Reimagining UK Pensions and Strategies to Unlock Value Through M&A

Piers Johansen
[ 00:00:14,900 ] Hello and welcome to Aon's discussion on value creation strategies for defined benefit (DB) schemes in the UK, particularly in the context of transactions. My name is Piers Johansen, Managing Director in our M&A and Transaction Solutions business. I'm delighted to be joined by colleagues from our pensions advisory team, Alice Wilmot and Matthew Richardson. Alice, could you introduce yourself?

Alice Wilmot
[ 00:00:36,070 ] I'm Alice Wilmot, Associate Partner in our Covenant team. My role involves advising pension scheme trustees and corporates on the underlying creditworthiness of employers sponsoring DB schemes, which is particularly relevant in M&A scenarios.

Matthew Richardson
[ 00:00:51,540 ] Thanks, Alice. Hi, Piers. I'm Matthew Richardson, an actuary by background and a partner in our UK Wealth business. I also lead our UK Wealth M&A practice, specializing in advising corporate and private equity clients on pension benefits and issues that arise during M&A transactions.

Piers Johansen
[ 00:01:09,470 ] Thank you. For myself, I'm a former lawyer, previously focusing on private and public M&A in private practice, so I'm quite familiar with the reactions when people discover a DB pension scheme in the context of a transaction. Historically, DB schemes were often perceived as a headache, but that's changing due to sustainably higher global bond yields since the end of 2022, improvements in investment performance, and sponsors plugging deficits over the last decade or two. This has created a positive situation for launching new strategies. Additionally, there will be changes in the pension landscape, providing earlier and easier access to surplus pension funds. Recent government figures estimate that, on a low dependency basis, there are £160 billion of surplus pension scheme assets in the UK. That's our focus today. Matt, what's driving this change in the UK government pension landscape, and when should we expect to see it?

Matthew Richardson
[ 00:02:40,079 ] The government has publicly announced that, with UK pension schemes now much better funded than in previous years, many should be able to pay some of their surplus funds back to scheme sponsors. The hope is that sponsors will use this capital to drive economic growth in the UK. Additionally, any pension surplus paid back to employers carries a 25% tax charge, so providing earlier and easier access to surplus funds also means earlier and easier access to tax revenues for the Treasury.

Piers Johansen
[ 00:03:25,040 ] Is it fair to view all DB schemes as assets?

Alice Wilmot
[ 00:03:28,350 ] Unfortunately, not all schemes can be viewed as assets. While a significant majority of schemes are now in surplus, many are still in deficit and therefore cannot be considered assets. In the context of new legislation, schemes can be viewed as assets in M&A scenarios due to the absolute value of surplus today and the potential to generate additional surplus in the future. This can be seen as a stream of future cash flows, valued similarly to other cash flows in M&A. However, a framework agreement and structure would be needed to access this value, requiring negotiation between trustees and corporates regarding the potential upside and the timeframe for extraction.

Piers Johansen
[ 00:04:28,920 ] What size scheme is relevant or viable for these strategies?

Matthew Richardson
[ 00:04:35,010 ] The economic argument for the so-called run-on strategy is more naturally cited with larger schemes, where it's easier to demonstrate strong economic rationale. However, smaller schemes can also benefit from this strategy, though additional risk exposure and the costs of continuing to run a pension scheme must be considered.

Piers Johansen
[ 00:05:06,090 ] You mentioned run-on and surplus release when the new legislation comes into effect. In an M&A context, that's not the only strategy available. Matt, could you discuss other strategies that sellers, in particular, are executing regarding DB schemes?

Matthew Richardson
[ 00:05:31,200 ] So another popular strategy that I think will remain popular, despite the sort of clarification of position on run-on strategies, is to remove pensions schemes completely from the balance sheet ahead of a business sale. In a lot of cases, this will still remain as the option number one for companies. And to think about why a business might choose to do that in advance of a sale. Well, firstly, a seller might take the view that bidders are likely to make a debt-like adjustment to their business valuation, reflecting the expected cost of insuring the pension scheme in the market, a number of reasons why they might choose to take that approach. And in that scenario by actually carrying out that insurance transaction in advance of a business sale. There's two major value drivers then for the seller. One is by transacting first with a well-broken process, you carry the opportunity of securing the scheme's benefits at a lower cost than is built into those estimates, and therefore benefit from that value differential. The second is by actually taking that pension risk exposure off the balance sheet in advance of marketing the business. You are able to invite more bidders into the process that might otherwise be concerned about pension risk. Historically, and therefore add to some of the competitive friction and drive up exit price in that manner.

Piers Johansen
[ 00:06:58,600 ] And I can see how, if you're on the buy side, you’d be looking at this. We were chatting with some bankers this morning, and they mentioned that some of their clients are quite opportunistic about the chance to access cash. They know things don’t move quickly in the pension space. No disrespect, but these processes do take time and are complicated. How do you see it from the buy side, Matt? How would you approach it, or how do you think bidders should approach it from a diligence perspective?

Matthew Richardson
[ 00:07:28,520 ] Yeah, that's a really good question. As we discussed earlier, I think many value creation opportunities tend to sit more naturally with sellers, but they can just as easily be leveraged by buyers. From a buyer’s perspective, there’s an opportunity for value arbitrage: acquiring a business with a well-funded pension scheme, where the overfunded position isn’t fully reflected in the valuation, perhaps because there’s no formal agreement for capital release. Then, post-acquisition, you can implement a strategy to either run on that pension scheme and generate additional free cash flow, or, if appropriate, eliminate the pension scheme, realize any pricing gains from taking it to market, and potentially release any remaining surplus. In both cases, buyers have the chance to add value right after acquisition by carrying out these activities.

