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Eight Tips To Avoid Crashing Your Pension And Benefits Operations In Mergers

October 1, 1999
Pensions and benefits represent an area of growing complexity to the most stable and well-established companies. Not surprisingly, the complexity is compounded when one company acquires another.

Most obviously, companies about to merge their operations face the additional challenge of merging their pension and benefits programs.

No matter how similar their programs, though, there will always be important differences that must be resolved.

Unfortunately, it is not enough for the parties to wait until the merger is complete before addressing the technicalities of merging pension and benefits programs. Potentially huge financial liabilities await merging companies that fail to do their homework before the merger is completed.

Any acquirer considering buying another company's stock or assuming liabilities as part of an asset purchase must understand the extent of potential costs surrounding pensions and benefits. This article examines the key issues deserving of attention by merging companies.

Because the financial dangers are most significant for acquirers, the analysis focuses most extensively on their concerns.

Acquirers must be alert to the possibility of assuming the unanticipated pension and benefits liabilities.

There is also the possibility of inheriting unanticipated assets and/or opportunities for savings on pre-existing pension and benefits programs. Regardless, smart acquirers make it their business to determine the extent of potential minuses and pluses in guiding their merger strategies.

One overriding technical factor that influences the assumption of liabilities and assets is the basic form of the acquisition. If the acquirer is buying stock, it automatically assumes the acquired company's liabilities.

If the acquisition is limited to assets, the liabilities remain the seller's obligation, unless the buyer assumes them.

In evaluating a merger, potential acquirers are well-advised to take the following steps as part of their due diligence:

  1. Audit present and past employee benefit plans maintained by the seller as well as its predecessors and affiliates. A first step in the due diligence process is doing the equivalent of an inventory analysis of the seller's pension and benefits plans. What exactly is the company obligated to-now and in the future?

    Because such plans can look back and ahead many years, the audit must be thorough.

    The most obvious examples for examination are tax-qualified retirement plans-defined benefit and defined contribution plans. Here the acquirer must be especially alert for single employer or multiemployer defined benefit plans maintained now or in the past by any current or former members of the company's controlled group.

    A prior plan termination or withdrawal may have triggered joint and several liability as to all members of the group, with the potential in some instances for the imposition of retroactive liens on a company's assets.

    The inventory analysis becomes more complicated if the corporation maintains a plan that owns employer stock, such as via an employee stock ownership plan (ESOP); voting and tendering provisions along with valuation requirements can restrict future company actions and obligate the company to unexpectedly large future payouts.

    Non-qualified retirement or deferred compensation plans for senior executives can also be lurking. Other areas deserving of attention are health (including post-retirement medical), life, dental, disability, severance, and golden parachute plans, as well as stock option plans, incentive compensation plans, employment contracts, and collective bargaining agreements.
  2. Assess potential liabilities (or assets) in the seller's plans. The biggest danger comes from older defined benefit pension plans. Many of these were adopted with great generosity and offered little in the way of long-range planning-all in expectation of seemingly endless profit growth.

    The employer's liability for accrued benefits should be disclosed in its financial statements. If the plan's assets are less than accrued benefits, the potential liability to the Pension Benefit Guarant Corp. (PBGC) must be established and negotiated as part of the merger agreement. Conversely, if the plan's assets exceed the accrued benefits and the plan permits employer reversions, the acquirer might decide to pay a premium for the company in anticipation of terminating the plan and taking possession of the excess (subject to income tax and an excise tax of up to 50%).

    The due diligence must also consider whether the pension plans have complied with ERISA and IRS tax qualification requirements. Retroactive disqualifications of a plan can mean the loss of a substantial portion of employer deductions going back many years along with income tax liability to employee participants on their vested benefits and earnings. The examination should also determine that the seller has paid previously accrued PBGC premiums and minimum annual contributions; failure on this front could mean a substantial premium liability along with a potential lien on the assets of controlled group members if a significant unfunded current liability exists.

    Fallout from noncompliance with ERISA and IRS requirements can also trigger substantial excise taxes on prohibited transactions, excess contributions, certain ESOP transactions, disqualified benefits in funded welfare benefit plans, and excess fringe benefits, among other problem areas. These taxes can be substantial-in some cases up to 100% of the amounts in question.

    Liabilities can also result from outstanding stock options. In some cases, acquisition of a company may trigger acceleration of option exercise dates. The acquirer may be obligated to substitute its own options.

