Infrastructure asset managers often find themselves facing complex pension issues. Due to the labour-intensive nature and histories of many companies, pension liabilities can be sizeable. In many industries, pension liabilities could represent a significant proportion, or in some cases exceed the value of, the company. This is particularly so in the electricity, telecoms and airport infrastructure sectors.
Lane Clark & Peacock (LCP) advises many companies, private equity owners and infrastructure asset managers on pension issues in Europe and further afield. Pension issues are particularly challenging when buying, refinancing or selling businesses, but with the right approach pension issues need not be deal-breakers. LCP has also seen companies walk away from deals when the true scale of the pensions risk has been identified and understood. Not surprisingly, owners and asset managers are becoming more involved in ongoing pensions decision-making processes.
The challenges associated with managing pension arrangements are growing and the cost of providing pensions is rising due to increased life expectancy in all regions. Falling bond yields and changes to legislation have recently pushed up costs further in many countries. Pension plan assets have also suffered from a decade of poor investment returns. To cap it all, regulators are taking a greater interest in pensions.
Owners and asset managers need to understand their pension risks; they need to be prepared for large movements in pension scheme liabilities over their investment time period. The need for specialist advice on pension issues is essential to effectively manage these risks and this advice is likely to provide good value for money. If faced with, say, over €100 million of pension liabilities, the cost of obtaining specialist advice is often insignificant compared to the liabilities and risk that might be taken on.
This article examines the pension risks that owners and asset managers need to consider when making investments; it also takes a look at steps that should be considered when managing assets post-acquisition; it also addresses a number of factors to consider when selling assets.
PENSIONS ISSUES FOR POTENTIAL PURCHASERS
Potential purchasers should consider pensions issues at an early stage. A high-level pension review at the outset can pick up potential pensions issues at limited expense, and the earlier the key issues are identified, the more time there is to find potential solutions. There are a number of areas to examine – below are six of the most important for asset managers:
The first key area is to understand the type of scheme sponsored by the target company and its financial status. This will mean digging far deeper than seeing what is presented in company accounts and information memoranda. Pension liabilities in company accounts tend to give an artificial, and flattering, picture in current conditions relative to a risk-free measure. In many European countries, accounting liabilities are normally calculated based on AA-rated corporate bond yields.
However, pension liabilities are often calculated quite differently for the purpose of determining cash-funding requirements. In the UK for example, the amount for cash-funding purposes has typically ranged from 110 percent to 150 percent of the accounting liabilities over the last five years.
Potential purchasers should therefore find out what the liabilities are on other frequently used methods and assumptions. Purchase-price adjustments should be considered to offset these higher liabilities. These could be calculated on methods used for cash funding purposes, ‘risk-free’ valuations or possibly the cost of securing liabilities with an insurer. If not available or not current, estimates could be made by specialist pension advisers.
Potential purchasers should also check whether the valuation assumptions are realistic. The assumption used to discount long-distant future-benefit payments to the present value is a key consideration. Other key assumptions include life expectancy, price inflation, salary increases, employee turnover and pension increases. If these assumptions are not realistic then pension liabilities could be understated.
LIABILITIES BEING TRANSFERRED
It is essential to understand what liabilities may be transferred. Will it just be those for existing employees or those for former employees and pensioners? Many infrastructure companies will have had long histories and may have material liabilities for former employees.
Potential purchasers should identify whether it is possible for sellers to retain responsibility for pension liabilities, particularly if the transaction will be an asset sale rather than share purchase. In some cases national governments may have, or be able to take on, responsibility.
For example, in October 2010 the UK High Court ruled that BT’s pension liabilities could be met by the government in the event BT became insolvent. In November 2010, it was reported that Portugal Telecom was to seeking to transfer some of its pension liabilities to the state. If a company knows that the state is able to meet pension liabilities, this potentially gives greater freedom when assessing the pension risks attached to a deal.
The seller may want a higher sale price if it retains liabilities. However, the purchaser may then find itself with significantly less pensions risk and agree that this is a price worth paying.
It is essential to understand the nature of the pension arrangements. Is it a defined-benefit plan offered to all employees? If it is still open to new entrants and continued-benefit accrual then there will be further build-up of the pension liabilities and risk going forward.
Potential purchasers will need to identify whether the long-term cost of pension accrual is adequately reflected in EBITDA numbers. Potential purchasers will want to consider if they can make any changes to benefits post-acquisition, such as controlling risks or even reducing costs. Traditionally, many companies have provided pensions linked to final salary at retirement, but over the last 15 years many companies have moved away from these arrangements to provide alternative arrangements where more, or all, of the risk is met by employees.
