2014-Issue 17—In the context of a deal, a buyer of a business that participates in a multiemployer pension plan (MEP) is faced with a series of unique considerations, including balancing the economics of continued participation or withdrawal, as well as evaluating the risk of changes to the legislative environment. Private equity buyers have an additional issue because of a recent First Circuit decision (see below).
Unfortunately, there is no silver bullet to wall off exposure to MEPs at the time of an acquisition; however, a savvy buyer may make more informed decisions about these risks, particularly as they relate to purchase price.
This article provides a brief overview of MEPs, the key areas of focus for a buyer of a company that participates in an MEP, and how to evaluate, measure and consider the associated risks in a transaction.
Overview of MEPs and Funding Position
A multiemployer pension plan is a retirement plan maintained under a collective bargaining agreement where many employers contribute to the same master plan. MEPs are subject to the Employee Retirement Income Security Act of 1974 (ERISA) funding regulations.
There are about 1,500 multiemployer pension plans in operation in the United States. Uncollected liabilities from bankrupt contributing employers have left many of these plans with liabilities that substantially exceed the value of their assets. Furthermore, as the U.S. union population continues to decline, MEPs face difficulty increasing active enrolment that could aid their ability to recovery their funded position.
MEP Cash Funding Requirements
The Pension Protection Act of 2006 attempted to deal with the shortfall problem by requiring different contributions to MEPs that were in critical or “red zone” status (less than 65 percent funded) and endangered or “yellow zone” status (between 65 and 80 percent funded). Endangered plans are required to adopt a funding improvement plan, and critical plans are required to adopt a rehabilitation plan, requiring either or both increased contributions and reductions to future benefits. As of the latest reported figures in 2013, nearly 10 percent of MEPs are endangered and nearly 15 percent are in critical status.
A participating employer’s contributions are typically reset upon the renegotiation of the governing collective bargaining agreement. Both critical and endangered plans will require higher contributions from participants; a critical plan must also collect a 5 or 10 percent surcharge from employers who have not renegotiated a new collective bargaining agreement. In the worst case, plans in poor funding position may also reduce future participant benefit accruals such as early retirement subsidies.
Accounting and Tax Implications
One of the advantages of participating in an MEP is the simplicity of the accounting treatment. A typical benefit under this plan is defined as a flat dollar amount at retirement, often determined based on the number of hours, shifts or years worked by an employee. Each participating employer contributes a fixed contribution to the plan on behalf of its participants for a given period. While the contribution rate may change, a participating employer records an expense in the income statement equal to the cash contribution made to the plan. There is no recognition of either plan assets or liabilities on the employer’s balance sheet; the employer treats the plan as a “pay as you go” arrangement.
However, if the employer considers a withdrawal to be “reasonably possible,” the employer must disclose the potential magnitude of the withdrawal liability in the financial statement footnotes. If the participating employer believes that a withdrawal is “probable,” it should book the liability on its balance sheet as an immediate hit to the profit and loss statement. This amount is typically recorded as the net present value of future cash contributions owed to the plan rather than the aggregate sum of the contributions. Annual contributions to the MEP are fully deductible for tax purposes.
Buyers Should Consider the Risk of Increased Contributions for Participating Employers
To estimate the value of a target business, many buyers may look to a cash-flows model as an indicator of price. Unfortunately, information as to the expected future cash contributions to an MEP can often be limited. In lieu of detailed projections, we recommend that a buyer contemplating the purchase of a business that participates in a “red zone” plan consider a minimum 10 percent increase in per annum contributions as a conservative starting point; in some cases, the annual increase could be as high as 20 percent.
Buyers Should Consider the Risk of Withdrawal for Participating Employers
Withdrawal exposure is merely a contingent liability until an employer ceases contributing to or withdraws from an MEP. Once triggered, the employer is liable for the employer’s allocable share of the unfunded vested benefits as determined under section 4211 of ERISA. An employer that withdraws is required to pay its liability in annual amounts based on its contributions during the preceding 10 years; any amounts not fully amortized by the end of 20 years are forgiven.
Withdrawals can be triggered voluntarily or inadvertently. The closure of a facility or a decision not to renew a union contract could easily cause a partial or a complete withdrawal. Generally defined, a partial withdrawal is triggered by a 70 percent reduction in participation over a three-year period, whereas complete withdrawal is 100 percent cessation in the plan. Alternatively, companies participating in an MEP facing a funding deficiency could collectively opt to freeze the plan through a mass withdrawal to prevent ending up in the “last man standing” position.
In a stock sale or merger, withdrawal liability is not triggered, as the purchaser assumes it by operation of law. In an asset sale, the seller will be liable unless the buyer contractually agrees to assume it (which is normally the case).
It is not uncommon for employers to be unaware of the real risk; further, it is not atypical that a participating employer does not have an up-to-date estimate of the financial exposure of such a withdrawal. In any case, we recommend the buyer and their advisors attempt to best estimate the target’s exposure and consider a risk-adjusted purchase price reduction.
