Historically defined benefit (DB) schemes were sometimes seen by corporate sponsors as financial burdens, but are now, increasingly, able to be considered as valuable assets in M&A negotiations (and more generally), thanks to improved funding positions and anticipated legislative and regulatory reforms.
What do these changes mean for trustees and pension scheme sponsors – and how should they be future-proofing their approach to pension scheme-management as a result?
From Value-Drag to Value-Add
For many years, most UK DB pension schemes were in the deficit doldrums and required ongoing cash contributions from sponsors. This created uncertainty and was generally undesirable for potential acquirers.
The landscape has shifted dramatically through sustained increases in gilt yields since 2022 coupled with, in many cases, steps taken to reduce risk. As such, many schemes are now in surplus – with UK government figures recently estimating an aggregate surplus of £160 billion on a low dependency basis.
There is also less risk (generally speaking) of funding levels deteriorating than there has been in previous decades. In general, most pension schemes are closed to new members and many to future accrual, with higher rates of hedging and investment strategies designed to protect funding position. This allows much greater certainty to be attributed to surplus today and excess return generation in future.
Legislative changes
The UK government has signalled support for surplus distribution prior to scheme wind-up (which is generally not possible now), citing the stronger financial position of DB schemes. To do this, it intends to enact new legislation and regulations in 2027, allowing companies earlier and easier access surplus funds. It expects this to stimulate UK economic growth through increased investment by DB scheme sponsors, while also accelerating tax revenues, as surplus refunds are taxed at 25 percent.
Implications for trustees and sponsors
The proposed legislation opens the door to the strategy of running-on pension schemes – allowing both access to 'day one' value from any existing surplus, plus an ongoing stream of cash flows, which could be valued in much the same way as operational cash flows are in an M&A context.
It also means that in the normal course of business, trustees are more likely to need to consider establishing a surplus release policy (as suggested by The Pensions Regulator's guidance) – or to expect to be approached by the sponsor with their preferred approach.
There are numerous considerations in establishing this policy. As a starting point, the balance of powers between trustees and companies in the scheme's Trust Deeds and Rules and the need for company-trustee agreement further lends itself to detailed negotiations.
Additionally, the company's risk appetite and creditworthiness play a role. Some sponsors (and acquirers) are willing and able to manage these long-term risks, while others consider them non-core, and would prefer to limit exposure. Additionally, some trustees will have concerns about the sponsor covenant that require more detailed consideration.
Alternative strategies
While the new legislation provides another avenue to access value – there are many well-established alternatives.
It remains common for trustees and sponsors to wish to transfer pensions risk to an insurance company which might lead to one-off surplus release.
Additionally, from an M&A perspective, many sellers still seek to remove pension schemes from their balance sheet before a sale, typically through insurance transactions. This has two benefits:
i) a well-brokered buy-in may achieve better pricing than the M&A pensions value adjustment, creating value arbitrage; and,
ii) the potential bidder pool for a business may be wider when pensions risk is already removed.
Additionally, there remains a lot of innovation in this market – with consolidators gathering momentum and trustees and sponsors watching with interest as to whether the Stagecoach / Aberdeen transaction was a one-off or might be replicated.
Expert discussion
Leaders from Aon's transaction and pension advisory teams sat down to discuss how UK DB schemes represent potential value opportunities in M&A situations and different strategies for unlocking that value.
This discussion can be viewed here