    Similarly, some companies have included provisions in employment agreements that accelerate vesting for stock options, restricted stock, and other incentive compensation in the event of an acquisition. And, golden parachutes may also be triggered-with no deduction to the new employer and the potential contractual obligation agreed to by the old employer to make employees whole for their 20% excise taxes on such payouts.

    The potential liabilities for acquirers of companies with multiemployer plans can be even greater than those with single employer plans. Upon complete or partial withdrawal from such a plan, the employer may be liable for a portion of the unfunded vested benefits in the multi-employer fund, determined under a formula.

    Liability to multiemployer plans otherwise triggered by an asset sale can be avoided if the acquirer assumes a seller's obligation to contribute to the plan and provides a bond, and the seller agrees to be secondarily liable for withdrawal liability for five years. However, a buyer of assets is generally not bound by or required to assume a seller's collective bargaining agreement obligations to contribute to the plan and provides a bond, and the seller agrees to be secondarily liable for withdrawal liability for five years. However, a buyer of assets is generally not bound by or required to assume a seller's collective bargaining agreement obligations.
  3. Assess the costs of continuing and terminating plans. Acquirers can often realize substantial cost savings by changing certain plans and terminating others. Because established companies often continue health and insurance programs with the same suppliers for many years, potential savings may not ever have been explored. An acquirer that puts such programs out to bid can often save many thousands, or even hundreds of thousands, of dollars-and still provide the same benefits. For example, an acquirer of a Long Island, N.Y., company that was paying $800,000 annually in benefits costs saved an immediate $150,000 simply by obtaining bids on the company's benefits package-without making changes in the provisions.

    Similarly, an acquirer that terminates a defined benefit plan, buys annuities, and substitutes a 401(k) plan may realize substantial savings. Moreover, younger employees may be just as happy with a 401(k) plan that gives them tax deductions and control over the fund investment decisions.

    Of course, terminating plans is easier said than done. Terminating pension plans trigger immediate vesting. Termination could also trigger the employees' rights to a current distribution. This would frustrate the purpose of early retirement subsidies in defined benefit plans, which is to encourage workers to consider early retirement to obtain a current benefit. In addition, the unanticipated cost of providing the subsidized early retirement benefit to all employees who satisfy the age and service requirement could be significant.

    It may also raise the issue of whether employees are entitled to retirement plan distributions while working for the acquirer.

    The issue may become complex, since in-service distributions are prohibited under pension plans; employees who continue to work for the buyer may not be regarded as having terminated service.

    An alternative approach may be to apply a "freeze." Under the freeze, there would be no future benefit accruals or contributions, and distributions could be deferred until participants otherwise qualify under the terms of the plan. However, there would be full vesting in profit sharing or stock bonus plans and possibly in pension plans.

    Terminating post-retirement medical plans may eliminate significant future liabilities, but would likely engender ill will among employees and invite litigation if the employer had not expressly reserved the right to amend or terminate the plan.
  4. Assess the impact on acquirer's benefit structure. After the acquisition, the tax-qualified plans of the acquired business and the tax-qualified plans of the acquirer and its controlled group will be considered together for purposes of applying the nondiscrimination, participation and coverage requirements.
  5. Among the actions buyers should consider:

  6. Renegotiate terms based on potential liabilities. The purchase price can be reduced by the amount or some percentage of the amount previously unanticipated current and future liabilities. For the purposes of negotiating an acquisition price, the parties can measure accrued benefit obligations on a "termination" or "ongoing" basis. Using an ongoing bases usually results in greater liability (although this will depend on plan provisions, assumptions, and employee population.)
  7. Negotiate new contracts with insurers. They are likely to be most flexible prior to completion of the merger.
  8. Seek other opportunities to reduce benefit costs. Acquirers who are expert managers can take advantage of proven methods to reduce certain costs. For example, installing safety equipment in manufacturing plants may reduce disability and workers' compensation costs. Instituting cafeteria benefit plans with employee contributions can reduce overall health and other benefit expenses. Acquirers taking over long-established defined benefit plans may want to evaluate whether improved investment returns are possible via a new investment adviser or a more aggressive investment strategy. It is possible to avoid income and excise taxes on any gains from termination of plans by transferring excess pension assets to a health benefits account.
  9. Be sensitive to employee concerns. No matter how amicable a merger, employees will be nervous. A major part of calming those concerns lies in the presentation of the new program.

The matter of merging pension and benefits programs in an acquisition is risky. Fast-changing tax and other laws simply multiply the risks.

If handled adeptly, though, pension and benefits program merger can be turned into an area of opportunity rather than of risk.