With our “Pensions Update” we would like to inform you regularly about labor law, tax law and accounting issues relating to company pensions.
In our second issue of 2014, our editorials cover the current framework parameters for asset preservation analysis in the review and decision on the adjustment of company pension benefits as well as the latest developments on the risk management of pension liabilities. This issue also includes articles on the medium-term development of the HGB discount rate and possible courses of action, on current trends in the treatment of pension liabilities in corporate transactions, and on current labor court case law. This issue is rounded off by a brief outlook on the BMAS’s current draft legislation on the modification of defined contribution plans.
We wish you a stimulating read!
Your Pensions Team of KPMG Rechtsanwaltsgesellschaft mbH and KPMG AG Wirtschaftsprüfungsgesellschaft
Susanne Jungblut and Dr. Lars Hinrichs
It is not uncommon for companies to experience temporary negative results due to a variety of influences. The obvious solution in this case is to suspend the adjustment of company pension benefits. However, this is not recommended without more detailed examination and an accompanying business appraisal. The article explains the relevant pa-rameters for the (non-) adjustment of company pensions.
Employers are required to conduct a review and make a decision on the possible adjustment of pension benefits every three years for current benefits from pension commitments that are subject to the German Company Pension Act (BetrAVG). The standard of review for the adjustment review and decision is derived from Section 16 of the German Occupational Pensions Act (BetrAVG). Accordingly, the interests of the pension recipients and the economic situation of the employer are to be taken into account equally in the adjustment review (Section 16 (1) BetrAVG).
The concerns of the company pensioners are deemed to have been taken into account if the loss of purchasing power suffered by the company pensioner is compensated. Alternatively, the employer may limit the compensation for the loss of purchasing power for the individual company pensioner to the real wage development of comparable employees of the company (Section 16 (2) no. 2 BetrAVG). The relevant review period for determining the two variables is generally the period between the pension commencement date and the current review date. The BAG alternatively recognizes in its established case law that the employer chooses a uniform cut-off date in the calendar year for the bundling of audit dates of all company pensioners in order to limit its administrative expenses (most recently, for example, BAG ruling dated October 21, 2014, 3 AZR 1027/12). Moreover, in the event that company pension adjustments were rightly omitted due to the employer’s poor economic situation, the period from the last to the current review date shall be taken into account.
The economic situation of the employer is not specified in the law. For this reason, the case law of the German Federal Labor Court (Bundesarbeitsgericht, BAG) has been (and continues to be) continuously concretized: According to this, an adjustment of current pensions may be omitted if the additional costs resulting from the adjustment place an excessive burden on the company and thus restrict or endanger the company’s competitiveness. Furthermore, it should not be necessary to accept the loss of jobs within the active workforce as a result of the increase in company pensions. The BAG recognizes an excessive burden if it can be assumed on the basis of a forecast on the adjustment date that the employer will probably not be able to raise the cost-of-living adjustment from the increase in the value of the company and its earnings in the period up to the next adjustment date. The forecast is to be based on the economic development in the three years prior to the adjustment date. The results of these three financial years are to be adjusted for special items which do not allow any conclusion to be drawn as to a sustainably improved or worsened future earnings situation of the company (BAG judgment dated October 21, 2014, 3 AZR 1027/12).
The financial statements prepared in accordance with German commercial law provide a suitable basis for assessing the economic situation. Based on the information from the income statement, the aba Arbeitsgemeinschaft für betriebliche Altersversorgung e. V. developed a model as early as 1987 – this has since been further developed – which assumes that the company only has a limited amount of financial resources available for any pension adjustments. Thus, existing financial resources must first be used for classic corporate purposes (cf. following figure) before free uncommitted funds can be used for salary adjustments, profit sharing, but also for pension adjustments.
In addition to the disclosures to be included from the income statement, the BAG also provides for two corrections required by business management which have a reducing effect on the disclosures under commercial law:
If the two adjustment variables are taken into account within the expenses, which must be incurred mandatorily or appropriately, and compared with the company’s actual earnings, the so-called adjustment potential is obtained. If the adjustment potential is a positive amount, a partial or full pension adjustment is to be assumed. A negative adjustment potential, on the other hand, indicates that no financial resources are available for pension adjustments.
What other facts, if any, need to be considered?
Irrespective of the amount of the adjustment potential, a pension adjustment is generally not applicable if the pension charges resulting from future company pension entitlements exceed equity. Furthermore, the individual company is granted sufficient equity capitalization. Thus, companies are not obliged to finance pension adjustments from the company’s assets. This also applies if new capital is injected into the company by its shareholders. Companies are therefore initially allowed to rebuild lost assets by using the annual surpluses generated after the loss-making phase to replenish equity.
If reliable indications (cf. the above explanations) can be proven which confirm the poor economic situation of the company, the company can rightly refrain from adjusting the company pensions as of the adjustment date. This is in accordance with § 16 para. 4 of the German Occupational Pensions Act (BetrAVG) in subsequent years, at least not for pension adjustments due after December 31, 1998. Subject to this, however, this shall also only apply if the employer has explained to the pension recipient in writing and in a comprehensible manner the economic situation that precludes the adjustment, has informed the pension recipient of the consequences of not objecting in due time and the pension recipient has not objected in writing within three months.
