Pension Liability Price Tag For Private Equity Funds and Their Investors

I have long maintained that any individual or organization that invests in a company needs to check under the employee benefits hood before allocating money initially, and regularly thereafter. I can give you countless examples where incomplete due diligence led to an overly rich acquisition or investment that resulted in a new owner having to deploy cash to write checks to retirees and/or incur the costs of restructuring an otherwise untenable situation.

Failure to carry out a comprehensive ERISA-focused due diligence of a target portfolio company is not good for numerous reasons. Having done economic analyses of companies with underfunded pension plans, I know firsthand that it is often a rude awakening for investors such as private equity funds when they are confronted with the reality that what they want and what they end up with in terms of buying forecasted growth are not always the same. Reasons to worry include, but are not limited to, the following:

  • A private equity fund may not be able to realize its target rate of return because a portfolio company cannot sufficiently grow without cash that is now redirected to support employee benefit plans.
  • A pension plan that has invested in said private equity fund will be none too happy if performance falls short of expectations, especially for something that arguably should have (and could have) been considered and addressed as part of the original deal.
  • An unhappy pension fund investor may turn around and sue a private equity fund for alleged failure to have properly researched "what if" situations, taken on "too much" risk and disclosed too little information. Litigation in turn can be an expensive proposition for a private equity fund, making it even more difficult to achieve even minimum hurdle rates.

The issue of private equity ownership and portfolio company pension liabilities was heavily discussed as the result of a 2007 Appeals Board of the Pension Benefit Guaranty Corporation ("PBGC") decision about ownership, control and responsibilities for portfolio company pension plan gaps. In "Private Equity Funds: Part of the ERISA Controlled Group?" (December 19, 2007), O'Melveny & Myers LLP attorneys Wayne Jacobsen and Jeff Walbridge explained that "[i]f the PBGC's position endures, it could have significant ramifications for private equity fund investments in portfolio companies that sponsor defined benefit pension plans...[t]he fund could be required to use any or all of its assets, including the ownership interests of the fund in any or all of its portfolio companies, to fund the pension obligations of the bankrupt portfolio company."

Imagine the happy faces in private equity land when the U.S. District Court of Massachusetts opined on October 18, 2012 in favor of Sun Capital Partners III, LP and related parties. According to "Potential ERISA Title IV Liabilities of Private Equity Firms - Eliminated by the Sun Capital Decision?" (November 2012), Edwards Wildman attorney Mina Amir-Mokri describes the decision as a "significant victory for private equity firms" but explains that Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund was to be appealed.

On July 24, 2013, the U.S. Court of Appeals for the First Circuit reversed the earlier decision and put private equity funds in a potential liability position once again. According to "Private Equity Funds Further Exposed to Portfolio Company Pension Plan Liabilities" (July 29, 2013) Latham & Watkins attorneys Jed Brickner and Austin Ozawa offer post-opinion practical hints such as the need for private equity firms to "carefully consider how to structure their funds and acquisition structures to avoid characterization as a trade or business and avoid inclusion in the same controlled group as their portfolio companies." Additionally, they urge private equity funds to pay attention to the "structure of their funds' investments"...possibly "dividing their investment between two or more of independently managed funds with distinct portfolios to support a finding that no individual fund (or group of 'parallel' funds) controls any portfolio company (and no set of funds is treated as a joint venture). Paul Hastings attorneys Stephen H. Harris, Eric R. Keller, Ethan Lipsig and Mark Poerio assert that private equity funds would do well to own "less than 80% of a portfolio company"...perhaps via "thoughtful adjustments to ownership structures and management operations" that can help to reduce the exposure to portfolio company pension liabilities. See "Private Equity ERISA Alert: Consider ERISA Pension Liability Risks from Portfolio Plans" (July 2013).

While legal experts weigh in on the important issue of what responsibilities belong to private equity funds, if any, to portfolio company ERISA plan participants, institutional investors such as pensions, endowments, foundations and family offices - and their investment consultants and advisors - should take heed. If a private equity fund's exposure to a portfolio company with a problem pension plan ends up shrinking the wallets of institutional investors, serious questions will understandably be asked about who should have done what and when.

