In German companies, corporate pension schemes are a main social benefit with a long tradition and high appreciation. With a share of nearly 70% (source: Lurse pension plan study), direct commitments represent the most important implementation method. It stands out due to its financial efficiency and flexibility compared to the other four implementation methods. The pension obligations can be netted with plan assets and a remaining deficit is shown as a provision in the balance sheet. Nevertheless, direct pension commitments are increasingly viewed critical today. Liability and market risk increases balance sheet volatility and impacts P&L, pension administration requires deep expertise and attracting and retaining these experts becomes more and more difficult.

Especially in M&A activities and restructurings, they are often considered obstacles. Against this background, companies are examining the optimization of their pension obligations and planning de-risking measures. In addition to traditional options, such as financing pension obligations through CTAs, reinsurance, pension funds, and plan redesign, the pension buyout is also included. Unlike CTA or non-insurance pension funds, the pension buyout allows for a complete pension liability risk transfer. In terms of IFRS accounting, it is a partial settlement while the remaining pension liability can be netted against the plan assets. The following article provides an overview of the current state of discussion and enables the assessment of the associated possibilities.

Release of Pension Risks
The transfer of pension obligations from pensioners and vested leavers and the corresponding assets to a pension company (German limited company) is referred to as a pension buyout. From a tax and German GAAP perspective, the pension obligations are dissolved which triggers a positive P&L effect. The required funding of the pension company represents a corresponding expense. It is a single-purpose company. This means that it will pay all pensions due until all obligations have been met. Additionally, it manages the pension obligations and the required capital. The pension buyout works for all types of pensions. There is no need for an approval from the work council, pensioners or the Pension Security Association (PSVaG). The pensions continue to be protected by the PSVaG. The required capital equipment of a pension company is derived from the case law of the Federal Labour Court (BAG) dated March 11, 2008 (3 AZR 358/06) and subsequently explained. Furthermore, according to § 133 of the Umwandlungsgesetz (UmwG), the transferring company and the pension company are jointly liable for pension payments that are due to pay within the first 10 years. The transfer of pension obligations can be done by a spin-off or a hive down according to § 123 of the UmwG (hereafter referred to as a spin-off) or within the framework of a share deal.

Transfer by spin-off versus Share Deal
A pension liability risk transfer is usually carried out in a two-step approach. First, spin-off of the pension obligations and the associated assets to a pension company. The financing is usually done through existing CTA assets and liquid funds. In a second step, the shares in the pension company are sold to a pension buyout platform. Upon sale of the company all risks are transferred, and the pension liability is deconsolidated. Hereafter, the management is replaced, the company name changed, and all references to the former owner deleted. These steps ensure that the pension company operates completely independently of the original company and has no connections to it anymore.

In a share deal, the first step is obsolete. The company has ceased operations or spin-off its business operations to another company. What remains are the pension liabilities and the plan assets. The company has thus become a pension company and a straightforward sale of the company to a pension provider is all that is required. The beauty of the share deal is, that it is not subject to the requirements of the Federal Labor Court (BAG) regarding the required capital equipment nor joint and several liability according to § 133 UmwG.

Supreme Court ruling
With its decision dated March 11, 2008 (3 AZR 358/06, DB 2008 p. 2369), the Federal Labour Court (BAG) approved the creation of pension companies and continued its corresponding case law. However, it also made clear that the transferring company must ensure an “appropriate” financial equipment of the pension company. Otherwise, even after the end of the 10-year joint and several liabilities, there is a risk of damage claims against the transferring company.

Although the BAG does not give a definitive answer on what this means, it does provide some guidance by addressing the three main valuation parameters: longevity, discount rate and inflation.

Longevity: The BAG recommends using conservative assumptions, such as the mortality table of the insurance industry, to account for longevity risks.

Discount Rate: The discount rate should be based on a reasonable commercial assessment, e.g., the IFRS discount rate or the expected return of an underlying investment.

Inflation: The BAG specifies that the average inflation of the last 20 years must be used to ensure a realistic assessment of inflation.

In summary, it can be stated that the employer has fulfilled its duty of care if the capital of the pension company is sufficient to meet all due pension obligations, including the required pension adjustments. If capitalization deviates from the German GAAP DBO, it should be assessed by an actuarial expert.

Financing Options and Governance
There is full flexibility regarding the financing of a pension buyout. One option is the use of existing trust assets from a CTA-Trust, while another possibility is the use of existing liquidity of the transferring company. If there is a financing gap, this can be closed, for example, by a payment promise from the transferring company to the pension company (loan). In 2022, a pension buyout was financed with 60% CTA assets and 40% in the form of a payment promise (loan from the pension company to the transferring company). The amount, term, and repayment modalities of this loan are freely negotiable and can be flexibly tailored to the needs of the transferring company. This increases the flexibility and postpones the impact on liquidity to the future.

To ensure the protection of pensioners, comprehensive governance requirements are included in the spin-off agreement and the SPA. These include, among others, a CTA trust that ensures the purpose-bound use and insolvency security of the trust assets. Often, the withdrawal of surpluses from the pension company is regulated, and it is also possible for the transferring company to retain a business share in the pension company and thus control and decision-making powers (golden share).

Conclusion:
By transferring pension obligations to a pension company, whether by spin-off or share deal, companies can efficiently transfer their pension liabilities and risks. In terms of accounting, a (partial) settlement is achieved. The pension buyout has now become an established option in the context of de-risking corporate pension schemes and is particularly used in M&A transactions, restructurings, and company liquidations. The Federal Labor Court provided the necessary legal certainty with its ruling in 2008, and “best practice” is increasingly emerging on the market.

Author: Thomas Huth, Partner, Lurse