Figures released by the ONS at the end of last year show that active membership of defined benefit pension schemes in the private sector has continued to decline. Only 1.9 million people in the UK are now accruing this type of benefit, and around 60% of those individuals are in schemes that are closed to new members. Clearly, employers are not keen on continuing to offer their employees a benefit promise, the cost of which is impossible to predict. However, despite the decline of these types of benefits—and as the private equity industry knows well—a lot of businesses in the UK are dealing with historic underfunded defined benefit pension liabilities.
Given the investment that some of these pension funds make in private equity themselves, they are not always bad news to the industry. However, it is understandable why, when due diligence reveals that a potential investment carries with it a defined benefit pension liability, this is not seen as good news. Investing in a business that has significant or open-ended pensions liabilities is never going to make the deal more straightforward. The would-be buyer or investor is also not helped, for example, by the protections that have been put in place over time for members’ benefits (such as stricter funding measures, inflation-linked increases, and the powers of the Pensions Regulator), by changing demographics (crucially, strengthening mortality) or by the ‘super priority’ that can now be given to such liabilities (following a Court of Appeal judgment at the end of 2011).
Three key approaches can be taken when this type of liability is part of the equation: walk away from the investment, seek to structure the transaction so that the liability is ring-fenced, or take on that liability. The third option, taking on the liability, may seem like something to avoid at all costs, but taking this approach could also be seen as a missed opportunity to gain a material price reduction given the unpredictability of such a liability. This opportunity stems from the various measures by which pension liabilities are valued. If a buyer or investor can extract a large price reduction on the basis of a conservative valuation (which puts the pension liabilities at a very high value), it should be the case that the ultimate cost of funding the benefits under that pension scheme over the longer term will be less than the price reduction negotiated. This is because, over time, the assets of the pension scheme should receive investment growth (which will not be taken into account by the conservative valuation measure used to secure the price reduction). This is therefore something to consider in conjunction with advisers before walking away/seeking to ring-fence the risk when a defined benefit pension scheme is involved.