To help assess scope for change, potential purchasers should find out how the pensions arrangements compare with those offered by their competitors. In some industries, there may be a limited amount of competitors, making comparisons a difficult exercise; in such a case, understanding general market practice will be important. It is of vital importance to consider the impact on industrial relations and the influence of trade unions.
Making change will be far from straightforward and will depend on the extent of employee relations within a given company. Infrastructure companies often have very large, loyal and experienced workforces, and employees may regard their pension arrangements as one of the most important parts of their employment package and, as such, they may be reluctant to see changes made.
Trade unions and works councils need to be consulted and are generally expected to react strongly to changes. Some employees may even have contractual rights to receive a certain type of pension benefit. However this does not mean change is impossible. Companies across Europe have successfully made changes to pension plans where these have been communicated effectively, or combined with improvements to other pay, benefits or employment terms.
Some companies may provide defined-contribution plans. In many cases, employees will be taking the investment risk, however they are not risk-free for employers in all countries. In countries such as Belgium, Germany, the Netherlands and Switzerland, defined contribution plans may have various forms of guarantee, including investment-return guarantees; the market conditions in 2009 and 2010 have resulted in a number of pension funds now having insufficient assets to cover the cost of these guarantees.
Potential purchasers need to look at how the pension arrangements are funded: are they backed by a portfolio of investments, or are they unfunded with benefits paid out of the company cash flow as they fall due? Unfunded pension arrangements are often found in Germany and Sweden and, in respect of early-retirement arrangements or leaving-service plans, in Belgium, France, Portugal and Spain.
If they are funded, a potential purchaser needs to understand how the assets are invested and the investment risks to which they would be exposed. Potential purchasers should request copies of pension plan accounts, investment policies and recent investment reports.
Many pension plans, especially in Ireland, North America and the UK, have significant exposure to equity markets, which means such asset allocations will leave shareholders exposed to equity market risk. In other countries, or where pension plans are mature, plans may have significant exposure to bond markets. These are often regarded as less risky investments but can still leave asset managers with un-hedged interest rate duration, inflation and longevity risks. Some plans may even have hedging arrangements in place to deal with these risks. Potential purchasers will need to understand the nature of the arrangements and the actual impact on investment risks.
Potential purchasers need to consider what impact the investment strategy could have on any future pension deficit. Even if equities outperform, there is a risk that pension deficits could increase if long-term inflation rises and the yield on government bonds falls.
Any increase in the deficit is likely to mean more cash from the company to make up the shortfall. Potential purchasers need to assess the potential range of deficit outcomes over the lifetime of their planned investment. They should also assess how much downside they are prepared to tolerate.
PENSION REGULATORY REGIMES
Due diligence should also cover the local regulatory regime. This will cover the local funding rules and the powers that employers have (or do not have) to make decisions in each territory.
In the UK, pension arrangements are set up under trust. Trustees are appointed and they manage plan investments and make funding decisions in consultation with employers. The level of power wielded by trustees has increased in recent years. Trustees are now seen as powerful creditors with the ability to exert significant leverage over the company, especially in M&A situations.
LCP has seen many trustees respond positively to transactions which are shown to support a company’s long-term growth prospects. Since there are no prescribed minimum funding rules in the UK, pension funding is now a matter of often complex negotiations with trustees. Pre-agreeing a pension-contribution schedule is usually one of the conditions for purchasing a business. Trustees may demand some form of contingent asset, such as parent-company guarantees or letters of credit, in order to provide additional security.
In some cases these contingent assets are being used as alternatives to cash funding and potential acquirers should consider their use if it helps bring trustees onside. In continental Europe, foundation boards are more common. Employers may have more of a say in how the pension fund is run. In the Netherlands and Switzerland there are prescribed funding rules meaning employers cannot negotiate the level of contributions. However, by having seats on the foundation board, employers in these countries can influence the investment strategy.
Potential purchasers need to be aware of the rules governing how they can recover pension costs from consumers. Local industry regulators may set out rules that prescribe the extent to which customers or shareholders must pay for pension costs; these vary by country and even by sector.
The UK has a number of industry regulators, with each taking a different approach to the treatment of pension costs, some of which are detailed as follows:
• Ofgem, which regulates electricity and gas distribution companies in the UK, has introduced new rules about the amount of pension costs that can be passed onto consumers from 2010 to 2015.
Companies will only be able to recover the cost of deficit contributions if they are deemed to be ‘efficient’. Companies have also been given incentives to reduce pension costs.
• Ofwat allows water companies to recover broadly 50 percent of deficit contributions from consumers.
• Postcomm, the Royal Mail watchdog, has developed a sharing mechanism to spread ongoing contributions between customers and shareholders.
