This article is just an example of the content available to mallowstreet members.
On average over 150 pieces of new content are published from across the industry per month on mallowstreet. Members get access to the latest developments, industry views and a range of in-depth research.
All the content on mallowstreet is accredited for CPD by the PMI and is available to trustees for free.
The trustees of the £3.2bn Yorkshire and Clydesdale Bank Pension Scheme are speaking to Clydesdale Bank and the scheme’s advisers to assess the impact of a corporate takeover. Three experts name some of the things trustees in M&A situations should think about.
The boards of Nationwide Building Society and Virgin Money UK announced on 21 March that Nationwide made a recommended offer to buy Virgin Money, which sponsors the Yorkshire and Clydesdale scheme, for 220p per share.
While the companies are hoping to strengthen their position and products, the acquisition will also impact their pension funds. Just as Nationwide has a defined benefit and a defined contribution arrangement, so does Virgin, including the Yorkshire and Clydesdale scheme, which is closed to new entrants but open to accrual for a few employees.
In its announcements from March, Nationwide said it will “safeguard the existing contractual and statutory rights of Virgin Money employees, including pension arrangements and redundancy policies”.
It added: “Nationwide’s intention is for employer contributions to the DB scheme and current arrangements for the accrual of benefits to continue in line with current requirements, and it intends to work constructively with the trustees of the DB scheme going forward.”
As for the Virgin Money DC scheme, “Nationwide’s intention is to maintain contribution rates in relation to Virgin Money’s defined contribution pension scheme for at least the 12 months following completion”.
Covenant now top concern
A decade or so ago, corporate acquisitions would often involve a DB scheme in deficit, where its trustees would seek cash contributions or other securities from the company as part of the deal, but how have the current higher funding levels changed such discussions?
The Yorkshire and Clydesdale Bank scheme was 109% funded in 2021, while the £7.3bn Nationwide scheme’s two DB sections also had healthy funding levels of 111% and 107% in 2023.
Scheme funding remains a critical consideration in takeovers. However, change of covenant is equally important, says Mark Hedges, a professional trustee at Capital Cranfield, who is also a trustee of the Nationwide scheme.
“It will be unhelpful for [a scheme] to see the covenant deteriorate because of a transaction. That's why there are all these questions around material detriment [the Pensions Regulator] has. You’d have to advise TPR if any of the tests were met as a result of work on the covenant,” says Hedges. If one test has been hit, then “you need to have a more robust conversation”, he says.
Trustees should understand the new corporate structure and how this affects who will be liable for additional contributions if needed, he advises. They should also seek clarity if the deal will trigger anything in the agreements between scheme and sponsor, as trust deeds can be very bespoke.
“You would need your lawyers to confirm that, at the same time as getting your covenant adviser to do these tests,” Hedges notes.
The better funding situation for many schemes has “eased the conversation” between employers and pension trustees, says John Harvey, a partner at consultancy Aon. Current higher funding levels mean that in many cases, trustees can get comfortable with an M&A deal quickly, but the underlying issues are the same, he stresses.
“The first concern is demonstrating security to members that pensions are not more at risk than before, and to the extent that they were a risk, guidance from TPR is clear that [the trustees] should be seeking compensation for that,” says Harvey.
Even where a scheme is very well funded, a transaction of this scale will alter the covenant, says Hamish Reeves, a managing director at covenant advisers Cardano.
A large scheme might want to run on, so the trustees “need to think carefully” about how the transaction changes the underlying risk covenant profile, including which entities the scheme has access to for funding.
Reeves says since the Pension Schemes Act 2021 came into force in October of that year, companies have been much more aware of the need for analysis.
"We are seeing corporates, including US and potential private equity buyers, taking advice on the way in from covenant advisers,” he says.
However, this does not always make the discussion easier. A corporate might argue that PSA 2021 is about ‘reasonableness’.
“A corporate will say PSA 2021 is effectively about reasonableness for the regulator to use its moral hazard powers. So if a scheme is very well funded, they will take a piece of advice around section 38 and these tests, and they’ll say, ‘We don’t think it’s unreasonable’,” he observes, whereas the trustees need to consider if the deal is in the best interest of members.
Making it clear early on that trustees look at the legislation and M&A through a different lens will spare some pain later on. “If you let a transaction play out and then you have that discussion, it can be quite difficult,” he warns.
Mitigation: Focus shifts from cash to ‘soft’ aspects
In the past, M&A would often trigger demands for mitigation in the form of cash or accelerated contribution plans. Now that schemes are generally well funded, it can spark a discussion about the scheme's objectives.
Reeves says that "these types of transactions can be good catalyst to put safeguarding or procedures in place to give you certainty that journey plan will play out as you hope”, such as contingent funding if the scheme falls below its journey plan.
It could even lead to a discussion on “getting hold of some capital that gets realised through a [M&A deal] to do an insurance type transaction or to plan for it, with things like escrows”.
While cash, extra guarantees or letters of credit might be sought where a scheme has a deficit, Aon’s Harvey says trustees can also ask for ‘softer’ things, such as a commitment to keep contributions at the same level for more than 12 months.
He thinks trustees in M&A situations focus increasingly on the administrative aspects of running a scheme as funding has become less of a concern for many. For example, if there has been a history of discretionary increases, they might ask to see that continued.
These “tend to be amicable discussions”, he remarks, as such demands are “far less controversial” for employers than trustees asking for large sums of cash up front.
Will the schemes need to merge?
Ultimately, companies will look to integrate the new entity. On the DB side, merging schemes is possible but complicated, depending on funding levels and benefit structures.
As well as this, there is currently another factor which means that most companies are keeping DB schemes separate, Harvey says. As higher funding levels have meant that more schemes can buy out, sponsors are keeping open the option to take one or more DB schemes off the balance sheet, rather than merging it.
For current employees, the picture is different. Company integration will very likely include the terms of the benefit structure, meaning one of the DC schemes will have to change. This can be positive or negative, Harvey notes.
While much resource will go into securing the benefits of the DB members, there is often little trustees can do on the DC side of things, particularly where employers have contract-based arrangements.
Surplus extraction: future driver of M&A?
M&A activity could be influenced by a government proposal to override scheme rules and allow surplus extraction before wind-up. The framework for this is currently under consultation, and depending on its shape, could attract future buyers to companies that have DB schemes with large surpluses.
Harvey says: “This is crystal ball gazing, but in future you might see that schemes with surplus become quite attractive to buyers because there is a source of cash there.”
Easy surplus extraction would create moral hazard – but he thinks the government is aware of this, as well as the need for checks and balances. “An obvious one is trustee consent,” he adds.
There is a risk of a company buying another for its DB surplus, agrees Reeves: “You wouldn’t be surprised to see private equity alive to [this] – they love value arbitrage, whatever it is.”
How have considerations changed for trustees in M&As?
