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How does a pension buy out work?
A pension buy-out has several stages:
If a company has made pension commitments to its employees, it must reflect these in its balance sheet and accrue the corresponding provisions. The provisions to be accrued are determined on the basis of an actuarial interest rate and other parameters, such as inflation or mortality. These pension liabilities can either be assigned to dedicated assets or they are covered by assets in general.
A pension buy-out aims to spin off the pension liabilities from the company and its balance sheet and thus transfer the risks to a so-called pension company.
In a first step, the pension liabilities of a company are transferred to a new company – a dedicated pensioner company - together with the assets required to fund them; this spin-off or hive-down is governed by the German Transformation Act (UmwG).
The adequate capitalization of the pensioner company is regulated by German labor law and the associated federal court rulings and has to be based on a conservative view on longevity and discount rates and account for the long-term inflation developments.
VEDRA Pensions will subsequently acquire the shares in this limited liability company for a corresponding purchase price and will thus also take over the economic risks and opportunities of the pension company. For the transferring company this means - if structured correctly - an immediate legal and balance sheet de-liability of the pension liabilities (de-risking).
VEDRA Pensions invests the capital transferred to the pension company to fund the pension obligations, services current and future pension payments. In the case of the establishment of a trustee, the trustee monitors compliance with the agreed investment guidelines and the corporate governance of the pension company
Our renowned investment committee advises and monitors, especially regarding liquidity management, asset allocation and the selection of investment partners. Our clients and our beneficiaries benefit here from the many years of relevant experience of VEDRA Pension and our carefully selected partners, which we naturally coordinate.
For everyone who wants to know a little more, we are happy to explain the procedure below.
In general, it can be said that there are several ways in which companies have dealt with their pension liabilities up to now:
On-balance sheet pension liabilities (“Unfunded pension liabilities”)
The first option, still surprisingly often chosen, is to hold pension liabilities on the balance sheet, i.e. without any funds specifically set aside to cover the pensions.
Surprising because this does not involve active risk management, so companies are exposed to the liquidity burden and the underlying risks over the entire course of time.
In addition, risks from the performance of operating assets and the ever-increasing expense associated with the highly complex regulations and their monitoring add up here.
The economic performance of the company must cover these risks and generate and sufficient free cashflow for future pension payments.
Ultimately, companies are not only liable with their entire assets for current and future pension payments, but also assume that cash flows will be sufficient to cover pension payments in the future.
Dedicated funding (and outsourcing of pension liabilities (“funded” pension liabilities)
Larger companies, on the other hand, have often already set aside financial resources and offset these against the pension liabilities with the help of constructions such as CTAs. (In some cases, also with the use of dedicated vehicles like German-style pension funds).
On the balance sheet itself, only the net amount as the difference between pension liabilities and pension assets is shown. However, legally the pension risks still remain with the company. If the gap between pension liabilities and investments widens, the difference is recorded on the balance sheet, leading to fluctuating equity ratios, for example.
Accordingly, companies not only bear the classic risks of the pension liability, i.e. inflation and mortality as well as discounting factors, but additionally also the risks and opportunities from the investment strategy.
Companies thus ultimately retain the pension risk.
Pension risk transfer via a pension buy-out
In a first step, pension liabilities together with a pool of assets are transferred as a spin-off into a newly created limited liability company (typically a German GmbH). The pension obligations are bundled in this company; its sole purpose is therefore the complete fulfilment of the pension commitments.
To ensure this complete fulfilment of the pension commitments, the legislator has regulated the capitalisation of the pension company at the time of the spin-off. Thus, conservative assumptions on longevity and discount factors must be used as well as an adjustment of pensions based on long-term inflation data.
The pension company with its liabilities and the financial resources covering them according to the above is outside the balance sheet of the operating company. This directly improves its balance sheet ratios and operating metrics.
In the same step, the legally exempting takeover of pension liabilities takes place.
VEDRA Pensions takes over both the settlement of the original pension commitments as well as the associated administration and the other risks of the commitment such as interest, longevity and inflation or market risks.
It is also important to note here that a buy-out usually also involves the use of a CTA, which is used for a specific purpose as a trust to protect the pensioners and brings with it additional insolvency protection (especially in the case of independent governance).
VEDRA Pensions makes pension payments over time from the assets taken over and the income generated from them. In a pension buy-out, as it has been carried out several times by VEDRA Pensions, the company therefore actually transfers all risks in full. Costs are also only incurred for the actual buy-out; the ongoing administration costs in the pension company are small due to the economies of scale of VEDRA Pensions.
For companies, a so-called de-risking has more advantages than it may seem at first glance.
After all, for many companies, pension commitments that are structured as defined benefit pension plans represent a major challenge due to the many risks involved, especially financial risks.
These pension risks definitely put a strain on a company's short-term profit and cash flow situation. But they also influence the long-term financial and strategic position of a company.
Again and again we find that they have a negative impact on planned M&A activities and thus deprive companies of needed room for manoeuvre. Outsourcing liabilities or risks to a pension company thus also simplifies corporate transactions and restructuring.
If you have any questions or would like more information, please contact us
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