When Your Deal Involves a Pension

Corporate deals abound perhaps like never before. Mergers, acquisitions, consolidations -- call them what you will. They're still deals and they involve pensions, sometimes frozen, more often than you think. If you are the acquirer in any of these transactions, it would not be at all surprising to find that your team is giving these pensions were getting shorter shrift than they deserve.

Why?

More than most other elements of a corporate transaction, the costs of sponsoring a pension plan (single-employer) or being a participating employer in one (multiemployer) are both volatile and perhaps a bit out of your control. On the surface, that's bad. And, a significant problem is that traditional due diligence does not address this.

What do I mean by that? There are plenty of firms out there that perform due diligence in deals. On the financial side of this, the work is typically done by large accounting firms and their consulting arms or by the larger, traditional, multi-service consulting firms. What I have seen, and I have by no means seen everything, tends to be a fairly standard report with numbers filled in. It often relies a lot on the past and tends to assume that the past will be reflective of the future. For many of those future costs, that's probably not a horrible assumption. For pensions, unfortunately, it often is.

You see, whether you are focused on cash or on financial accounting, the amount of your future costs is dependent on rules. The rules are complex and they do not lend themselves to cost stability. Today, estimating what those costs will be is not easy. Doing so under a variety of economic scenarios is more complex and likely more expensive. Developing strategies to control those future costs adds even more difficulty and even more cost. It also takes a long time. And, of course, you are never able to work with current or perfect data. In the future, it will be much simpler. At least that sounds nice, but our predictions about the future are often wrong.

The future is here. It's here today.

Everything I said above that was difficult and expensive and more difficult and more expensive and takes a long time -- it doesn't have to.

We don't need great data. We don't need to bother your staff. We can move at the speed of deals. And it won't break the bank.

That future you were hoping for -- it's here now.

Focusing on the Pension Part of the Deal

Let's suppose you're on the finance side of a business. That business is buying a company and you learn that the company that you are acquiring has one or more defined benefit (including cash balance) pension plans. What do you do now?

Pension plans and the finances associated with them are among the most confusing and misunderstood elements of a deal like this.The rules are unnecessarily complex and are often misunderstood even by people that you might be inclined to engage as experts. Cash flow requirements do not align well with financial accounting charges and not knowing the right questions to ask could seriously impede your ability to get the answers that you need.

So, how can I help?

Among the really nice things about pension plans is the amount of information that is publicly available on each of them. You see, in its infinite wisdom, Congress and the agencies that Congress has entrusted to regulate pensions have deemed that a myriad of such information has to be disclosed every year for each plan. In unknowing hands, that information is just that -- information. In the right hands, however, it's a veritable goldmine.

As a senior finance person, what do you need to do?

1. Identify all of the plans that you might be (will be) acquiring.
2. Identify what measures are important to you (e.g., cash flow, financial accounting expense, government disclosures, volatility, loan covenants).
3. Identify your constraints (e.g., available cash to use for pensions, funded status triggers to loan covenants).
4. Identify your goals with regard to the plans.

Notice that I didn't mention plan documents, participant census data, plan asset statements, or anything else that you thought you needed to provide. This is where that goldmine comes in.

I call your attention to a recent situation where we had just the information in 1. through 4. above. The goals were fairly simple and included roughly these:

• Help us to understand the amount of cash necessary to pay for the plan(s),
• Tell us what is not being done optimally, and 
• Help us to find ways to optimize these plans on a path to termination.

Our client now has a 10-year forecast of cash flow requirements under multiple scenarios. They understand what has not been done optimally over the last 10 years or so. And, they now have a strategy all set to go so that when they do pull the trigger and finish their deal, they'll be putting their pension dollars to optimal use.

This is a place where off-the-shelf, cookie-cutter solutions don't work. Every plan is different. Every plan has different thresholds. Every company is different. Every company has different resources.

But what makes every company the same is that every company needs a solution that is customized to their situation.

Why Due Diligence Should be Like a Home Inspection

When you buy a house, even though you think of it as a home, it's also a long-term investment. Both from the standpoint of being a place to live and from a financial standpoint, you want everything to be right. Similarly, and even more so, when your company is buying another company, you want everything to be right. While you would like for everyone on both sides of the deal to be happy, it's purely a financial transaction.

If you were hiring a home inspector, how would you go about it? If you were prudent, I think you would want references not of how an inspector wrote a nice report, but about problems that he had found that either resulted in purchase price adjustments, things getting fixed before the deal closed, or even killed a deal. The alternative is that you get a nice guy who doesn't want to stir the pot and cause problems. He won't cause problems, but you will get stuck with the problems.

Due diligence when doing a corporate acquisition should be the same. Unfortunately, oftentimes, it is not.

