THE BUSINESS SCHOOL FOR FINANCIAL MARKETS

The conditions under which pension schemes merge is an important issue that has been underresearched. Mergers can affect the strength of the sponsor’s covenant and the balance of power between the trustees and the sponsor, as well as the scheme funding ratio. This paper sets out two financial criteria to be met by any pension scheme merger:no profit or loss on merging with another scheme; and no dilution of the funding ratio. After defining a merger basis for valuing the assets and liabilities, and allowing for adjustments to the funding ratio via side receipts and payments; it is shown that, whether or not these criteria are met, depends on the state of the financial markets. Author: Charles Sutcliffe Professor of Finance, ISMA Centre, The University of Reading, Whiteknights Park, Reading RG6 6BA, United Kingdom, Email: C.M.S.Sutcliffe@rdg.ac. uk Acknowledgement The author wishes to thank Bill Trythall and Maureen Merrison for their very helpful comments on an earlier draft of this paper. ISMA Centre Discussion Papers in Finance 2005-09 Throughout this paper, merger refers to any situation where two defined benefit pension schemes pool their 1 assets and liabilities without any ring fencing or special sections, and active members of the transferring scheme receive past service credits. This paper does not consider the administrative difficulties of merging schemes, and the problems of replicating the benefit structures of both sets of pensioners and deferred pensioners within a single scheme. Nor does this paper address the question of choosing a strike date on which the assets and liabilities are valued. The one-off transactions costs, as well as any long run cost savings generated by merging schemes, are not considered. There are a number of reasons for the merger of defined benefit pension schemes:2 • a merger between two companies, followed shortly afterwards by the merger of their pension schemes; • one company takes over another (and then merges the pension schemes); • two schemes, previously run by the same employer, are combined; • a group of employees, all working for the same employer, is transferred from one company pension scheme to another. [Strictly this is a bulk transfer, but the economic principles are similar. ] • a scheme merger may result from a company either joining a multi-employer scheme, or transferring an additional group of employees into a multi-employer scheme. In 2005 the National Association of Pension Funds was urging small schemes to form multi-employer schemes. If there is a substantial difference in size between the two schemes, any loss or cross-subsidy from the large 3 scheme on the merger may be trivial, and their trustees may be prepared to overlook such matters. 1 Copyright © 2005 Sutcliffe It is increasingly recognized that, when taking over, merging with, or selling a company; careful consideration needs to be given to the pension schemes of the companies concerned . For 1 example, in 2004 the takeover bids for WH Smith by Permira, and for Marks & Spencer by Philip Green foundered on problems concerning the pension schemes, as did the bid by Duke Street Capital for Uniq in 2005; while the Santander Central Hispano bid for Abbey National only succeeded after they agreed to inject €950 million into the Abbey National pension scheme. Since pension schemes can involve very large amounts of money, and the value of the liabilities may be many times greater than the value of the employer; dealing with the pension schemes can be an important aspect of the merger terms. Surprisingly, the effects of pension schemes on company mergers or takeovers has only recently assumed importance, and little attention has previously been given to this matter by researchers. This paper addresses the problem of setting the terms under which two defined benefit schemes merge . There is considerable scope for variation in these terms, and the objective adopted here 2 is to devise conditions under which (a) the value of the assets and liabilities of the target company’s pension scheme are in balance, i.e. there is no profit or loss on taking over another scheme; and (b) there is no transfer of value from the members of one scheme to those of another, i.e. the merger does not involve a cross-subsidy. 3 There are many complicated legal restrictions on the operation of pension schemes in most countries, and these rules are subject to constant revision. The purpose of this paper is to address the fundamental economic issues of profit or loss and cross-subsidy, and the circumstances in which such effects can be avoided. In this context, the underlying legal framework is not considered in any depth, and some proposals may require legal changes in some countries. Recent legislation in the UK has facilitated the economic approach adopted in this paper. For expositional simplicity let firms A and B merge to form firm C, and let scheme A (the receiving scheme) be the pension scheme to which all of the members of pension scheme B (the ISMA Centre Discussion Papers in Finance 2005-09 If the trust deed and rules do not give them the power to initiate a winding-up, the trustees can make 4 representations to the Pensions Regulator for the scheme to be wound up. From 11 June 2003, the liabilities th on such a wind-up have been valued on a full buyout basis (including the administrative costs of the wind-up). 2 Copyright © 2005 Sutcliffe transferring scheme) transfer, to create the merged scheme, called scheme C. The problem is to specify the conditions under which the merger is acceptable to the trustees of both schemes A and B? The merger criteria considered here will tend to be enforced because the trustees of scheme B may either refuse to agree to the scheme merger, or trigger a winding-up of their scheme if the receipts from a wind-up (including any share of the surplus on scheme B attributable to its members) exceed the benefits of becoming a member of scheme C . Alternatively, rather than 4 merge with scheme A, the trustees of scheme B may consider using the assets of their scheme to buy out the scheme liabilities; e.g. by the purchase of annuities and deferred annuities from an insurance company, Chapman and Jagelman (1980, 1982); or they may continue as a closed scheme. Conversely, the trustees of scheme A may be unwilling to receive scheme B if this leads to the members of scheme A becoming worse off. After explaining the zero profit and no dilution criteria, this paper argues that a merger can affect the balance of power between the trustees and the sponsor, and the strength of the sponsor’s covenant. A merger basis for valuing the assets and liabilities of the merging schemes is then defined. After introducing side receipts and payments to adjust each scheme’s funding ratio, it is concluded that simultaneously meeting both merger criteria requires that both schemes A and B are at least fully funded. Since scheme funding levels vary with the state of the financial markets, whether two or more schemes can reach a merger agreement depends on the financial markets. Delay may mean that funding levels rise, and a merger which did not meet the criteria specified in this paper becomes possible. Conversely, it is possible that, while the merger criteria are currently met, this will cease to be the case if there is delay. 1. Alternative Views on Acceptable Terms for a Merger There are two distinct views on setting acceptable merger terms for defined benefit pension schemes, and these are outlined in this section. 1a. Zero Profit or Loss. The first view is that at the time of the merger the assets and liabilities of scheme B should be in balance, leading to no profit or loss on the transfer. Members of schemes A and B are deemed to have no interest in the size of their scheme surplus because (a) they have no claim on any surplus (although this depends on the scheme rules); and (b) the extent of any over-funding is irrelevant as, following GN16, the security of the pensions promise need not be considered when devising merger terms. The trustees of scheme B will not wish to transfer a surplus, while the trustees of scheme A will not wish to take on a deficit; and this leads to the requirement that the assets transferred from scheme B to scheme A should exactly cover the liabilities. 1b. Zero Dilution of the Funding Ratio. The criterion of no actuarial profit on scheme B does not rule out a cross subsidy from scheme A to scheme B. This will occur if scheme A has a surplus, ISMA Centre Discussion Papers in Finance 2005-09 If scheme A is in deficit, while scheme B is not, the merger will lead to a cross subsidy from scheme B to 5