Risk of Legislative Changes
The Pension Protection Act, which governs funding to MEPs, has certain provisions such as the special rules for yellow and red zones that expire December 31, 2014. Many believe that the expiration of existing legislation may prompt Congressional review as to whether existing rules should be extended or a new framework should be established. To represent the MEPs’ interest, the National Coordinating Committee for Multiemployer Plans created a separate Retirement Security Review Commission in 2011, comprising more than 40 labor unions and large employers, to address plans’ funded status and develop a way to attract new employers to the plans.
In addition to the need of employers to review the Pension Protection Act funding provisions, it is also important to consider the future solvency of the Pension Benefit Guaranty Corporation (PBGC). The PBGC was established in 1974 as an insurance vehicle to guarantee qualified pension benefits in the U.S., covering both single-employer plans and MEPs in the event of insolvency. In both cases, the PBGC limits the level of guaranteed benefits per individual. The PBGC is generally funded through premiums paid by contributing employers to MEPs and sponsors of single-employer plans.
A recent statement by the PBGC reported that the aggregate plan deficit of MEPs was nearly $500 billion, an amount that creates a real risk given the current financial position of the PBGC, which has admitted to solvency concerns. Should the PBGC be required to assume more single-employer plans or MEPs through bankruptcy or other settlements, the PBGC’s financial position will worsen. This could result in substantial increases in annual PBGC premiums.
In the M&A context, a buyer of a business that participates in an MEP is faced with a unique dilemma in order to address the risks outlined above.
First and foremost, diligence alone may not fully uncover the severity of these risks. Employers are not automatically provided with information as to an MEP’s funded status. Further, if information is provided, it may be outdated and the liability may not be on the same basis that would be used to calculate the withdrawal liability for a given participating employer. We recommend that a buyer seek to obtain the latest available information about the plan’s status and at least consider an adjustment to purchase price for the probability-weighted value of the full withdrawal liability, as calculated through a discounted cash-flows method.
Looking to legal protections, we would also recommend that the buyer insist on protective representations and warranties in the purchase agreement; however, these are almost always limited to the risk of a withdrawal event prior to the closing date. It is uncommon for a seller to agree to a representation to honor withdrawal liabilities associated with a future withdrawal after the closing date.
Additional Strategic Considerations During Acquisitions
If the uncertainty of withdrawal exposure coupled with the continued worsening of the plan deficit is too risky for a buyer, it could consider voluntarily withdrawing from the plan. While this would require negotiation with the union, it would fix the amount due at withdrawal as of the closing date.
The cost of voluntary withdrawal from an MEP is not for the faint of heart, as even small employers may face millions of dollars in withdrawal liability if the plan is severely underfunded. In fact, the regulations were designed specifically to discourage companies from negotiating cessation with the unions. However, in recent years, employers have migrated their views from concern about inadvertently triggering withdrawal to voluntarily crystalizing the amount owed to the union plan before the situation gets worse.
Further Exposure for Private Equity Buyers
Under ERISA, each member of a controlled group of trades and businesses is considered jointly and severally liability for the employer’s share of defined benefit plan obligations. Until recently, the private equity community generally operated under the assumption that the fund and its portfolio companies were not in the same controlled group, as the fund was not a “trade or business.”
In fact, “trade or business” is not defined by ERISA or the Internal Revenue Code. Further, the position above was backed by a prior tax law precedent that investment activity alone is not considered the same “trade or business” (Whipple v Comm’r, 373 U.S. 193, 202).
That said, more recently, the First Circuit undercut this position in a case involving the withdrawal liability. A company owned by a number of private equity funds that previously contributed to an MEP withdrew from the plan and thereafter filed for bankruptcy. The MEP sought $4.5 million in withdrawal liability and argued that the private equity owner (which was solvent) was jointly liable because it and the employer constituted a controlled group. The U.S. District Court ruled in favor of the private equity fund, but the First Circuit reversed this decision, finding the private equity sponsor liable because it constituted a trade or business. (Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, 1st Cir. July 24, 2013)
Private equity firms and their advisors are still looking at this case to determine if it sets a wider precedent that the argument of separate controlled groups is now moot. The decision could have a significant impact, as it calls into question several other operating questions such that each portfolio company and newly acquired entity could be tainted by the same reach.
Alvarez & Marsal Taxand Says:
In many cases, the risks associated with acquiring an MEP may simply be chalked up to the cost of doing business. The risks outlined above, however, may lead to very real and material costs. Even if a buyer can gain comfort that the risks of triggering a withdrawal in the near term are unlikely, the issue is likely to crop up again in future years if the MEP’s funded status does not improve. Therefore, we recommend that a buyer consider the following:
- When estimating MEP future funding costs, assume a minimum 10 to 20 percent increase in per annum contributions in order to be conservative;
- Make an adjustment to the purchase price taking into account the probability and liability that would arise if there is a full withdrawal from the MEP; and
- Use protective representations and warranties.
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