Finally, it should be clarified that in the following case constellations, special features must be taken into account in the adjustment test:
– For pension commitments that grant an adjustment guarantee.
– In the case of pension commitments by the Essener or Bochumer Verband.
– In the case of pension commitments based on collective bargaining agreements.
– In the case of group interdependencies-
In this case, it may be necessary to include other test criteria in the decision-making process. A more detailed discussion of these case groups will be the subject of an article in the next issue of Pensions Update.
It is not only the results of the annual financial statements that determine the suspension of company pension adjustments due to the employer’s poor economic situation. In addition to taking account of corrections required for business reasons, it must be examined whether the company can actually raise the cost-of-living adjustment from future earnings. The employer should therefore regularly flank the adjustment review with a business appraisal which, in the event of a decision to refrain from an adjustment for the relevant economic reasons, at the same time forms the basis of argumentation for justifying the refraining from the adjustment.
By promising a company pension, the employer typically establishes very long-term obligations towards its employees. With this comes a host of potential risks. Identifying and managing these risks is one of the key objectives of comprehensive pension governance. How well-developed is pension governance at German companies? KPMG used a questionnaire to assess the maturity of risk management with regard to pension obligations. The responses provide a clear picture of the extent to which pension governance has already been implemented at large companies.
Due to its long duration and a number of uncertain influencing factors, a number of potential risks are associated with the promise of a company pension. These can be broadly divided into the following categories:
As a rule, financing and liquidity risks are most present to companies. In general, there is a risk of insufficient or insufficiently liquid funds being available at the time the promised benefits fall due. On the one hand, there is a risk that expected funding requirements will be underestimated, for example due to ever-increasing life expectancy. On the other hand, the investment risk plays a role in external capital cover. This is particularly evident in the current low-interest phase, in which higher returns can often only be achieved with higher-risk and thus more volatile investments.
A distinction must be made between financing and liquidity risks and valuation risks. A change in the valuation assumptions – whether due to changes in the economic environment or to legal or accounting requirements – may result in an unexpected and sudden increase in the pension provisions recognized in the balance sheet.
Political, legal and procedural risks are often underestimated. The current EU mobility directive on the dynamization of vested rights to occupational pension benefits (dated May 20, 2014) shows once again how legislative changes can increase the scope of companies’ obligations. Inadequately defined responsibilities or processes in connection with the company pension plan, on the other hand, often do not cause a direct increase in the scope of obligations. However, this may give rise to significant unrecognized risks, the materialization of which at a later date may result in an unexpected increase in pension obligations.
What are the options for minimizing risks?
Financing and liquidity risks in particular, but also valuation risks, vary in severity depending on the structure of the pension commitment. Traditional pension commitments are of a defined benefit nature, with benefits often dependent on final salary (final salary commitment). For several years now, the trend has clearly been toward defined contribution plans. Selected risks can thus be eliminated or at least reduced for the employer if the plan details are suitably designed.
The transfer of certain risks to an external provider (e.g. outsourcing of longevity risk by means of life insurance or longevity swaps) can also be a sensible risk-reducing measure.
How can risks be managed?
The concrete form of pension governance can take different forms depending on the individual situation of a company. Nevertheless, there is a certain basic consensus on which aspects should be taken into account as part of a “best practice” approach. These include:
First of all, it is essential to create transparency about the existing pension obligations. This requires a careful qualitative and quantitative inventory, which also includes the existing pension management processes and their documentation. After taking stock, identify the points for which action is required. The information collected should be analyzed for missing or overlapping responsibilities and processes. In addition, interfaces between responsibilities and processes must be identified.
Starting from this basis, the future control processes are to be defined. This also includes determining the people and bodies involved and clearly defining the corresponding responsibilities and competencies. It should always be noted that comprehensive documentation is an elementary component of pension governance.
Within the framework of the organizational structure thus created, all qualitative and quantitative risks arising from pension plans are to be recorded, analyzed and evaluated. It should be noted that this process should not be a one-time event, but should be continuous in order to capture interim changes in a timely manner.
Pension governance also includes checking whether the accounting bases used for valuation are still adequate and quantifying existing risks, for example by means of sensitivity calculations with stressed accounting bases. From a financial perspective, cash flow and liquidity forecasts are of high importance. In the presence of external capital cover, asset liability matching can be used to optimize returns.
How well-developed is pension governance at German companies?
KPMG used a questionnaire to evaluate the maturity of pension governance at 19 companies from the DAX30 and MDAX. This corresponds to one third of the DAX30 and MDAX companies that report material pension obligations in their annual reports. In summary, it can be stated that large companies are aware of the specific risks associated with pension obligations and are working to manage these risks – although relatively large differences can be seen in the actual implementation. It can be assumed that large corporations will play a pioneering role in this area. It is therefore to be expected that for many smaller medium-sized companies – especially those in the family business sector – risk management related to pension obligations is still in its infancy. However, as these companies also often have significant pension obligations, it is also necessary for them to start introducing appropriate processes and control bodies for risk management.
We will be happy to support you in the detailed analysis of your status quo and the optimization of your pension governance.
The unequal treatment of employees on the basis of their age in pension commitments continues to be the focus of the BAG’s case law. This year, for the first time, the BAG had the opportunity to assess the AGG conformity of comprehensive pension commitments.