The differences also spread into other countries. Therefore, potential investors need to fully understand the extent to which the costs of meeting future deficits and pension costs will fall on them as shareholders rather than the company’s customers.
MANAGING ASSETS POST-ACQUISITION–BE INVOLVED
Once an investment is made, asset managers need to consider how the pensions risk will be managed going forward. At the very least, all of the issues identified during the purchase should be addressed, and asset managers are increasingly involved in pensions funding and investment-strategy decisions.
Asset managers should also be kept informed of any factors that could have a significant impact on pension costs (for example, regulatory developments, trends in market practice, changes to actuarial assumptions and market movements). This can often be provided in annual board reports or more frequently where the pensions risk is material.
One of the most important considerations is the level of cash that needs to be paid into pension schemes. A long-term asset manager, with a time horizon extending beyond more than five years, may be prepared to take an equally long-term view on pensions. In this case, the asset manager may hope that plan assets grow at a faster rate than plan liabilities, and that over time the cash calls to fund pension plans will even out.
However, this cannot be guaranteed as short-term volatility in equity markets can often lead to sudden calls for large amounts of cash contributions.
Asset managers have to decide if they can tolerate making up shortfalls over the period of their investment. They should ask themselves what level of investment risk they are prepared to accept. They should also consider what they would do under adverse market movements. More companies are looking at hedging strategies and increased diversification to provide protection in these scenarios.
Investment-strategy decisions are normally made by pension fund boards; in countries such as Ireland, the Netherlands, Switzerland and the UK, these are independent from the employer. If investment risk is a concern, asset managers should find out the extent to which they can influence investment decisions. In some cases, the pension fund board will consult with the employer on all investment-policy decisions and the employer can provide input for this process.
A corporate pension committee, whose role is to monitor all key pension risks from a corporate perspective, is independent from the pension fund boards and will often suggest strategies for local pension fund boards to consider. A committee would typically consist of senior company management; often those with finance, treasury, HR or legal roles. Some employers will include some non-executive directors or shareholder representatives on these committees, especially when dealing with strategic issues such as investment policy.
SELLING INVESTMENTS–BE PREPARED
Asset managers will, at some point in the future, want to realise their investment. The sale price could significantly depend on the financial health of the pension scheme at that time.
If pension provision was an issue for an asset manager as a buyer, it may be even more of a challenge when it assumes the role of vendor. Sellers should plan ahead and anticipate the questions that a potential purchaser is likely to ask. Providing potential purchasers with clarity on the pension arrangements can help achieve an optimal outcome.
Sellers should consider whether they can make any changes to the arrangements before a sale process starts. For example, if a seller is able to implement difficult benefit changes or successfully de-risk the plan’s investments, potential purchasers may enjoy additional comfort that the plan has been well managed. This means a buyer would not need to make difficult pensions decisions immediately if it were to buy the company. As a result, the buyer may then be more willing to take on the pension liabilities.
This chapter has set out some of the pension issues that asset managers should consider when purchasing, managing and selling infrastructure assets. Pension issues can be very complex and the details differ greatly from country to country, and they also vary considerably from company to company. The approach adopted for one company in a particular industry can be very different from a similar size of company in another industry or in another country.
Colin Haines is a partner in the corporate and international practices at Lane Clark & Peacock, a London-based pensions consultancy.
This article is an extract from the PEI Media specialist publication ‘Best Practice in Infrastructure Asset Management’ ©(see www.peimedia.com/publications).
Large pension liabilities
Many state-run, public and/or privately owned infrastructure companies have billions of pension liabilities. By way of illustration, the following examples detail the extent to which these liabilities are evident in the infrastructure industry:
• The 14 UK electricity distribution network operators had a combined pensions deficit of £2.6 billion as at September 2009 (source: Ofgem).
• National Grid, the international gas and energy company, disclosed total UK and US pension and other post-retirement obligations of £22 billion in its 2010 accounts.
• NATS, the UK’s major air traffic services provider, disclosed pension obligations of £3 billion in its 2010 accounts.
• Ferrovial, the Spain-headquartered transport infrastructure operator, disclosed global pension obligations of €3.5 billion in its 2009 accounts.
• Vattenfall, the Swedish power company, disclosed total Swedish, German and Dutch pension obligations of SEK39 billion (approximately €4 billion) in its 2009 accounts.
• France Telecom disclosed total global pension liabilities (including early-retirement plans) in France, the UK and Poland of €2 billion in its 2009 accounts.
Any deal involving these or similar organisations, or their subsidiaries, is likely to have significant pensions risk. In all cases these are liabilities shown in their last set of published accounts (or other publicly available information) for reporting purposes. As discussed in this article, the value of the pension liabilities for other purposes could be very different from these numbers.