Pensions and Politics

I have a favorite shirt that gets a few laughs when I wear it. The message is "Change is good. You go first." That is how I feel when I hear pundits talk about the future of pensions and the need for reform. What I continue to believe and have said many times in the last ten years is that the retirement issue is getting closer to the point of no return. Politicians will jump in to allegedly save the day. Part of the problem is that there is a battle of interests with few constituencies aligned to move in the same direction. When this occurs, a central authority typically intervenes.

On May 2, 2013, one speaker who presented as part of the "Bloomberg Forum on Pension Reform" called the situation "desperate." Another speaker said that he is optimistic that the U.S. Congress is proceeding apace with relevant reform. Another speaker hinted at inevitable higher premiums to be paid by plan sponsors to the Pension Benefit Guaranty Corporation ("PBGC"). Comments were made that some underfunded plans will have to materially cut retirement benefits in order to survive.

People are starting to ring the alarm bells. In its 2013 Retirement Confidence Survey, the Employee Benefit Research Institute ("EBRI") found that only 13 percent of workers feel "very confident" about the ability to enjoy a comfortable retirement. That means that 87 percent of workers do not feel confident. Click to see the results of the 2013 Retirement Confidence Survey.

It is unclear how much power voters will have to effect movement as relates to retirement reform such as tax incentives to save, especially when the issue is seldom discussed as part of political campaigns. That could change over time.

When I recently took my 22-year old nephew out to lunch, we talked at length about his views on the budget. He has no debt and has found a job but he knows that many of his peers are not so fortunate. They are graduating with large school loans, have not found a job and are sleeping on mom's couch. These "boomerang" kids are growing in numbers around the world. While they may not be an economic force right now, they vote. At the polar opposite end in terms of desire for how the system should change, if at all, retirees vote as well.

How will politicians respond to younger persons who do not want to shoulder the high costs of social safety net programs and seniors who want them?

Politics and pensions may not make for strange bedfellows after all. As a champion of free markets, I am not particularly happy about the prospect of a "one size fits all" law(s) that seeks to create a national retirement system and/or levies tax penalties for those who wish to save more than $3.4 million or whatever level is deemed "too much." Think higher compliance costs, perverse incentives, the law of unintended consequences, moral hazard and the loss of flexibility. Unfortunately, with disparate owners who each want different things, something will have to take place soon. Many of the retirement piggybanks around the world are close to empty.

Withdrawal Liabilities, Corporate Sponsors and Union Members

Like many others, union members are grappling with a jittery economy and its impact on plan sponsors. As a result, companies are exploring ways to restructure employee benefit plans in order to contain costs and still keep pension promises.

Just yesterday, Pensions & Investments' Barry Burr wrote that United Parcel Service, Inc. ("UPS") is paying $1.2 billion as a withdrawal liability to the New England Teamsters & Trucking Industry Pension Plan. In exchange, and subject to approval by its employees who are union members, UPS will not have to pay for other companies' employees. According to "UPS to leave New England fund, strikes funding deal," the popular delivery company will write a check every year over the next half century for $43 million. An accounting charge of $896 million will be recognized in this year's financial statements.

On August 28, 2012, Dow Jones Newswires explains that UPS sees the creation of this new pension plan - to replace the old one - as "being fair" to multiple constituencies such as shareholders as well as to employees.According to "UPS Restructures Pension, Sees $896 Million 3rd-Quarter Change" (Nasdaq.com, August 28, 2012), over 10,000 employees will be affected.

The action did not go unnoticed by at least one rating agency. On August 28, 2012, Standard & Poor's explicitly referenced the company's liability exposure to multi-employer plans as part of its rating assessment of UPS and added that the IOU is seen as a "debt equivalent" and "significant."

The take-away points are clear.

The large and long-lived costs associated with offering ERISA plans continue to dominate the discussions in numerous corporate corridors. Besides having to infuse cash (sometimes billions of dollars), company plan sponsors may be in danger of ratings downgrades. A drop ratings boots the cost of capital which in turn narrows the universe of positive net value opportunities that help to grow enterprise value. Funding issues with employee benefit plans could force M&A deals to evaporate.