The AGG, which entered into force on August 18, 2006, stipulates in § 2 para. 2 sentence 2 that the Company Pension Act applies to the company pension scheme. In its first decisions on the compatibility of pension commitments with the legal requirements of the AGG, the BAG has already clarified that the AGG is also applicable to company pension commitments insofar as the company pension law does not contain any overriding special provisions (BAG ruling dated December 11, 2007, 3 AZR 249/06). The AGG’s audit regime applies to company pension commitments in all implementation channels. Therefore, in addition to the employer’s direct commitment, pension commitments made via external pension providers are also covered. In terms of time, all pension commitments – regardless of their date of issue – are covered by the provisions of the AGG which (still) apply after the AGG has come into force (see only BAG judgment dated October 15, 2013, 3 AZR 294/11).
In its case law on the AGG, the BAG had initially developed a comprehensive casuistry on the permissibility of age limits in pension commitments (for an overview of the latest legal developments, see only the article in our Pensions Update 01/2014, including the current legal status for the permissibility of maximum age limits and minimum waiting times: https://kpmg-law.de/docs/Pensions_Update_01_2014.pdf#page=5). In its decision of February 18, 2014 (3 AZR 833/12), the BAG now had the opportunity for the first time to rule on the compatibility of the maximum amount limits typically contained in comprehensive pension commitments with the requirements of the AGG.
Capping of a total pension commitment
A total pension commitment is characterized by the commitment of a specific total pension benefit, taking into account the pension from the statutory pension insurance and, if applicable, other supplementary pensions (in particular from other employers). If benefits under the statutory pension insurance scheme decline, the share of the total pension to be provided by the employer increases accordingly. The amount of the commitment is generally limited to a certain percentage of the most recent gross or net income.
In the case underlying the decision of February 19, 2014, the total pension commitment provided for a cap on the total pension benefits at 75% of the last income earned by the beneficiary employee. The actual amount of the (total) pension benefit was determined on the basis of a basic amount of 50% of the pensionable income and an increment for each year of service of 1.25% of the pensionable income. The total pension benefit was capped at 75% (salaried employees) and up to 86% (hourly workers). These capped amounts require a maximum of 20 years of service (salaried employees) and 29 years of service (wage earners) to be taken into account. The plaintiff employee, who had more than 30 years of service, claimed that the cap on the amounts that could be earned through service was ineffective in determining the total pension and demanded a pension benefit, the amount of which was to be calculated without the cap. He bases the alleged invalidity of the cap on impermissible discrimination against employees with more years of service than the cap, who would typically be older than employees whose total pension contributions are not covered by the cap provision. In this respect, the cap violates the provisions of Sections 1, 3 (3) of the German Civil Code protecting against such age discrimination. 1 and 2, 7 AGG.
The BAG dismissed the action. It denied the inadmissible age-related discrimination asserted by the employee. The limitation of the further total pension amounts that can be earned through length of service does include an indirect unequal treatment of (older) employees with a length of service exceeding the cap. However, this unequal treatment is justified with regard to the permissible purpose pursued by the employer with the cap, namely the secure calculability of such occupational pension benefits, and with regard to the instrument used to pursue this purpose (limitation of occupational pension benefits taking into account other (statutory) pension benefits).
The decision of the BAG and its reasoning were predictable in view of the legal principles already established in its previous AGG case law on the permissibility of age limits in pension commitments: In the case of a company pension plan financed by the employer, the employer is free to decide on its introduction. If it decides to do so, it shall also be free to decide for which of the services listed in § 1 para. 1 of the German Occupational Pensions Act (BetrAVG) and how it limits its benefit obligations to calculable risks. The ruling nevertheless creates legal certainty for the practice of age-related AGG conformity of comprehensive pension commitments. It closes another flank for the (age-related) AGG conformity of traditional design instruments in occupational pension schemes.
Clarification by the (supreme) court from the perspective of the AGG is thus still required, among other things, on the use of age gap clauses for survivors’ benefits and the failure to take into account periods of maternity leave and parental leave, which is sometimes encountered in practice, when determining the pension entitlements relevant for the pension amount.
In recent months, the BAG has also continued to be active in other areas of occupational pension provision. Among other things, it clarified the requirements for the revocation of pension commitments in the case of contractual reservations of revocation and the insolvency law scope of an intra-group assumption of debt for pension commitments and developed its case law on the transparency control of pension commitments based on general terms and conditions.
Revocation of a pension commitment: Restrictive requirements also in the case of a reservation of revocation in the employment contract and waiver of pension benefits by the employee in the termination agreement
According to the established case law of the BAG, the employer may revoke the pension commitment – only if the employee’s invocation of his or her pension entitlement is an abuse of rights (BAG Urt. v. 13.11.2012, 3 AZR 444/10, see only the article in our Pensions Update 01/2014: https://kpmg-law.de/docs/Pensions_Update_01_2014.pdf#page=13). In the opinion of the BAG, this is the case if the employee, due to his conduct in breach of duty, has caused damage to the company which endangers the economic situation of the employer and has thus at least contributed to the employer’s inability to pay the company pension. In such cases, the employee cannot demand that the employer nevertheless fulfill its obligation under the pension commitment. It would be contrary to good faith for the employee to rely on this.