Companies about to do an acquisition usually (in my experience) do not go through the same level of prudence in choosing their external partners for their due diligence team. So often, it consists of their regular accounting, tax, and legal advisers. Some of them may be excellent, but some may be in a comfort zone with respect to the company. They want the deal to go through. They don't want to be a troublemaker.

If you were to ask me whether I can be a due diligence "troublemaker" or not, that would be easy.

• In one situation, a client was seeking to buy a company of similar size. My review caused me to tell them that the benefit and compensation plans were significantly undervalued and that their true cost was much higher. My client changed their offer. They were not the winning bidder. The winning bidder didn't win either; the deal put them out of business.
• In another, a SERP attached to an employment agreement was worded very strangely. The seller said that it was the same thing that they had given their previous CEO. It sure was a good thing that somebody put pencil to paper, so to speak, to determine the cost of a change-in-control. Once the deal is done, there is not much leverage to go back and negotiate.

So, which home inspector are you going to engage? Who do you want to have performing your due diligence?

M&A Post McCutchen

Yesterday, I wrote about US Airways v. McCutchen. Today, I consider another practical application.

For those who didn't read yesterday's post or have already forgotten, McCutchen was clear in telling us that in the case of employee benefit plans, unambiguous plan provisions are controlling. What we also learn is that where plan provisions are ambiguous, well, we don't know exactly what we learned.

Now, let's consider the M&A world. Typically, when one organization is looking at buying another, a due diligence process starts. The acquiring company and its representatives (attorneys, accountants, consultants, etc) review documents, properties, and virtually everything else of any value that the potential acquisition may have. Typically, among the last of those elements to be reviewed are those that may fall under human resources, among them compensation and benefits programs.

Let's go back to McCutchen. Suppose the proposed deal is a stock sale, one in which the acquirer purchases the assets and liabilities of the other company. Among those liabilities are any resulting from benefits and compensation programs. Suppose one of the plans has terms that are vague. Further suppose that there is no particular documentation of the interpretation of those vague terms.

In my experience, representations and warranties frequently do not protect against such an occurrence. Consider a defined benefit pension plan. If the acquiring company has the opportunity to review all the documents and does, but in the case of this plan spends its time reviewing the results of actuarial calculations, what happens if the actuary is taking a reasonable, but incorrect interpretation of vague plan provisions. Perhaps the interpretation is based on the explanation of a benefits manager who retired years ago. Perhaps there is little if any documentation.

In a post-McCutchen world, this could be problematic. Perhaps the plan's obligations are larger than the acquirer has reason to know.

How can the acquiring company deal with this? During due diligence, review the plan provisions side-by-side with determinations of benefits. If every provision seems clear and the benefits determinations seem to confirm this, then things are probably just fine. If they are not, take particular care before the deal is done.

Again, typically, this sort of review is done by attorneys and accountants. Typically, neither has any experience with plan administration and often, neither has experience with actual determination of benefits. Ask an expert for help.

HR Issues in an M&A World

Do you work for a company that acquires other companies? Are you involved in the due diligence process? If so, I'd bet that you have encountered all sorts of outsiders during the process:

• Attorneys
• Accountants
• Investment Bankers
• IT Consultants

How about actuaries and HR consultants? If you've seen them, you might be in the minority. If they get called in at all, it's usually in the last day or two before a deal closes. Then, because they didn't find much in their limited time, they don't get used next time.

The other people that I mentioned above don't find everything. Their views are biased by their experiences. They tend to miss the things that they don't deal with every day.

Here is a short list of things that I have seen over the years that have been missed by the usual suspects:

• A poorly designed SERP that was due to pay out hundreds of billions of dollars to a single person upon change in control. The accountants missed it. The attorneys missed it.
• A valuation of retiree medical benefits that understated obligations by more than $25 million in a roughly $100 million deal. The accountants looked at the actuarial assumptions that they are familiar with. They missed a few biggies.
• 401(k) plans with lots of outstanding loans that could only be repaid by payroll deduction from the plan sponsor. What happened? Dozens of employees unknowingly defaulted on their plan loans resulting in adverse taxable events. The attorneys didn't look for administrative issues.
• A defined benefit plan that had less plan assets than 12 months of upcoming benefit payments, but no minimum required contributions. Nobody focused on this one.
• An acquisition that had a higher-paid employee group than the rest of the company and a much more generous retirement benefit structure. Everybody ignored this one, and in fact, since this was a top-secret acquisition, nobody in HR or HR Legal even new that this acquisition had happened until it was too late to properly assimilate this company's benefits into the corporate structure. A few million dollars later, this problem got fixed.

So, what's the message? Engage independent HR consultants and actuaries in the due diligence process. Compared to other advisers, their cost may be low, and they might not find anything, but if they do, it could save you a lot of money.