Expect other companies to announce pension restructurings.

What remains to be seen is whether a showdown between shareholders and participants will ensue with either or both groups asking ERISA fiduciaries to justify the terms of a particular deal in court.

Is More Regulation for Corporate Plan Sponsors On Its Way?

Two items caught my eye of late, mostly because they seem to intimate new bargaining power for organized labor. Yes, I know, it hardly seems plausible when automotive workers are currently being challenged to accept lower benefits in order to keep their employers afloat.

In "Organized labor 'thrilled' with Obama's pick for labor secretary" (December 18, 2008), CNN.com reports that Representative Hilda Solis, if confirmed, would be considered a "voice for people who work." Hailing from California, this Democrat lawmaker is the "daughter of two immigrant workers and union members."

In "The Employee No Choice Act" (CEO Magazine, November/December 2008), law professor Richard Epstein writes that a new political regime in the United States will force a "major sea change in labor relations law." This notable University of Chicago free marketeer opines that interest arbitration, a key component of this proposed legislation, empowers an arbitration panel to "dictate a 'first contract' lasting two years that will govern all aspects of the employment relationship." Wages, work conditions, job security and outsourcing are a few of the items that can be decided by those outside of any particular corporation.

Epstein offers that unionization could become a foregone conclusion, with employers having little or no sway over the final outcome, once an initiative to organize commences. In stark contrast, he writes that arbitrators "are empowered to flesh out all the book-length terms of that first key contract, terms never put to a vote." He adds that workers who sign cards to authorize the creation of a union will not be permitted to withdraw them if they change their view later on. Epstein further adds that this legislation, if approved, would be "tantamount to giving a new union a powerful claim on  firm assets."

If Epstein is right, how will shareholders, plan participants and union members co-exist peacefully, if at all? Many questions arise, a few of which are shown below:

  • Will shareholders' economic interests in an ongoing concern become inferior to those of union members and, if so, how will that reveal itself in share price?
  • How will union members deal with conflicts that arise from wearing multiple hats as might be the case if a Taft-Hartley plan owns stock issued by contributing employers?
  • In the event of a bankruptcy filing, who gets what and when? Will union members rank pari passu or superior to everyone else?
  • How will a multinational firm fare if its U.S. operations fall under the auspices of the Employer Free Choice Act but offshore units are unaffected by similar rules?

This next year will be an interesting one for sure but not likely to be one in which everyone sits on the same side of the table.

Editor's Note: For an opposing perspective about the Employee Free Choice Act, click to visit a site sponsored by AFL-CIO.

U.S. Celebrates Labor Day

According to the U.S. Department of Labor website, Labor Day occurs on the first day of every September and is "dedicated to the social and economic achievements of American workers." Over 100 years old, the holiday was first celebrated on September 5, 1882 in New York City, due to efforts of several labor unions.

Editor's Notes: Here are a few information sources about labor in the U.S. and elsewhere.

CalPERS Invests in Infrastructure

According to blogger extraordinaire and Sacramento Bee reporter Jon Ortiz , the California giant will now invest in "PPP" (public private partnership) deals but with strings attached. According to their policy entitled "Infrastructure Program," posted on "The State Worker" and elsewhere, projects to build bridges, roads and other types of infrastructure should avoid displacement of California municipal workers "provided that CalPERS' fiduciary responsibilities are met." Subsequent text adds that "the investment vehicle shall make every good faith effort to ensure that such transactions have no more than a de minimus adverse impact on existing jobs."

Far be it from me to impugn any group of workers, municipal or private. However, one does wonder if CalPERS and infrastructure fund managers will soon find themselves at loggerheads. If I read the policy correctly, it seems to put an awful lot of responsibility on external portfolio managers to address wage differentials (if any exist) for the express purpose of assessing the cost-effectiveness of labor resources. Employment economics is a speciality in its own right. Should infrastructure moneymen (and women) hire outside experts to undertake a comprehensive study to determine whether private versus public workers are best suited for a particular project? How might such fees, paid to labor economists by money managers but passed along to institutional investors such as CalPERS, erode reported returns? Could returns be eroded by so much that the benefits of investing in infrastructure in the first place are more than offset by CalPERS' mandate to avoid loss of state jobs?

