Employee Benefits in Mergers & Acquisitions: Key Considerations When Acquiring a Defined Benefit Pension Plan

Although pension plans are increasingly rare, if your business is considering acquiring a company that sponsors a pension plan, then several new diligence and deal considerations come into play for the transaction. This can be incredibly daunting if your business does not already sponsor a pension plan, because pension plans are fundamentally different than defined contribution plans, such as 401(k) plans, in many respects. This article highlights some of the material diligence, transaction, and post-closing issues that you should consider if the target entity sponsors a pension plan.

1. Do You Understand the Funding Status of the Pension Plan?

• Pension plans are not required to be fully funded, i.e., it is not a legal requirement that the plan’s assets equal the plan’s liabilities. The “funded status” of a defined benefit pension plan can be viewed in different ways depending on the purpose for which the funding status is determined. For example, a pension plan that is considered “fully funded” (at 100% or more) for the plan’s most recently reported adjusted funding target attainment percentage (or, AFTAP) may not be considered “fully funded” if the plan was terminated and liquidated. This is because most ongoing actuarial funding certifications (like the annual AFTAP determination) are calculated by making certain actuarial assumptions related to the plan remaining in effect.
• Pension plans are only required to complete formal actuarial funding determinations on a periodic basis and then, those determinations are reported on a delayed basis. For example, for a calendar year pension plan, as of May 2024 the most recent Form 5500 available is for the 2022 plan year, which will report assets and liabilities as of the last day of the 2022 plan year. For a calendar year, that information is now almost one and a half years out of date. Unless an updated actuarial valuation is completed in connection with a transaction, the buyer will inevitably review “stale” funding data for the pension plan and must either demand an updated valuation (which may take time) or at a minimum, obtain an updated plan asset valuation so the buyer can at least assess more recent asset values.
• The funding status of the pension plan is important because if a plan is underfunded, then it’s likely the buyer will have to make periodic contributions to the plan’s trust to fund the plan, or a potentially large contribution if the intention is to terminate the plan. Further, an underfunded pension plan will pay more in annual PBGC premiums than a fully funded plan. These liabilities should be considered in the context of the overall financial aspects of the transaction.

2. Have You Reviewed Historical Compliance and Plan Governance?

• While the funding issue described above will likely be the most important issue to address in the transaction, the buyer should also review historical pension plan documents and governance to confirm that there are no significant outstanding compliance issues or liabilities sitting with the pension plan.
• At a minimum, the buyer should carefully review current plan documents, trust agreements, summary plan descriptions, participant notices (including distribution election materials), evidence of PBGC premium payments, Form 5500s, and any correspondence with the IRS, Department of Labor, or PBGC about the plan.
• To the extent there are outstanding compliance issues discovered in the diligence process, the buyer can address them in various ways. For example, the purchase agreement can require that necessary corrective actions to bring the plan into compliance be completed prior to the closing of the transaction, if feasible. Or, the parties may address material issues through purchase price adjustments or specific indemnity obligations, as needed.
• A buyer also needs to understand the current third-party administration arrangements and governance structure to determine if or when changes are needed following the closing of the transaction. For example, if the target company has established a benefits committee to serve as the plan’s administrator, then a buyer will need to consider if that committee should remain in place following closing (or, if members of the committee may no longer be around after the closing) or if the buyer has its own plan fiduciaries that it intends to appoint as the plan administrator going forward.

3. Do We Need to Address the Pension Plan in the Purchase Agreement?

• The purchase agreement will need to address the pension plan; however, how the plan gets addressed will vary depending on the overall business deal.
• The purchase agreement should contain certain representations from the seller about the overall compliance of the pension plan. If there are outstanding compliance issues, then the buyer may want to consider specific indemnification protections to address those risks.
• Depending on how a buyer views the pension plan’s overall funding and any minimum required contributions that are due prior to closing (or that relate to the pre-closing period, to the extent not due by closing), certain purchase price adjustments may need to be included within the purchase agreement. A buyer may also require a target company to make additional contributions to the pension plan’s trust prior to closing a transaction, which would also need to be documented under the purchase agreement.
• If the buyer expects the target company to take any corrective actions discovered during diligence or make any changes to the plan in connection with the closing, then pre-closing covenants and/or closing deliverables covering these items should be included under the purchase agreement.

4. Can We Freeze or Terminate the Pension Plan?

• If the target’s pension plan is still actively adding new participants and accruing new benefits (or, the plan may be frozen to new participants, but current participants are still accruing benefits), a buyer will want to consider fully freezing the plan to limit future benefit obligations. Decisions about freezing a pension plan will need to consider the buyer’s philosophy for retirement benefits going forward, any obligations under the purchase agreement to maintain defined benefit plan accruals for some post-closing period, and, in the event any plan participants are governed by a collectively bargained arrangement, those decisions will be subject to bargaining requirements. In addition, there are advanced notice requirements to freeze a pension plan that may make it impractical to implement a freeze at or shortly after the closing of the transaction. However, a pension plan can be frozen at any time on a prospective basis.
• Unlike a 401(k) plan, a buyer could terminate and liquidate a pension plan after the closing of a transaction. Even if a buyer does not plan to continue operating the pension plan after closing, the buyer does not necessarily need to require a seller to terminate a pension plan before closing (and, depending on the timing of a transaction, that may not even be feasible). A buyer could elect to terminate the pension plan at some later point after closing. Terminating a pension plan is a detailed and lengthy process that includes plan amendments, participant notices, potential funding obligations, ongoing Form 5500 reporting obligations, and PBGC and IRS reporting and determination processes, and can take around a year to complete.
• If the buyer intends to terminate the pension plan at or shortly following closing, then determining the appropriate funding status of the plan and whether additional contributions are needed (and who will pay for such contributions within the purchase agreement) becomes a critical point to address during the transaction.

5. What Do We Do with the Pension Plan After the Transaction Closes?

• Determine whether any plan amendments or updated participant communications or notices are necessary.
• Determine who are the pension plan’s current fiduciaries and plan administrators and if those delegations need to be updated to transition to the buyer’s other previously established fiduciary committees or to change authorized signatories for the plan.
• Ensure there are sufficient procedures and policies in place to adequately administer the pension plan and to implement the plan’s governance, investment, and other fiduciary decisions. Establish a regular cadence for review of the plan’s administration and investment performance. Establish contact and ongoing correspondence with third-party service providers for the plan.
• If the buyer already maintains other pension plans within its controlled group and will maintain the newly acquired plan after closing, then consider whether there are cost or administrative efficiencies in consolidating pension plan third-party vendors (e.g., plan recordkeeping, investment fiduciaries, etc.) and the appropriate timing for making those changes.
• If the buyer already maintains other pension plans within its controlled group and will maintain the newly acquired plan, then consider whether it makes sense at some point to merge the pension plans into a single plan. There are various considerations when deciding whether and when to merge pension plans, including those related to the funding status of each plan and PBGC premium costs. The plan sponsor should consult its various advisors before consolidating pension plans.