Defined benefit pensions: a manageable obstacle to success

With ever more DB pension schemes closing to accrual, private equity houses are finding more and more companies with investment potential where a DB pension arrangement still exists, but no longer serves to help recruit and retain staff. Finding an effective way to manage these DB schemes can open up a range of investments that private equity houses may not have previously considered due to perceptions of heightened risk.

The pensions market has developed a number of de-risking and liability management solutions for trustees and scheme sponsors, which are equally viable for private equity houses looking to manage any DB pensions attached to their portfolio.

For example, member options to amend their pension increases or transfer the value of their benefits to another arrangement have now become popular and can help reduce the size and volatility of the scheme liabilities.

A pension increase exchange (PIE) option can be presented to existing pensioners in bulk, or to individuals at the point of retirement. It allows them to exchange future annual increases above statutory minimums for a one-off uplift in pension now. The terms of exchange are typically set at 70-100% of the expected value of the increases given up, so the company should see a positive impact to the profit and loss account. The size of the gain depends on the member take-up rate for the option, which is typically around 25%. The exchange also reduces the company's exposure to two key risks facing most pension schemes – inflation and longevity.

An enhanced transfer value exercise (ETV) on the other hand encourages non-retired members with retained benefits in the scheme to take the "cash equivalent" value of their benefits and transfer them to another pension arrangement. Members may be offered an enhancement to the "cash equivalent" value to encourage them to transfer. The benefit of this type of exercise is principally a reduction in the liabilities retained by the scheme, and therefore greater certainty over the ultimate cost of the scheme. In some cases, depending on the level of enhancement, the transfers may also cost less than the corresponding accounting reserves. The scheme as a whole will also become less sensitive to changes in future expected investment returns at the longer terms, ie 20 years plus.

The insurance market for defined benefit pension liabilities is also very strong. Last year saw the highest level of bulk annuity business completed since 2008, with transactions worth around £7bn. Scheme sponsors can choose to "buy in" liabilities (where insurance policies matching the benefits to be paid remain in the name of the trustees) or "buy out" the liabilities (where the policies are transferred to individual members and the scheme sponsors obligations are terminated). More innovative products are also reaching the market; for example, bulk annuity contracts allowing for medical underwriting of individual members.

Anecdotal evidence suggests that a typical scheme could realise a saving of as much as 10% compared to standard bulk annuity rates. Features to ease cashflow issues are also available, for example bulk annuity contracts with deferred premiums, meaning that a scheme can lock into current insurance company terms while retaining its exposure to growth assets for a period of years.

Regulatory obstacles
Alongside these developments in the pensions market are developments in the regulatory framework, which could be seen as obstacles that private equity firms must overcome to maximise the value of deals involving pension liabilities. In particular, there is now increased focus on a company's willingness and ability to support the pension scheme. Typically, the transfer of ownership to a private equity house is likely to be viewed as a weakening of the covenant. In these situations, proactive trustees may seek some form of company guarantee (a legally binding promise to meet contribution requirements under certain circumstances), or additional security by way of a contingent asset (a significant asset that would transfer to the scheme in the event of employer insolvency).

Alternatively, trustees may look to secure an increase in the level of ongoing contributions to the scheme. A purchaser can seek to negotiate contribution requirements with the trustees before finalising the transaction, although any agreement would be up for review within three years, as part of the next formal valuation.

One further potential obstacle to successful deals in the near future is the compulsory equalisation of guaranteed minimum pensions (GMP). While it has been widely known for many years that GMPs will need to be equalised between men and women, a detailed method for doing so has yet to be agreed. With guidance from the Department for Work and Pensions expected later this year, it is likely that auditors will be expecting to see provisions made imminently. With an increase in liabilities of up to 5% on the cards, private equity houses will want to avoid having responsibility for a pension scheme at the point that a new provision is made, or the actual increase is implemented.

Overall, there are still significant issues for private equity houses in relation to defined benefit obligations, but pension liabilities are now more manageable than ever before and can be safely navigated. As always, the key to a successful deal lies in making sufficient allowance in the purchase price, which requires expert knowledge of what to look out for.

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