According to Brian K. Miller ("CalPERS Changing PPP Language," GlobeSt.com, August 15, 2008), the California Public Employees Retirement System ("CalPERS") altered its policy so as not to be sued by the Professional Engineers in California Government ("PECG"). The American Council of Engineering Companies of California (the private equivalent of the PECG) countered that threat of litigation does no one any good.

Does this type of allegedly veiled political "intervention" sound familiar?

Just a few days ago, Massachusetts State Treasurer Tim Cahill said "no thanks" to Governor Deval Patrick, when asked to allocate pension assets to bonds issued by the state's student loan organization. In "Cahill rejects student-loan proposal" by Casey Ross (The Boston Globe, August 8, 2008), fiduciary concerns are front and center. In "Massachusetts Pension Plan Urged to Invest in School Loans" (August 8, 2008 blog post), I wrote as follows:

Here's the rub. The state pension trustees have a fiduciary duty to make sure that the plan is in good financial shape. Will statutory investing put those fiduciaries at risk for allegations of breach in the event that MEFA bonds sour or perhaps offer a sub-optimal return?

I think the same principle applies to the CalPERS decision, sending mixed signals about competing constituencies - state engineers versus plan participants. Complicating things, could state workers win now by keeping their jobs (for certain infrastructure projects) but lose later on if infrastructure investments fare poorly due to labor-related cost issues and so on?

What a dilemma!

Massachusetts Taxpayers Protest New Benefits

According to Boston Globe reporter Matt Viser ("Bigger pensions drawing protests," May 28, 2008), an increase in retirement benefits for teachers and state workers will cost more than $6 billion. Meant to help individuals cope with a higher cost of living, some local officials say it will cost jobs instead. With no funding and limited budgets, the money has to come from somewhere and layoffs are inevitable. Making matters worse, taxpayers argue that closed-door hearings make it impossible to understand the likely fallout for cities and towns. Critics counter that "this has been a very open, transparent discussion." Besides the obvious impact on cash flow, State Treasurer Timothy P. Cahill calls attention to the bigger picture, adding that the "Legislature's approach will put the state's credit rating in jeopardy."

According to "Promises With a Price: Public Sector Retirement Benefits," Pew Center on the States, December 2007, Massachusetts has an unfunded liability in excess of $14 billion. (In contrast, the reported unfunded liability for states such as California and Illinois topples $40 billion.) According to their color coded map, Massachusetts is a blue state, meaning that its defined benefit plan funding falls between 70 and 79 percent.

Though written nearly two years ago, our blog post entitled "Tea Party Redux: State Pensions in Turmoil" (July 27, 2006) is worth a quick read. There is absolutely no doubt that retirement issues will occupy more and more of lawmakers' time. To repeat what I said then:

<< Nothing is ever free. Someone, somewhere, somehow, pays the bill. How will politicians respond? After all, grumpy taxpayers tend to vote. >>

Pension Power in the Boardroom

On April 7, 2008, this blogger wrote about unhappy pension campers, seeking to rid troubled companies of certain board members. (See "Three Public Pension Plans Say No Thanks.") At the time, the general consensus seemed to be "good luck but don't count on being able to oust anyone" in part because experts suggest that boards may be limited in their oversight capabilities. In what appears to be a win for protesting pensions, director Mary Pugh has resigned from Washington Mutual. According to The Street.com, CtW Investment Group had asked shareholders to draw support for Pugh (chairwoman of the bank's finance committee) and a second director, James Stever (chairman of the human resources committee). In a slide presentation and on its website, CtW blames this duo for failing "to recognize and act in a timely manner on the risks to shareholder value presented by the housing bubble" and for not reducing executive bonuses as a result of "this risk management failure." Note that she was re-elected with "50.4 percent of the shareholder vote" according to the Associated Press ("WaMu directors narrowly re-elected in shareholder vote, April 16, 2007), notwithstanding a Q1-2008 reported loss of $1.1 billion.