In its ruling of June 17, 2014 (3 AZR 412/13), the BAG also confirmed this restrictive case law on the revocation of a pension commitment in the event that the employer attempts to lower these restrictive requirements for revocation by means of employment contract agreements with the employee.
In the case underlying the decision, the employer had expressly reserved the right to revoke the pension commitment under the terms of the employment contract for certain groups of cases specified in the pension commitment. Among other things, the contractual provisions provided for revocation in the event that the employee or beneficiary commits acts that would entitle him or her to immediate dismissal. The employee, who had been employed by the employer since 1968 and who most recently held a managerial position with granted power of attorney, committed a large number of privately motivated transactions during the employment relationship to the detriment of the employer, from which he obtained a comprehensive economic pecuniary advantage. The employer then terminated the employment relationship in 1986 without notice and revoked the pension commitment. In the termination agreement concluded in connection with the extraordinary termination without notice, the employee waived, among other things, all claims and entitlements under the pension commitment.
The employee claimed pension entitlements under the pension commitment after reaching the age relevant for retirement pension benefits (65) in 2008. The employer refused to fulfill the pension benefits, citing its revocation declared in connection with the extraordinary termination and the employee’s waiver of the pension benefits in the termination agreement; in addition, the employee had forfeited his claims from the pension commitment in view of his inactivity of more than 22 years between the waiver declared in the termination agreement and the first assertion of the pension benefits.
While the Hamburg Regional Labor Court rejected the employee’s claim in the lower instance (ruling dated January 29, 2013, 2 Sa 61/12), the BAG ruled in favor of the employee. In its reasoning, the court stated: (1) The waiver of pension benefits declared by the employee in the termination agreement was invalid due to a violation of the prohibition of severance payments or waivers of pension benefits stipulated in Sec. 3 BetrAVG. (2) The revocation of the pension commitment declared with reference to the contractual reservation also comes to nothing; in the opinion of the BAG, the contracting parties cannot reduce the restrictive requirements of its case law on effective revocation by means of a contractual agreement. (3) Forfeiture was also to be denied with regard to the lapse of time of more than 22 years between the waiver and the now assertion of the pension claims, since the employer, due to the invalidity of the waiver declaration after the conclusion of the termination agreement, could not have built up any confidence that the claims from the pension commitment would no longer be asserted.
The ruling once again demonstrates the very high requirements of the BAG for the revocation of a pension commitment – regardless of any contractual agreements to the contrary. The revocation of company pension benefits due to (alleged) breaches of duty under the employment contract can still generally only be considered if the breach of duty has caused damage to the employer to an extent that puts the employer in a position that threatens its existence. In such cases, it is generally (more) advisable for employers to assert claims for damages due to the breach of duty and to offset them against the company pension claim. In individual cases, the conclusion of a factual settlement in the termination agreement to be concluded on the occasion of the specific breaches of duty may also be worth considering.
General Terms and Conditions Control of Pension Commitments: A Farewell to the “Main Provider” Clause
Since January 1, 2003, provisions in the employment relationship that are based on individual legal grounds have been subject to the statutory requirements for monitoring the effectiveness of general terms and conditions (GTC). The general terms and conditions of occupational pension schemes include provisions that are agreed in an individual commitment or in an overall commitment or that are determined by the employer. This is independent of the benefit content and the implementation method.
The legal regime for the control of general terms and conditions contains, among other things, the transparency requirement (Section 307 (1) sentence 2 of the German Civil Code) as a core provision. According to the transparency requirement, the factual prerequisites and legal consequences for a specific claim must be described so precisely that no unjustified scope for assessment arises for the user. The conditions and the scope of the obligation to perform must be so defined or at least so determinable that the contractual partner of the user can already recognize what is in store for him upon conclusion of the contract. A clause violates the transparency requirement if it contains avoidable ambiguities and opens up leeway; in this case, it is invalid.
In its ruling of September 30, 2014 (3 AZR 930/12), the BAG had to assess the application of these legal principles to an individual commitment made by the participating employer to an executive employee, which included the commitment of a widow’s pension. According to the specific clause of the contract, however, the widow’s pension was to be granted only in the event that the beneficiary had “predominantly provided for the maintenance of the family.” The contractual clause – sometimes referred to in practice as the “main breadwinner clause” – did not contain any further criteria on the question of when such “predominant” bearing of the maintenance costs could be assumed.
The BAG considered the contractual clause to be non-transparent and therefore not compatible with the legal requirements of the AGB control. The BAG initially related the lack of transparency (already) to the temporal dimension, since it could not be inferred from the contractual clause whether the entire period of marriage, the entire period of the active working life of the beneficiary or the period from the beginning of the beneficiary’s employment until reaching the statutory retirement age is relevant, or whether only the period during which the employment relationship of the beneficiary with the employer owing the pension existed is relevant. Also on the scope of content (consideration of all costs actually incurred? (Only) consideration of the monthly fixed costs?) and the possible consideration of the spouse’s income, the contractual clause does not provide any information and is therefore not compatible with the requirement of transparency under the law on general terms and conditions for these reasons either. The associated invalidity of the clause meant that the main maintenance clause was not to be taken into account for the assessment of the requirements for the widow’s pension.