Piers Johansen
[ 00:08:29,760 ] Alice, I know we were chatting earlier. There’s a tactical point here: if you’re on the buy side, you want access to the trustees, and whether you make that a condition to closing or even prior to signing, it’s important to have that in place. What are you seeing with companies that have these schemes? Are they almost chaperoning discussions with trustees? I suppose you need to be a preferred bidder, right? You can’t do this with everyone. How are you seeing that play out in practice?

Alice Wilmot
[ 00:08:58,390 ] It's a good point, Piers, and I guess to an extent it will come down to how much of a value driver the scheme is in the context of the transaction overall. But where there's a substantial scheme, we do see that it is. Like access to trustees to have the conversations on how they'll behave post transaction. So the bidders have visibility of that and can sort of start to build that relationship and understand what the go-forward strategy might look like. On the flip side, on the sell side, if there's already an agreed strategy in place that you've implemented and that the trustees are happy with, and you can articulate a good story to the trustees around what's happening in the M&A context. There's probably less need to have that sort of tripartite discussion early, and there might be a desire to almost seek to push that to as late in the process as possible. So I think that there will always be a tension there, and the right answer will depend on the facts. But it's easier on the sell side to have less parties to that discussion.

Piers Johansen
[ 00:09:58,140 ] So, Matt, going to a specific practical example, segueing a little bit, Synven acquired Grant Thornton UK recently. Can you maybe just give us a little bit of a description of the work that you were doing around the pension scheme, the DB pension scheme for Grant Thornton ahead of that transaction?

Matthew Richardson
[ 00:10:15,410 ] Yes, so Grant Thornton was one of the companies that kind of fit into that bucket of having a view that removing the pension scheme from the balance sheet ahead of a business sale would add value for them. So we helped Grant Thornton to approach the insurance market and secure a buy-in policy within a relatively short time period, about eight months or so from initially approaching the trustees and putting that in place by the time they sold that business.

Piers Johansen
[ 00:10:46,020 ] And just to be clear, do you mind just explaining the buy-in concept and then how do companies generally do a buyout, because I know there's a difference.

Matthew Richardson
[ 00:10:55,400 ] Generally speaking, with a buy-in policy that results in the pension scheme remaining on the company's balance sheet, but the trustees hold an insurance policy that mitigates the majority of the risks associated with the pension scheme. It's quite a good strategy in an M&A context where there isn't sufficient time, and by 'time' I mean two to three years to complete all the actions required to buy out a pension scheme, formally transfer all of the obligations to an insurance company, and wind up the pension scheme so it's no longer on the company's balance sheet. If you can achieve a buy-in transaction by the point of a business sale, it's also possible and indeed we've advised on putting in place specific transaction structures. That allows the bidder, or multiple bidders, the trustees and the pensions regulator to have certainty that the follow-on actions require to buy out and wind up a pension scheme are both funded and expected to be completed within a suitable time frame. From a bidder perspective, that gives you all the certainty you need. To price competitively and to engage in the bidding process fully.

Piers Johansen
[ 00:12:06,360 ] So maybe the buy-in is kind of more M&A friendly.

Matthew Richardson
[ 00:12:08,980 ] I think it often is. I think our message generally to sellers is, whatever your strategy, if you have good visibility ahead of a potential exit. Then, having multiple years to implement your pension strategy will put you in the most competitive position, the most advantageous position, but where real life comes into things and you have a limited time frame to work with, there's certainly pension strategies you can implement and transaction structures that can sit alongside those that get you the majority of the benefits but with a bit of a real world lens on it.

Piers Johansen
[ 00:12:42,680 ] So Alice, we know one size does not fit all, right? We also know that everyone wants to get the value they can if there's surplus or if there's opportunity. So how do they do it?

Alice Wilmot
[ 00:12:51,200 ] That's why, from a DB perspective, it's critical to be well advised. Information is power in these negotiations. From a sell-side perspective, as we've talked about, it's much easier for a pension strategy to be priced in from an M&A perspective if it's implemented or very close to being implemented. And as we talked about, to implement a pension strategy requires negotiation with trustees, which can have, these are sort of materials— discussions, they can have quite a long lead time. So it's important to start them as early as possible. Having said that, we're regularly brought in once an M &A process is sort of in contemplation, is kicked off. And as Matt says, there's roots to value in that scenario too. And I guess, if we think about things on the buy side and what you need to be thinking about on the buy side, obviously you don't have such a long lead time necessarily to be thinking about pensions in advance. But once the DD process starts, we'd be saying it's really important to have a good handle on what the pension scheme looks like, what the art of the possible is, and also have thought about your strategy and practically. The value adjustment range will be a mixture of both, and the broader competitive tension in the M&A negotiation.

Piers Johansen
[ 00:14:03,910 ] Okay, fantastic. Well, thank you both very much. Just to wrap up with our key takeaways: we’d like to propose that UK DB schemes can be reimagined, from perceived headaches to potential value drivers. This shift will be facilitated, or even accelerated, by the new pensions landscape coming into effect in 2027 or 2028.

Alice, as you mentioned, preparation is key. And I completely agree that information is power. So, taking action now to prepare for these changes would be a prudent step, whether a transaction is being considered or even on a standalone basis.

From our perspective, our call to action for everyone watching, whether you’re a corporate, a PE owner of a corporate with a DB scheme, or an advisor, is this: it’s a complex area, with a myriad of strategies, considerations, and perspectives. It’s exactly the kind of challenge we enjoy tackling at Aon, and we’d welcome the opportunity to discuss your situation and provide any advice we can.

Thank you.