Click to read "WaMu Director Resigns Under Pressure" by Laurie Kulikowski (TheStreet.com, April 15, 2008).

Parisians Protest Pension Cuts

Ooh la la! Parisians take to the street to protest proposed pension cuts. (Fresh in the memory of many New Yorkers, transit workers stateside went on strike in late 2005 for similar reasons. Read the CNN account  entitled "Union votes to end New York transit walkout.")

Over a week ago, Gallic transportation employees said "no" to suggested cuts in their pension benefits. BBC News reports that "Opinion polls suggest voters back the French leader's plans to reform 'special' pensions which allow transport and utility workers to retire early, but a majority sympathises with civil servant grievances." While French President Nicolas Sarkozy holds firm, large crowds of teachers, hospital workers, air traffic controllers and postal clerks actively sympathize. Click here to read more about what is being described as a massive strike. The video below presents the opposing point of view.

The outcome will speak volumes for France and other countries, struggling to achieve greater economic growth, at the same time that unions seek to protect workers' rights.

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Fly Away Pension Promises?



Memorial Day fireworks will be extra special for two airlines - American and Continental. In a pre-holiday move, Congress and the White House okayed the use of an 8.25% rate to determine the estimated DB liability, attempting to create parity for solvent airlines. (Higher discount rates lower the projected net unfunded liability for a defined benefit plan.) According to reporter John Crawley ("US Congress weighs new pension relief for airlines," May 24, 2007), this is "still below Northwest and Delta but more generous than the tougher formula required by lawmakers last year." Click here to read the article.

In response, the Allied Pilots Association (APA), "representing the 12,000 pilots of American Airlines (NYSE: AMR)" cautioned management not to use new rules as an an excuse to reduce funding. APA president , Captain Ralph Hunter, reiterated the unions' agreement to annual concessions of more than $600 million, motivated in part by the recognition of being "at risk in bankruptcy court." Click here to read the full text of the May 25, 2007 press release.

This is not the first, nor the last time, that discount rate discussions will take center stage. Questions about appropriate assumptions linger. (According to the H-15 Statistical Release, 20-year U.S. treasury bond yields as of May 21, 2007 were reported as approximately 5.02%.)

In a December 11, 2006 speech to CPAs, SEC Fellow Joseph B. Ucuzoglu cites an important element of the Pension Protection Act of 2006, taken together with the Financial Reporting Release No. 72. Registrants "should provide transparent disclosure in Management's Discussion & Analysis of the Act's anticipated impact on the company's liquidity and capital resources. Although in some circumstances it will be difficult to forecast precise funding requirements due to the annual recomputation required by the Act, it will often be possible to provide disclosure of the magnitude of cash commitments for future annual periods assuming present market conditions remain constant."

What are the implications?

1. New legislation allows additional airline carriers to use an estimated discount rate that is, by some accounts, "too high."

2. If the result is an artificially low estimated liability number, SEC filings could reflect an overly optimistic assessment of a company's liquidity situation and related ability to pay.

3. Plan participants may therefore want to take a tour "behind the numbers." After all, cash is required to pay benefits, irregardless of discount rate assumptions.

4. Don't stop with airlines. Compare reported discount rate assumptions with economic reality for a given plan. Does the number comport with current capital market conditions? Is it sustainable? If not, what is the likely TRUE impact on benefit plan payouts and the funding needs of the plan sponsor and isn't that important information to have?

Union Pension Power

In response to a request from the United Brotherhood of Carpenters and Joiners of America, American Express Co. is slicing retirement benefits for top executives by more than ten percent. According to Wall Street Journal reporter Robin Sidel, the changes "come amid shareholder criticism over supplemental executive retirement plans, or SERPS, that award big pay packages to departing executives." (See "Top Executives at American Express Will See Retirement Benefits Shrink" - January 27-28, 2007).

This is not the first time that unions have taken an activist stance nor will it likely be the last. Check out the long list of Annual Group Meeting (AGM) resolutions brought by union pension plans, courtesy of Ms. Jackie Cook, a researcher on director interlocks and corporate social responsibility. Click here to access the list.