The restrictive legal requirements for the control of general terms and conditions of pension commitments under individual law, and in particular the transparency requirement, are still sometimes underestimated in practice. If the employer wishes to tie the granting of individual pension benefits to certain conditions, it must define the conditions transparently and as clearly as possible in the pension commitment.
The (unsplit) pension formula also in company agreements: The final obituary for a split pension formula
In its ruling of May 20, 2014 (3 AZR 936/11), the BAG decided on the dynamic treatment of a pension formula in a commitment governed by a company agreement which provides higher benefits for salary components above the contribution assessment ceiling (BBG) than for salary components below the BBG (so-called split pension formula). It ruled that even company pension commitments made in company agreements with such a split pension formula are generally to be interpreted in such a way that the “additional jump” in the contribution assessment ceiling to be recorded due to an unscheduled increase in the contribution assessment ceiling in the statutory pension insurance as of January 1, 2003 is not taken into account in favor of the employees when calculating the amount of the relevant company pension benefits.
The BAG thus abandoned its previous case law, according to which the gap in the regulation resulting from the unscheduled increase in the BBG was to be closed by way of supplementary interpretation in accordance with the original regulation plan to the effect that the company pension was calculated without taking into account the increase in the BBG and that the amounts by which the statutory pension increased as a result of higher contribution payments were to be deducted from the amount calculated in this way. The BAG conceded that, on the contrary, there are several equally valid options for closing a possible loophole. Works agreements are also only amenable to supplementary interpretation if either only one regulation can be considered to fill the gap according to mandatory higher-ranking law or if, in the case of several possible regulations, it can be reliably determined which regulation the parties to the agreement would have made if they had recognized the gap.
If the pension commitment is regulated in a works agreement, the works council alone may demand an adjustment of the pension commitment in accordance with the legal principles of disturbance of the basis of the contract (Section 313 BGB).
Conclusion: After the BAG abandoned its interim case law on the fictitious omission of the unscheduled increase in the BBG in 2003 when calculating company pension benefits in its rulings of April 23, 2014 for pension commitments with a split pension formula in collective agreements or overall commitments (3 AZR 23/11 and 3 AZR 475/11), with this decision it was also able to revise its interim case law for the assessment of pension commitments with a split pension formula in company agreements. Employers who have issued pension commitments with a split pension formula can now continue their existing pension commitments in a legally secure manner without fictitious fading out of interim legislative activities.
Statutory insolvency protection in the event of intra-group debt assumption
The ruling of the BAG of May 20, 2014 (3 AZR 1094/12) deals with the obligation of the Pension Protection Association (PSV) to enter into company pension commitments in the event of insolvency of a group (parent) company which joined the commitment of a (non-insolvent) group subsidiary by way of an assumption of debt and subsequently fulfilled the pension commitment.
In the case underlying the decision, the plaintiff employee had received a pension commitment from the subsidiary of a German GmbH, which had the legal form of an English limited company. The GmbH joined the pension commitment by assuming the debt and, after retirement in 2002, also (initially) – exclusively – fulfilled the pension benefits from the pension commitment. Insolvency proceedings were opened against the assets of the GmbH in 2010. The Limited was not affected by the insolvency from the point of view of insolvency law, but subsequently failed to fulfill the employee’s pension entitlements under the pension commitment. The employee then asserted the pension claims from the pension commitment against the PSV. In support of this, it referred to the original claim to pension benefits created by the GmbH’s assumption of debt, which the PSV had to fulfill by virtue of its statutory obligation under Sec. 7 of the German Occupational Pensions Act (BetrAVG).
The BAG dismissed the action. The court rejected the PSV’s obligation to pay, since the GmbH had not issued the pension commitment in the form of an employment contract with the plaintiff employee. The PSV would only enter into such pension commitments for which the insolvent company had issued the pension commitment as the contractual employer. This is not the case if the obligations of the insolvent companies were (solely) created by way of an assumption of debt.
With this decision, the BAG clarifies the system for statutory insolvency insurance pursuant to Section 7 of the German Occupational Pensions Act (BetrAVG). Only pension commitments of the contractual employer are covered by the statutory insolvency insurance. This system must be carefully considered, especially in insolvency cases in groups of companies in which individual group companies join the existing company pension commitment by way of an assumption of debt: If, in this case, the group company acting as the contractual employer is insolvent, the PSV has a duty of subrogation – in the event of any subrogation in relation to any internal compensation claim of the insolvent group company against the group company declaring the debt assumption.
Pension obligations reach very considerable dimensions at many companies. In the context of corporate transactions, these must be taken into account when determining the purchase price. In addition to the classic approaches, there are also alternatives that are attracting increased attention in the current low-interest phase.
The basis for determining the purchase price in the context of corporate transactions is usually an enterprise value estimated with the aid of valuation models. Obligations for pensions (and other similar long-term employer benefits such as partial retirement obligations) that are transferred to the new owner as part of a transaction must also be taken into account in such a business valuation model.
In our experience, a widely used approach is to recognize existing obligations from defined benefit pension commitments that are not or only partially externally funded (unfunded liabilities) as net debt1. In addition, this approach takes into account the cost of the annual service cost (for defined benefit plans) or the contribution payments (for defined contribution plans, defined contribution) when determining EBITDA2.
Is IFRS still the right benchmark?
