Parties in corporate transactions have always included standard representations and warranties regarding “big-ticket” employee benefit items such as retiree medical obligations and defined benefit pension plans.  In some cases, the purchase agreement language is fairly straightforward—for instance in a stock purchase transaction where the acquired company sponsors the pension plan and is the only company participating in it.  In those situations, the focus is on making sure the buyer conducts due diligence to properly value the assumed liabilities.

Recently, however, there appears to be an increase in parties transferring only a portion of a defined benefit as part of a transaction (i.e., a transfer of pension plan assets and liabilities).  Such transfers of pension plan assets and liabilities are particularly common where larger corporations with historical pension plan liabilities have contracted with buyers who are purchasing divisions or lines of business and the seller wants to divest itself of all liabilities related to a particular division or line of business.  In addition, such transfers may occur if the buyer assumes a collective bargaining agreement from the seller that requires the maintenance of a pension plan for union employees.

Buyer Issues

A buyer that agrees to accept a transfer of pension plan assets and liabilities must agree to establish a pension plan that provides benefits that mirror the seller’s pension plan on an active or a frozen basis.  Any buyer agreeing to sponsor and maintain a pension plan should be aware of the following liabilities related to pension plans:

• Insurance premiums (based on participant headcount and funded status of the plan) are payable to the Pension Benefit Guaranty Corporation (PBGC).
• Pension plans must be funded annually according to requirements and actuarial assumptions set forth in the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code of 1986, as amended (the Code).  The amount of such funding requirements fluctuates with investment returns, interest rate assumptions and future benefit accruals. 
• Liabilities for required funding contributions, premium payments to the PBGC and unfunded benefit liabilities upon termination of the pension plan are joint and several liabilities of a buyer and any other member of a buyer’s “controlled group.”  A “controlled group” consists of entities (whether or not incorporated) connected directly or indirectly through common ownership of 80 percent or more, and can include private equity and venture capital funds. 
• Lending agreements require specific and often strict representations regarding the value of unfunded pension plan liabilities.

Seller Issues

A seller that agrees to transfer pension plan assets and liabilities should consider the affect of the transfer on the funded status of the seller’s pension plan.  In some cases, the statutorily required pension plan asset allocation method may result in the amount of assets transferring to the buyer, hurting the overall funded status of the seller’s pension plan.  A seller should work closely with its actuary to determine if this is the case before agreeing to a transfer of pension assets and liabilities. In addition, if the buyer is undercapitalized or becomes insolvent, and terminates its pension plan within five years of the transfer of the pension plan asset and liabilities, the transferred pension plan liabilities that are unfunded on the date of plan termination may again become the liability of seller under Section 4069 of ERISA if a principle purpose of the sale transaction between buyer and seller was to evade avoid pension liabilities.  Further, the transfer of pension plan assets and liabilities requires notice (often advance notice) to the PBGC and the IRS, which may invite increased governmental scrutiny (although depending on the amount of unfunded liabilities of the pension plan, the mere news of the proposed transaction may trigger a PBGC inquiry).

Implementing the Transfer

Once the parties have determined to agree to a transfer of pension plan assets and liabilities, the purchase agreement must be drafted to state the parties’ intent.  When drafting pension transfer language, both parties should consult with pension actuaries to ensure that the actuarial assumptions used to value the transferred assets and liabilities comply with ERISA and the Code.

The valuation of transferring pension assets is governed by Section 414 of the Code and Section 4044 of ERISA, which sets forth a statutory framework for valuing liabilities and allocating pension plan assets to the various classes of liabilities based on factors such as whether the benefits relate to voluntary or mandatory employee contributions, when the benefits were accrued, whether they are vested, etc.  Such sections of ERISA and Code also specify reasonable actuarial assumptions to be used in this process. 

Typically, actuaries are not able to complete this type of work in less than 60 days and often, the actual transfer of the assets to the new pension plan is not accomplished until four to six months after the closing date of the transaction.  In part, this is because computing and valuing the liabilities often requires calculating and reviewing the benefit of every participant in the plan (both participants’ benefits that are being transferred and those that are staying behind). 

Because of the lag time, the value of the transferring assets determined by the actuary in accordance with ERISA and the Code should be adjusted for investment experience and benefit payments.The purchase agreement should specify the date on which such liabilities will bevalued (often the closing date) and the actuarial assumptions used to value the pension liabilities.In many cases, the liabilities are measured based on the actuarial assumptions used for measuring funding requirements and accounting requirements.

Generally, the seller’s actuary prepares statements setting forth the value of the transferring assets and liabilities determined in accordance with ERISA, the Code and the purchase agreement and seller bears the cost of the actuary’s services.  The purchase agreement should contain a review and dispute mechanism, to provide an opportunity for buyer’s actuary to review seller’s actuary’s work, and any underlying data.  In the event that the actuaries do not agree that the amounts have been correctly calculated, the purchase agreement should provide for the review of a third, independent actuary to settle any such disputes.  Typically, costs relating to the services of a third, independent actuary are equally split between the parties.

After the method for determining the transferring assets and liabilities has been agreed upon, the parties must negotiate the amount, if any, of a purchase price reduction relating to the difference between the transferred assets and the transferred liabilities.  Usually, the transferred liabilities are larger than the transferred assets because pension plans in general carry unfunded liabilities. Moreover, the effect of the recent economic downturn on asset values combined with low interest rates have left most pension plans with significant unfunded liabilities. 

The determination of a purchase price reduction varies with the business deal in each transaction.  In some transactions, buyers build an estimate of unfunded pension liabilities into the initial purchase price offer thus making a purchase price reduction unnecessary.  This approach requires buyer to have had an actuary perform a significant amount of pension asset and liability estimation prior to the signing date of the transaction.  Another approach is to provide for a purchase price reduction based on the unfunded liabilities as part of the purchase agreement.  This second approach allows the actuarial valuation of the pension assets and liabilities to be performed after signing an agreement, but leaves the parties with an unknown economic term for some period of time after the signing date of the transaction. 

A third approach is to allow for the purchase price reduction in the purchase agreement and limit the reduction to amounts in excess of an agreed upon amount of unfunded liability.  Under this approach, the buyer estimates the amount of unfunded liabilities that will be transferred to the buyer prior to the signing date of the transaction and builds that amount into the purchase price.  If the actual unfunded liabilities are greater than the amount accounted for in the purchase price after the signing date and after the completion of the actuarial valuation of the transferring pension assets and liabilities, there is a purchase price reduction for the amount that the actual unfunded liabilities exceeds the estimated unfunded liabilities.  The purchase agreement can also be drafted to provide for a purchase price increase if the pension assets transferred to the buyer exceed the pension liabilities transferred to the buyer by an agreed upon amount.

The parties should expect to work together to establish the new mirror buyer pension plan, agree on the valuation of the transferred assets and liabilities, and agree on the value of any purchase price reduction or purchase price increase for period of four to six months after the closing date of the transaction.  Given the complex issues associated with negotiating a transfer of pension plan assets and liabilities, employee benefits counsel and actuarial consultants should be engaged by both parties to aid in drafting the purchase agreement, the new pension plan and valuing the assets and liabilities that are to be transferred.

Conclusion

The transfer of pension plan assets and liabilities raises unique issues in the M&A context.  First, the parties must understand the risks associated with agreeing to a transfer of pension plan assets and liabilities.  Then, the purchase agreement and the plan documents must be drafted to include valuation and transfer language that satisfies certain governmental requirements.  Lastly, the parties must determine whether there will be a purchase price adjustment relating to any unfunded pension plan liabilities assumed by the buyer.