Now that new, and arguably more rigorous, SEC executive compensation disclosure rules are in effect, it will be interesting to observe union response. Will juicy corporate pay packages encourage even more attempts at reform? Will rank-and-file workers find it difficult to lobby for cuts in executive perks while asking for personal hikes? How will the dual role of employee and shareholder affect union clout?

"Workers unite" could start to take on an altogether different meaning.

Protesting Pension Contributions - Who Should Pay?



According to a recent article in the Press-Enterprise, University of California workers expressed their outrage at being asked to contribute to their pension plans. Likely to impact 18,000 workers, "UC officials maintain that employees must contribute to the pensions to preserve them." A university spokesman, Mr. Brad Hayward, said that this sharing of responsibility is nothing new. "UC employees did contribute to their pensions until the early 1990s." He added that employee contributions wil occur gradually with no expected impact on take-home pay during the first post-reform year.

Critics argue that clerical and other lower-wage workers are already in a financial pickle without adding additional burdens.

This story caught my eye for several reasons, not the least of which is what I believe is the beginning of a heated (perhaps incendiary) debate about the rights of taxpayers versus municipal workers. This would include public universities such as the University of California, self-described as among the best in the world.

(In case you missed it, click here to read about the modern day version of the Boston Tea Party.)

An oft-cited position is that municipal workers agree to accept relatively lower wages in exchange for generous benefits. Accepting this point as reality (and ignoring for a moment that some do not accept that view), does a public employer's proposed rule change suggest a violation of an implicit work arrangement with employees? (The situation is arguably different when a labor-negotiated contract exists.)

What are the rights of the taxpayers who fund these benefits? Do they ever get a chance to approve or veto benefit payments or are they simply expected to pony up when benefits are due?

Moreover, this event illustrates the undeniable trend towards shifting post-retirement financial responsibility to employees and away from employers. Low-wage workers are not the only ones affected. Even middle managers know that the array of post-employment benefits is dwindling. Many companies no longer offer a defined benefit plan or, in some cases, any type of defined contribution plan.

Then there is the issue of fiduciary responsibility with respect to oversight of a growing net unfunded liability. Returning to the article, Hayward is quoted as saying "We need to be in a position where employees who retire actually receive the benefit that has been promised to them."

On the outside looking in, this statement is disturbing. It seems to suggest that there are insufficient funds to make current retirees whole without getting monies from those who still draw a regular paycheck.

This sounds familiar, doesn't it?

Think Social Security and any other "pay as you go" scheme that cannot survive without cash from current payrolls.

Labor Day Roots



1. According to the U.S. Department of Labor website, "The first Labor Day holiday was celebrated on Tuesday, September 5, 1882, in New York City, in accordance with the plans of the Central Labor Union."

2. The Public Broadcasting Service (PBS) website provides some additional insight with a variety of articles about this U.S. federal holiday. "Conceived by America's labor unions as a testament to their cause, the legislation sanctioning the holiday was shepherded through Congress amid labor unrest and signed by President Grover Cleveland as a reluctant election-year compromise."
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Pensions, Manhattan Style





New York Times reporter Mary Walsh and Michael Cooper offer a grim assessment of New York City's pension finances in their August 20, 2006 article entitled "New York Gets Sobering Look at Its Pensions". Their research suggests a funding gap as large as $49 billion or "nearly the size of the city's entire annual budget and the equivalent of the city's publicly disclosed outstanding debt."

A key point of contention is how to properly measure the true economic value of the city's pension obligations. According to the article, New York City employs a unique method that sets the pension shortfall to zero. By doing so, it is never clear whether the plan is in deficit and to what extent. Apparently the method started at a time of bounty, with the aim of preventing a raid by officials.

As this author has repeatedly said, you must be able to properly measure the pension liability. Otherwise, how can one identify what corrective action to take, if any, to set the plan right? (Written for private plans, the same commentary applies in concept to public plans. Good information is everything. Click here to read "Will the Real Pension Deficit Please Stand Up?")