For the determination of the value of defined benefit obligations – i.e. the net liability – a valuation according to IFRS principles is very often considered and used as an appropriate benchmark. However, other valuation approaches are also conceivable. Especially against the background of the currently very low IFRS interest rates (which, ceteris paribus, lead to an increase in the value of the obligation), there is increased discussion about the appropriateness of a reporting date-based IFRS valuation for the purposes of the more long-term company valuation. The extent to which the current extremely low interest rates in a historical context lead to a fair value of the – extremely long-term – pension obligations is sometimes questioned, especially in cases where the cost of pension payments is independent of the development of capital market interest rates (e.g., in Germany in the case of purely internally fi-nanced pension plans).
What are the alternatives?
As an alternative, the interest rate used for HGB valuations may be used instead of valuing the obligations at an IFRS interest rate (accurate to the reporting date). The HGB interest rate is calculated as an average of the last seven years and is currently significantly higher than the current IFRS interest rates. It can be argued that the HGB interest rate, as an average interest rate over the last few years, provides a more realistic picture of the level of the obligation in the medium term than a reporting date approach based on IFRS. However, if the current low-interest phase continues, it can be assumed that the HGB interest rate will approach the IFRS interest rate level. In addition, a significant rise in interest rates could have the opposite effect, i.e. IFRS interest rates could then be higher than HGB interest rates.
In addition to the application of an HGB interest rate, other interest calculation methods are conceivable. For example, an internal rate of return could be used, especially for internally financed pension obligations. Furthermore, determination procedures based on forward rates are entering a broader discussion. An attempt is made to extract market participants’ expectations of the future development of interest rates implicitly contained in the yield curve. In some circumstances, it can be argued that the current structure of the forward yield curve suggests that the market expects a return to “normal” market conditions. Even if these interest rates are often only of limited use as a reliable prediction of future interest rate developments, such an analysis can be used as an argumentation aid to steer the valuation parameters on which the valuation of pension obligations is based in a direction that is more favorable for the respective party during purchase price negotiations.
In summary, IFRS pension valuations remain a very common approach for business valuation purposes. At the same time, however, there is increasing discussion of alternative valuation approaches, which are meeting with growing acceptance against the backdrop of the low interest rate phase, which is unusual in a historical context.
Since the introduction of the German Accounting Law Modernization Act (BilMoG) in May 2009, the discount rate under HGB must be set as a near-market rate (at least AA-rated corporate bonds and zero-coupon fixed-rate swaps). For low market volatility, the interest rate is averaged over a period of 84 months. The interest rates are determined and published by the Deutsche Bundesbank and, contrary to international accounting standards, are not derived by the companies themselves. The only company-specific component that is included is the duration (average payment focus of the obligations) of the portfolio, unless the simplification option pursuant to section 253 (2) of the German Commercial Code (HGB) is exercised. 2 sentence 2 of the German Commercial Code (flat-rate application of a duration of 15 years).
The averaging over 84 months means that the effects of the current low-interest phase will be felt more slowly in HGB accounting. Whereas, for example, a discount rate under international financial reporting standards (IFRS) fell by more than 100 basis points in most cases between October 2013 and October 2014, the impact under German GAAP over the same period was “only” 28 basis points. Nevertheless, the low-interest phase cannot be circumvented here either. This is also shown by a look at the current development of the HGB interest rate. While in recent years the interest rate has fallen only very marginally from month to month, the interest rate is currently falling by around four basis points every month. However, this jeopardizes early recognition of the obligation. Although HGB allows the interest rate to be set up to three months before the balance sheet date (see IDW RS HFA 30, paragraph 65), this option may only be exercised if the impact on the amount of the obligation is immaterial. In the past, this effect was mostly insignificant, so that in practice the majority of interest rates were fixed two to three months before the balance sheet date. This enabled an early assessment of the obligation.
This year, it can be assumed that the interest rate will rise to the December 31, 2014 approximately seven to eight and ten to twelve basis points below the interest rate at October 31, 2014 respectively September 30, 2014 will be. Depending on the duration of the portfolio and the company-specific materiality thresholds, this may well have a significant effect on the amount of the provision. For this reason, in the event of an early measurement of the obligations at the December 31, 2014 to be based on a forecast interest rate. In forecasting the interest rate at the December 31, 2014, it should of course be noted that for averaging purposes the past 82 months (as of the end of October 2014) are already known and “only” the interest rate development for two months needs to be estimated.
The use of a forecast value nevertheless entails (minor) risks insofar as the actual interest rate has not been hit at the end of the year. If the estimate is too conservative, the same applies as for the use of the September or October 2014 interest rate: materiality determines whether the interest rate is permissible. The situation is different if the interest rate was set too progressively, i.e. an interest rate was used that is lower than the published interest rate as of December 31, 2014. Based on averaging over the past 84 months, it can be assumed that the yield curve is currently monotonically declining. Accordingly, if the approach were too progressive, an interest rate would be selected that is not reached until after the balance sheet date. As of December 31, 2014, we therefore recommend an interest rate of 4.55% for a duration of 15 years.
