UK: The Mouse That Roared: The Impact Of Pension Scheme Liabilities

Who would have predicted that the dry, dusty subject of pensions would grab the headlines in the way that the new Financial Reporting Standard 17 has? FRS 17 and the furore surrounding it has ensured that the "technical and dull" tag which usually attaches to the subject has been well and truly cast off. But what is all the fuss about and what impact is it having on M&A activity?

FRS 17 dictates that as of 22 June 2003, companies will be required to account for the assets and liabilities of their pension funds in their accounts. Much has been made of the effect that this will have on a company's willingness to continue final-salary pension schemes, Marks & Spencer being one of the latest, high profile names to close its scheme. However, this is just one of a raft of unwelcome side effects that FRS17 will have.

At present, actuaries commonly value the assets of final salary pension schemes by reference to the anticipated future income they will generate, rather than their current market value. Any surplus/deficit in the scheme is usually spread over the working lifetime of the workforce. The new standard requires that assets are valued on a current market basis and any surplus or deficit of the fund must be recognised immediately in the balance sheet. Consequently, company accounts may appear more volatile due to temporary fluctuations in the funding position of the scheme. A recent example being the meteoric rise (and equally dramatic fall) in the value of new technology stocks held by pension schemes.

Without forward planning, the new standard will impact on corporate deals, especially where the price is linked to a balance sheet valuation or where there are significant post-deal performance incentives. Examples of potential pitfalls include:

• Transactions where the funding for an investment or acquisition relies upon future dividend income. Adjustments to the profit and loss reserve may prevent the payment of a dividend.
• Earn-outs and other calculations linked to a balance sheet valuation may be artificially inflated or deflated by fluctuations in the funding position of the scheme.
• Employee incentives linked to company performance may not work as originally envisaged.
• Existing banking covenants in the target business may need to be reviewed and renegotiated.
• If pension benefits are enhanced (for instance following a disposal as part of a redundancy programme) under the new standard the costs will have to be reflected immediately rather than spread over time.

At its most dramatic, buyers may simply be unwilling to acquire a company with an open-ended commitment to a final salary scheme. Disposals may, as a result, be harder to close and there will certainly be a knock-on impact on pricing. The recent sale of Kalamazoo, the specialist software company, in which Pinsent Curtis Biddle acted for the trustees of the pension fund, is illustrative. Despite having been closed to new members since 1993, Kalamazoo's final salary pension scheme's assets still fell short of the government-imposed minimum funding requirements. By law, the company's exposure to the pension fund deficit was unlimited and in practice this meant that Kalamazoo was liable to make good a shortfall of more than £5m.

Understandably, negotiations for the sale of the company stalled because potential buyers were simply unwilling to assume the shortfall liability. Indeed, the Chairman of Kalamazoo, Robert Jordan, confirmed to shareholders that the potentially significant future liabilities impacted on interested parties' views of the value of Kalamazoo.

In the end, the trustees agreed to accept a compromise settlement of the pension scheme deficit. This in turn enabled Kalamazoo to sell its business and assets which allowed it to pay all its debts – including the funds borrowed to enable it to pay a £5.2 million settlement figure to the pension scheme – and to distribute the remainder to shareholders through a voluntary liquidation.

No doubt Kalamazoo would have found a buyer more readily and may well have achieved a higher price had it not been for the deficit in its pension scheme. Kalamazoo may have been one of the first to suffer the consequences of the new regime. But it will certainly not be the last, as pension scheme liabilities are now firmly at the top of the agenda for discussion in the M & A market place.

Unless, of course, the critics, including trade unions and, it is rumoured, members of the Accounting Standard Board itself, get their way and the standard is shelved. However, given the swing after the collapse of Enron towards greater transparency and away from hiding liabilities off balance sheet, it does not look as though pension scheme issues will be out of the headlines for some time yet.