 16 percent of the companies, this applies to less than 50 percent of the commitments.
The study also illustrates the scale of the actual amounts involved: At one in five companies, pension liabilities total more than one million euros.
Further figures illustrate the threat this issue poses to balance sheets. Today, a pension commitment of 100 euros for a 35-year-old is valued at a provision of 2,600 euros—in five years, that figure would already be 8,100 euros, and the trend is set to continue rising. No wonder, then, that rising pension shortfalls have already led to breaches of covenants in loan agreements.
The problem here is the extreme decline in yields. The logic is this: the higher the interest rate, the less money needs to be set aside for commitments that won’t be due for decades. This discount rate currently stands at around 4.3 percent. Actual returns, by contrast, are close to or even below zero. By 2021, however, this discount rate will fall to 2.06 percent. This alone will cause the funding ratio to decline by an average of 35 percent in mathematical terms.
The form of the acquisition also sets the tone when it comes to pension liabilities. Most commonly, the buyer acquires the legal entity as such and thereby assumes all pension obligations (share purchase/share deal). From the perspective of corporate pension plans, this type of acquisition is actually the simplest. However, this does not necessarily apply to corporate group structures, as such groups often use external pension providers or have established a so-called Contractual Trust Agreement (CTA). Specifically: In a CTA, a separate trust company is established to manage the pensions. If the acquirer wishes to continue using the CTA, permission from the financial services provider is required.
Unlike a share deal, in an asset deal, current pension recipients and the pension provisions for former employees remain with the seller. Thus, at the time of purchase, only the pension obligations for active employees—that is, the employees who will also work for the new company—are transferred. Under the Works Constitution Act, all employer benefits—including the company pension plan—must not be reduced for a period of at least one year.