In the long term, it can be assumed that the interest rate under HGB will be around 3.0% by the end of 2018. The reduction in the interest rate can result in an increase in the volume of obligations of between 25% and 35% over the same period, depending on the composition of the portfolio. Companies are therefore increasingly asking themselves how the resulting effort can be reduced. Although over the total period (service commencement to death of the beneficiary or death of the surviving dependents) the total expense is equal to the sum of all actual pension payments and is therefore independent of the discount rate, for most companies it is a question of splitting the expense between the operating result and the financial result. It is precisely the reduction of expenses for the operating result that is of particular importance to companies.
One possibility of reducing the operating result is the option under IDW RS HFA 30, paragraph 88, to report the so-called interest rate change effect in the financial result. This effect describes the change in the pension obligation solely due to the change in the discount rate. The effect is therefore greater the more the previous year’s interest rate deviates from the current interest rate. This could amount to roughly five percent of the obligation this year, assuming a change of 33 basis points (Dec. 31, 2013: 4.88%; Dec. 31, 2014: 4.55%) and an assumed remaining term of 15 years. In contrast, the interest expense from discounting the pension obligation must be reported in the financial result.
Another way to relieve the operating result is to critically scrutinize the other valuation parameters. Much discussed in this context is inflation. Although this parameter is not directly included in the measurement of the pension obligation in Germany, it is at least a starting point for determining the pension trend for commitments with an adjustment review obligation pursuant to Sec. 16 (1) of the German Stock Corporation Act (AktG). 1 BetrAVG. The European Central Bank currently still gives a long-term inflation expectation of just under 2% p.a.. Despite a currently low inflation rate, the longer-term inflation expectation and thus the pension increase should not be set below 1.7%, unless there are economic reasons for the company to do so. In particular, a reduction in the pension trend by more than 25 basis points compared with the previous year is discouraged. In addition, if necessary, orients itself. The salary increase would also have to be set in line with inflation and would thus have to be adjusted consistently with the pension dynamic.
In addition, it is also possible to adjust the calculated funding age, i.e., to adjust the age at which the beneficiaries are expected to draw their pension benefits in the form of retirement pensions or retirement capital. This could be based, for example, on the statutory retirement age or the date from which the pension beneficiary receives a pension from the statutory pension insurance without deductions. The amendment would have the effect of delaying the commencement of the payment of the pension benefit. At the same time, however, any actuarial deductions derived from the pension commitment are no longer taken into account when determining the amount of the benefit. The impact on the amount of the obligation therefore depends on the specific individual case.
As described in the previous section, since the BilMoG came into effect, the discount rate used for HGB purposes has necessarily been a smoothed market or near-market rate. The option previously available to select the pension provision value calculated for tax balance sheet purposes at an interest rate of 6% in accordance with Section 6a of the German Income Tax Act (EStG) as the (minimum) provision approach under German commercial law has been eliminated with the implementation of the BilMoG. In addition to the discount rate, which is now mandatory to differentiate between the commercial and tax balance sheet rates, at which the pension provision is valued as of the reporting date, a further difference between the two valuations results from the fact that for HGB purposes the provision value as of the reporting date is calculated in accordance with Section 253 (2) of the German Commercial Code (HGB). 1 sentence 2 HGB is now to be calculated on the basis of the (expected) settlement amount of the obligation, i.e., in particular salary and pension trends are to be included. In contrast, the tax balance sheet value follows a static approach, which mandatorily waives the inclusion of these trends (Sec. 6a (3) No. 1 EStG); as a special tax regulation, Sec. 6a EStG prevents the material authoritative effect of the respective commercial balance sheet approach.
Due to the aforementioned valuation method, the provision value under commercial law in accordance with § 253 HGB is regularly higher than the provision value for tax purposes within the meaning of § 6a EStG. Since all payments actually incurred until the complete settlement of the pension case (death of the employee or, if applicable, surviving dependents) have been fully recognized as personnel expenses for both the commercial and the tax result, these are, however, only temporary valuation differences, on the basis of which the reporting entity has the option of recognizing deferred tax assets (Sec. 274 (1) Sentence 2 HGB).
Deferred tax liabilities for which recognition is required under Sec. 274 para. 1 sentence 1 of the German Commercial Code (HGB) are not likely to occur in practice, with the exception of certain forms of deferred compensation commitments, as the present value calculated in accordance with the HGB is almost always higher than the going-concern value within the meaning of Section 6a of the German Income Tax Act (EStG) due to the trend assumptions that must be taken into account under commercial law.
However, deferred tax liabilities may arise – in isolation – in connection with the formation of pension plan assets: Whereas these are classified as plan assets if the requirements of Sec. 246 (2) of the German Income Tax Act (HGB) are met. 2 sentence 2 of the German Commercial Code (HGB) (ensuring that the assets can only be used for specific purposes for pension payments, even in the event of the possible insolvency of the company preparing the financial statements) must be measured at fair value at the balance sheet date under commercial law (Sec. 253 (1) sentence 4 HGB), the maximum acquisition cost principle (Sec. 6 (1) no. 1 EStG) applies for tax purposes as a special rule under tax law, on the basis of which the materiality principle does not apply.
