Key Drivers for External Financing of Pension Liabilities Occupational Pension Schemes in Germany
In Germany pension commitments are traditionally structured as so called direct pension commitments. Under these direct pension commitments the sponsoring employer becomes the direct and sole debtor of the pension benefits. The sponsoring employer must accrue book reserves on his trade and tax balance sheets in a statutorily limited scope to mirror his future liabilities under the direct pension commitments (so called pension liabilities). Such Pension Liabilities have an alleviating effect on the sponsoring employer’s taxable profit and hence contribute to the financing of the pension benefits, that are payable from the sponsoring employer’s floating capital/cashflow.
Action Item A number of recent developments have triggered a reconsideration of the way pension commitments are financed in many German-based organizations. Business managers in Germany indeed have many reasons to investigate into ways of transferring or funding pension liabilities. • The sponsoring employer’s liabilities under direct pension commitments are unusual in an international context and qualify as unfunded liabilities under IFRS and US-GAAP. The higher these pension liabilities are, the bigger the concerns and the discomfort they tend to cause in M&A transactions involving multinationals. This is likely to impact the respective purchase price. In a worst case scenario, unfunded liabilities can even cause the complete cancellation of the transaction, because a bidder who runs its accounts according to international accounting standards often refuses to take on any unfunded liabilities. • As international accounting standards are becoming ever more important – not only in relation to transactions – a significant number of German organizations, in particular subsidiaries of international companies, are under business pressure to clean out and shorten their balance sheets by getting rid of their unfunded liabilities. • A further driver for the outsourcing of pension liabilities can result from the rating agencies’ treatment of pension liabilities as real debt capital. Hence, high pension liabilities potentially cause a disadvantageous equity ratio which, especially in the light of the Basel II framework, may result in aggravated refinancing conditions. Strategic objectives such as concentrating on core business areas, reducing administrative workload and costs (in respect of the pension scheme) or the intention to increase the attractiveness of the employer’s pension scheme for the beneficiaries can also be the drivers for an outsourcing of pension liabilities. • Finally, the newest reform of the German trade balance law, has led to a substantial increase of the amount to be accrued on the trade balance sheet as pension liabilities. This will show its effect for the first time in 2010. Many companies would like to eliminate this additional strain on the liabilities side of the German trade balance sheet. Options for Outsourcing or External Funding of Pension Liabilities Individual circumstances and objectives do matter There are numerous ways to accomplish an outsourcing or external funding of pension liabilities under German law. Finding the appropriate implementation structure requires a thorough examination of the individual circumstances and objectives of the respective organization. The content of the pension scheme to be restructured and the particular objectives that shall be met are of the highest importance. In practice, a solution tailored to meet the client’s needs and objectives often requires a combination of different measures. It is important to note that the sponsoring employer can generally not be legally released from his liabilities under the pension commitments. A release such as this is generally prohibited under particular provisions of the German Pensions Act. The employer remains liable at least subordinately. However, the structures described in here can trigger an economic release from pension liabilities. There are a range of structuring possibilities that include corporate law restructuring, (establishment of a so called pensioner company) and the use of re-insurances, as well as solutions that use an external pension fund or trust like structures. The latter two (pension funds and trust like structures) have emerged as the methods that most often meet the respective organization’s needs. “Real” Outsourcing of Liabilities via Transfer of Pension Liabilities to a Pension Fund One option to outsource pension liabilities is to change the financing method by replacing the direct pension commitment scheme with a pension fund scheme. A German pension fund is an independent legal entity, which is subject to supervision by the German financial markets regulator, but nevertheless has far reaching freedom with regards to its investment possibilities. Pension funds operate in the market with different tariffs, some of which calculate with mandatory insurance interest and return assumptions and others with market-related assumptions. Under a pension fund scheme, the beneficiaries claim pension benefits from the pension fund. After the transfer of the liabilities, the employer remains indirectly (subordinately) liable for the beneficiaries’ benefit claims. The employer continues to be obliged in case the pension fund is unable to fulfil the liabilities under the pension commitments given to the beneficiaries. As compensation for the transfer of liabilities, the employer is regularly requested to make a material one-off payment to the pension fund. To the extent pension liabilities are transferred to the pension fund, the sponsoring employer can dissolve accrued book reserves. Hence, the change of the scheme structure from a direct