Actuarial Advice in a Transaction Paul Geeson

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Actuarial Advice in a TransactionPaul Geeson

• Staple Inn Hall
• Tuesday 5 July 2005

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Agenda

• What does financial economic tell us to do?
• Can the transaction dynamics bend the rules?
• Cash flow planning paying off the deficit?
• Dealing with mortality uncertainty.
• International issues.

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Options for pricing pensions

• Wide range of options from
• MFR
• Ongoing funding basis many choices
• FRS17
• Gilts matching
• Insurance buy-out
• Q What are you using currently?

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Insurance buy-out ?

• Only current market in pension liabilities
• Insurers statutory regime differs to pension
  schemes
• Requirement for solvency margins
• Capital intensive return on capital
  needed/profits
• Guaranteed nature of benefits conservative
  pricing?
• Is the scheme really going to wind up?
• But post June 2003 this is the debt on the
  employer

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Gilts matching

• Matching asset class (nominal ILG)
• Removes investment mismatching risk
• Avoids transfer of risk at zero price
• No allowance for uncertain future investment
  return
• Assumes scheme run on and avoids wind-up
• Assumes benefits are secure for members
• Ignores reinvestment risk on longer terms
• Cannot be a perfect match - some risks must remain

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FRS17

• Random result no theoretical basis for use
• Just similar to gilts matching but weaker
• Retains certain level of investment risk
• Reasonable level of risk?
• Risk of accounting drift AA to gilts?
• Accounting use/Regulator use/availability
• Seen as ongoing measure of pensions debt
• Commercial advice? acceptable risk?
• Emerging as accepted pricing basis

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Ongoing funding basis

• Allowance for asset out-performance
• Capitalises future uncertain returns
• Converts this into immediate cash for vendor
• Would you pay more for the assets in any other
  situation than their market value?
• No allowance for risk of lower returns
• Punt on equity markets outside pension schemes

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Commercial advice

• Educate your client
• Ensure they understand risks
• Significance of different bases
• Can wind up be avoided ?
• Minimum FRS17....but gilts is proper rationale.
• Clients view on risk and overall commercial
  situation
• Eye on the exit how will it be valued?

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Including pensions in business price

• General business valuations based on a multiple
  of EBIT(DA)
• Earning before Interest, Tax, Depreciation and
  Amortisation
• Cost of servicing pension debt is Interest type
  item
• Hence treat past service liability as a debt item
• Consider deferred tax treatment
• Factor future service cost only in EBIT model
• Assess on consistent bases!
• Avoid double counting

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Typical example

• Projections current cash costs 2m p.a.
• Service cost under FRS17 3m p.a.
• EBITDA business multiple 8 - value difference 8m
• Past service FRS17 deficit 6m
• Total valuation impact 14m
• But buyout debt/gilts matching will be higher
• Process of negotiation/education on both sides
• Fully prices without addressing actual cash

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Bending the rules a case study

• Difficulty in selling a UK manufacturing business
• Original buyers DD recommended a gilts basis
• Value impact was too great deal killed
• Brought in to advise seller on pension
  education
• A new buyer was found new outlook on pensions
• Structured finance buyer profit from debt not
  equity
• Key concern was immediate/short term cashflow
• Commercial situation allowed different
  consideration

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Bending the rules a case study

• Issues
• Forthcoming Scheme Specific funding
• Closed scheme rapidly reducing headcount
• Realistic future short term salary increases
• Produced report projecting cash costs on various
  basis illustrating upsides and downsides.
• Purchaser and adviser were able to review,
  challenge and then reach a commercial position.
• Therefore different outcome to suit situation.

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Different deals different solutions

• Business carve-out
• Leave DB liabilities behind new DC set-up
• Bulk transfer? To DB or DC...
• Will the trustees pay a transfer? case study
• Debt on employer issues
• Clearance and the pensions regulator
• New process in doing deals
• Trustee involvement
• More work for vendor advance planning
• New practice to emerge

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Different deals different solutions

• Debt on employer on ceasing to participate
• Be sure it is multiple employer!
• Currently MFR due to become buyout
• Potential for using SFO alternative
• Subject to sufficient support
• May hinder deals in future
• Regulator suggests FRS17 now for clearance?
• Impact of orphan debt apportionment
• Debt reduced if transfers way forward?
• Split of schemes in advance solution?

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Different deals different solutions

• Whole business and scheme
• Taking on the liabilities
• Eye on the exit how will pensions be priced
• Management of scheme between now and exit
• Short term or long term view
• Ability to change benefits factor in pricing?
• Protected employees
• Other situations always consider each case
• Participation in public sector schemes
• Outsourcing contracts end game
• Executive arrangements/liability concentrations

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Clearance - application

• What are you being cleared for?
• Test for clearance
• Ability to issue FSD and CN
• Accepted process
• Not ongoing protection for purchaser
• Trustees need to be involved
• Culture of giving something to the trustee
• Timescales
• Involve regulator early

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Other assumptions

• Mortality
• Salary increases
• Withdrawal
• Early retirement
• Normal retirement
• Cash commutation
• Cap/collar pension increases

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Cashflow planning

• Theoretical pricing on matching basis
• Cashflow incidence will vary
• Vital need for cashflow planning
• Difficult to predict
• Statutory Funding Objective Sept 05
• Prudent assumptions
• Allowance for covenant/affordability

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Cashflow planning new funding

• Real issue
• Current uncertainty
• Pre-empting SFO prudent funding basis
• Need to speak to trustee in advance
• Regulator clearance
• Expect FRS17 to be typical?
• Deficit spreading 10yrs? 5yrs? Immediate?
• Affordability and covenant
• New standards and practices to emerge

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Cashflow planning deficit spreading

• Current deficit cash funding usually insufficient
  
• Actuarial spreading techniques?
• Often insufficient to cover interest
• Valuation assumes no ER or withdrawals
• Not a realistic assessment
• Need to reassess
• What is going to happen to assets?
• Give more get asked for more?
• Assume a safe position

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Cashflow planning future service

• No withdrawals/no early retirement
• What is really happening to closed schemes
• But gives potential for future service saving
• Can require detailed projections
• But new process may give more time...
• Greater understanding for client
• Accurate assessment of changing costs
• Sensitivity testing

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Mortality uncertainty

• Area of significant difficulty
• Lack of real knowledge
• Lack of real experience
• Lack of information given to Seller
• Education process on both sides
• Big move in table from PA90 to PMA92mc
• Scheme actuaries slow to move bases

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Mortality uncertainty

• Feeding in technique...
• Simply not justified in transaction
• But to address can cause conflict
• Require firm evidence from Seller
• Seek Scheme Actuary to hold to table?
• Seek trustees views (and educate them)
• Level of uncertainty
• Potential to destroy value in a deal
• New products to hedge risk?

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Mortality uncertainty

• Socio-economic effects are significant
• Assessing the population
• What allowance to make
• Size of pensions
• Executive liabilities
• Impact of term of cohort
• Continuing future improvements
• Implication for future accrual

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International issues

• Same basic analysis
• Care to cover all benefits
• Unfunded arrangements
• Retirement/leaving service indemnities
• Post retirement medical benefits
• Part time old age plans
• Need to question local advisers closely
• Keeping a sense of proportion
• Measurement of liabilities

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International issues

• Utilise local resources
• Mortality issues remain
• Increasing cash costs for reserve building
• Are plans really DC?
• Investment and conversion guarantees
• Complex carve-out issues
• Co-ordination with other HR areas

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Summary

• Consider pricing carefully
• Ensure pricing is consistent
• Educate your client
• Address the cashflow
• Each situation is different
• Look for new solutions