If, for example, securities are purchased at a price of EUR 100 (including incidental purchase costs) and their value rises to EUR 120 at the balance sheet date, income of EUR 20 is recognized in the income statement under commercial law, but no income is initially recognized for tax purposes due to the maximum acquisition cost principle. However, if the securities are subsequently sold at an unchanged price, this results in a realization transaction for tax purposes, which is fully taxable in the case of equity securities, for example. Under commercial law, on the other hand, there is no longer a result. This is accounted for by recognizing deferred tax liabilities in the amount of the anticipated individual company tax burden. With a trade tax rate of e.g. 450%, the tax burden would amount to 15.83% as corporate income tax (incl. solidarity surcharge) plus corporation tax. 15.75% as trade tax and thus a total of 31.58%. The deferred tax liabilities would thus amount to EUR 6.32.
If (as is regularly the case) deferred tax assets also exist on the basis of the corresponding pension commitments, these can be reported either netted or unnetted.
If unrealized gains are recognized under commercial law as a result of the fair value measurement at the balance sheet date (in the above example, the price gain of EUR 20), these gains less the deferred tax liability attributable to them (in the above example, EUR 6.32) are blocked from distribution in accordance with section 268 (2) of the German Commercial Code (HGB). 8 S. 3 HGB.
Current developments in legislation: The draft of the new version of §17 BetrAVG – a new option for company pension schemes?
Currently, a defined contribution plan in Germany always includes a minimum guarantee. The employer is liable for these. Does a possible new version of Section 17 of the German Occupational Pensions Act (Be-trAVG) now allow pure defined contribution plans without a minimum guarantee and without employer liability in future?
A proposal by the German Federal Ministry of Labor and Social Affairs (BMAS) to add another implementation option to the company pension scheme is currently causing a great deal of discussion. The collective bargaining parties are to be given the option of implementing the company pension scheme for employees via a joint institution. This instrument is not new, as there are already such social institutions based on collective agreements, for example the Sozialkasse Bau. What is new, however, is that guaranteed minimum benefits no longer have to be promised in this context and the employer is to be released from liability.
The German Occupational Pensions Act (BetrAVG) currently defines defined contribution plans and defined contribution plans with minimum benefits as possible forms of occupational pension provision (Section 1 (2) Nos. 1 and 2 BetrAVG). In the case of a defined contribution plan with minimum benefits, the employer pays contributions to a Pensionskasse, a pension fund or a direct insurance company for the benefit of the employees. The subsequent pension benefits are derived from the contributions paid in and the income generated thereon, whereby the sum of the contributions paid in (less the costs of any risk protection) must be guaranteed as the minimum benefit. The defined contribution plan, under which the pension benefits are also derived from the contributions granted, does not contain any such statutory definition of a minimum benefit. Nevertheless, it is generally understood that here, too, the employer must promise a minimum benefit that must not fall short of the minimum of a defined contribution plan with a minimum benefit. In simple terms, therefore, the sum of the contributions paid in is also to be guaranteed here in principle.
In connection with the respective minimum guarantee, it is significant that the employer is liable for the benefits under the minimum guarantee even if the company pension plan is not implemented directly through him (Section 1 (1) sentence 3 BetrAVG). Although the employer can, in fact, largely discharge itself from liability if it chooses an insurance-based form of implementation due to the supervision of the providers by BaFin and the Protektor protection fund set up for the life insurance industry, purely formal discharge is not possible. A certain residual risk therefore remains.
Under the proposals of the Federal Ministry of Labor and Social Affairs (BMAS), a pure defined contribution plan would therefore be permissible in the future, with benefits resulting solely from the contributions paid in and the returns generated. A minimum benefit would no longer be required, and the employer’s subsidiary liability for the fulfillment of benefits under the pension commitment would cease. The prerequisite for this is that the company pension scheme is organized via a joint institution of the collective bargaining parties in the form of a Pensionskasse or a Pensionsfonds and that this joint institution becomes a compulsory member of a security fund yet to be created. This would be implemented by amending Section 17 of the German Occupational Pensions Act (BetrAVG) and inserting new Sections 17a and 17b.
How does the practice react to this proposal?
Reactions in the occupational pension market vary widely. While the introduction of a pure defined contribution plan without any liability on the part of the employer is viewed positively in principle, at the same time the question remains open as to why this option should only be reserved for the new “tariff funds”. It is also feared that many older pension plans will close – ultimately, non-wage costs cannot be extended indefinitely, which may lead to “cut-throat competition” among implementation options.
The version presented so far for the modification of §§ 17ff. BetrAVG include a discussion proposal. Further discussions in the BMAS, with the collective bargaining parties and the other interest groups concerned will show whether and, if so, in what form the present proposal will be implemented. At this time, it looks like the project will not be pursued. Should the tide turn again, we will accompany any further legislative process in our Pensions Update.
We welcomed more than 150 participants to the events of this year’s roadshow on occupational pension provision, which we organized in the period from June 24, 2014 to July 23, 2014 in Düsseldorf, Frankfurt, Hamburg, Munich and Stuttgart.
turned into stimulating and entertaining discussions at all events and especially in talks following the events. There was a particularly great need for discussion on the options for action in occupational pension provision in the low-interest phase.
We will continue our roadshow event series in 2015. We will preview the topics in the next issue of Pensions Update.
If you already have special topic requests, we will be happy to take them into account in the final topic planning. For this purpose, please let us know your topic preferences by e-mail (firstname.lastname@example.org or email@example.com).
Registration for the events in 2015 will be possible in the proven manner by registering on our website (www.kpmg.de/bav.html) or by e-mail.
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