pension commitment plan into a pension fund scheme triggers the dissolution of the pension book reserves and thus the deletion of the unfunded liabilities from the employer’s balance sheet. Such dissolution may result in an increase of taxable income, however, the one-off payment to the fund may be deducted as operating expenses, provided the employer meets certain conditions. The legal structure of a pension fund scheme is as follows: Changing the structure from a direct pension commitment scheme into a pension fund scheme has been tax privileged by the German legislator. The employer’s one-off payment to the pension fund that is necessary to finance the beneficiaries’ past service entitlements is usually exempt from income tax for the beneficiaries under certain pre-requisites. The beneficiaries are thereby encouraged to agree to a transfer of their pension entitlements from their employer to the pension fund. In practice, a change of the scheme structure into a pension fund scheme is likely to impact the pension scheme structure as a whole. Hence, the beneficiaries’ consent is required. As a consequence, a transfer of pension liabilities to a pension fund requires comprehensive information of the affected beneficiaries as well as negotiations with the competent works councils. We therefore strongly recommend an open, timely and direct communication with the beneficiaries and their representatives with regard to all matters concerning the sensitive field of pensions to avoid the emergence of misunderstandings and mistrust. A further important point which must not be forgotten which regards a change of the scheme structured into a pension fund scheme is that future contributions are tax exempt pursuant to Section 3 No. 63 German Income Tax Act (Einkommenssteuergesetz, EStG) only up to an annual amount of 4 percent of the state pension scheme contribution ceiling (EUR 2,640 in 2010). If this contribution amount is not sufficient to finance the promised found an alternative solution must be found to finance benefits that are earned by work in the future (so called future services). “Virtual” Outsourcing of Liabilities via Set-up of Contractual Trust Arrangements (CTA) As an alternative to changing the scheme structure into a pension fund scheme, pension liabilities can be funded by setting up a so called Contractual Trust Arrangement (CTA). By establishing a CTA the employer creates plan assets under IAS 19 respectively SFAS 87, that can be netted off against the employer’s pension liabilities. This enables the employer to shorten his balance sheet and to eliminate the unwelcome unfunded liabilities. According to German GAAP as defined in the German Commercial Code (Handelsgesetzbuch, HGB) such netting off was not possible for a long time. The latest reform of German GAAP, however has introduced the possibility of netting off into German GAAP. To achieve the objective of balance sheet shortening, the employer irrevocably transfers assets to a separate legal entity (the trustee) that often has been established solely for the purposes of the CTA. This trustee is usually incorporated in the legal form of a registered association (eingetragener Verein). The assets must be expressly assigned to the purpose of funding and securing the fulfillment pension liabilities. These transferred assets must also be completely secured against the risk of the employer’s insolvency. This requires an additional security measure, often in form of a security trusteeship. Under international accounting standards the employer is entirely free in determining the scope and the kind of assets that are assigned to the purpose of funding the pension liabilities and which are transferred to the trustee. No minimum funding requirements or regular funding obligations apply to CTAs. Also CTAs are not subject to any investment restrictions. This makes the CTA a very flexible financing vehicle. Under the contribution of assets that are essential to operate the sponsor’s business is not allowed. Due to a special trust agreement between the employer and trustee the economic ownership of the transferred assets remains with the employer. Therefore, the transfer of the assets does not have an effect according to German tax accounting rules. The assets held in trust will remain on the employer’s tax accounts. The pension liabilities also remain with the sponsoring employer. The employer continues to be the direct debtor of the pension benefits. However, the employer can also be reimbursed by the trust for the amounts paid in fulfillment of the pension liabilities. The CTA may also be structured in a way that the trustee directly pays out pension benefits on behalf of the sponsor.In view of the intended impact on the employer’s balance sheet, the set-up of a CTA requires close cooperation and communication amongst the involved legal advisors, accountants and the tax authorities. We recommend to request a binding statement on the CTA’s tax effects from the tax authorities before any assets are transferred from the employer to the Trust, to avoid the uncovering of hidden reserves. Besides the financial effect, the almost unlimited flexibility is an advantage of the CTA. The legal structure of CTA is as follows:The set-up of a CTA is not subject to any works council co-determination rights. This is due to the fact that the creation of plan assets does not affect the rules of the pension scheme, especially the principles under which the benefits are allocated among the beneficiaries. By creating the CTA, the employer creates additional insolvency protection for the beneficiaries. He remains fully obliged under the direct pension commitments. Hence, the virtual transfer of the pension liabilities to the trustee does not affect the beneficiaries’ interests.