A defined benefit deficit is a debt-like item, but which deficit, and whether tax relief comes off, can move the equity price by more than a turn of EBITDA.
A defined benefit pension deficit is deducted from enterprise value as a debt-like item, and the price depends on which deficit is used and whether tax relief is netted off. On an illustrative UK deal at an enterprise value of £150.0 million, the same scheme gives deductions from £18.00 million (accounting deficit, net of tax) to £38.00 million (funding deficit, gross), and the most defensible figure, the present value of the agreed recovery plan after tax relief, is £20.96 million. The gap between those two positions is £20.00 million, 1.07 turns of EBITDA.
Worked in full in Closing the Deal by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A defined benefit scheme has as many deficits as it has measurement bases, and each side of a deal will reach for the one that suits it. The accounting deficit under IAS 19 discounts the liabilities at a high-quality corporate bond yield and is usually the smallest. The funding deficit on the trustees' technical provisions uses a more prudent discount rate and is larger; it is the basis on which the employer and the trustees agree a recovery plan of cash contributions. The buyout deficit, the cost of having an insurer take the whole scheme, is the largest and is only relevant if a buyout is actually planned. On top of the choice of basis sits a second question: contributions to the scheme are deductible for corporation tax, so a deficit funded over time costs less than its face value after tax.
| Item | Value |
|---|---|
| Enterprise value, 8.0x EBITDA of 18.75 | 150.0 |
| Financial net debt | 40.0 |
| IAS 19 accounting deficit | 24.0 |
| Technical provisions (funding) deficit | 38.0 |
| Buyout deficit | 70.0 |
| Agreed recovery plan, per year for 8 years | 4.5 |
| Corporation tax rate | 25% |
| Discount rate for the contributions, pre-tax cost of debt | 6.0% |
The recovery plan totals 36.0 over eight years, less than the funding deficit, because it assumes some investment return on the scheme's assets. EBITDA is stated before deficit contributions, with only the current service cost charged above it.
Post-tax contribution = 4.5 × (1 − 25%) = 3.375 a year
Annuity factor, 8 years at 6.0% = (1 − 1.06−8) / 0.06 = 6.2098
PV of the recovery plan after tax = 3.375 × 6.2098 = 20.96
Equity price = 150.0 − 40.0 − 20.96 = 89.04
Excel: =PV(6%,8,-4.5*(1-25%))
Before tax the same contributions are worth 27.94; the tax relief is worth 6.99 in present value. That relief is real only if the target pays tax: a business with losses or limited profits cannot use it on the timetable assumed, and the deduction should move back towards the pre-tax figure.
| Basis | Deduction | Equity price | % of equity | Turns of EBITDA |
|---|---|---|---|---|
| IAS 19, net of tax | 18.00 | 92.00 | 16.4 | 0.96 |
| Recovery plan, PV after tax | 20.96 | 89.04 | 19.1 | 1.12 |
| IAS 19, gross | 24.00 | 86.00 | 21.8 | 1.28 |
| Funding, net of tax | 28.50 | 81.50 | 25.9 | 1.52 |
| Funding, gross | 38.00 | 72.00 | 34.5 | 2.03 |
| Buyout, gross | 70.00 | 40.00 | 63.6 | 3.73 |
The seller opens with the IAS 19 deficit net of tax, the buyer with the funding deficit gross: 20.00 apart, on a line that is 18.2 per cent of the 110.0 equity value before the pension. The recovery plan basis sits between them for a reason, not as a split: it is the cash the buyer's new subsidiary is actually committed to pay, valued like the debt it resembles, after the tax it actually saves. It also tracks the item through to the buyer's own model, where the contributions will appear as a cash outflow below EBITDA.
| Scenario | Total contributions | PV after tax | Change |
|---|---|---|---|
| Agreed plan, 8 years at 4.5 | 36.0 | 20.96 | 0.00 |
| Trustees shorten to 5 years at 7.2 | 36.0 | 22.75 | 1.79 |
| Trustees shorten to 3 years at 12.0 | 36.0 | 24.06 | 3.10 |
| Discount rate 4%, agreed plan | 36.0 | 22.72 | 1.76 |
| Discount rate 8%, agreed plan | 36.0 | 19.39 | −1.56 |
The shortened plans matter because a change of control is exactly the moment trustees reassess the employer covenant. A leveraged buyer weakens it, and trustees can ask for faster contributions or other mitigation before the deal completes. If the price is fixed on the agreed plan and the trustees then shorten it to three years, the buyer has paid 3.10 too much. That is why buyers either deduct on a prudent basis or ask for the trustees' position to be settled, and priced, before signing.
Deducting the deficit while the multiple is applied to EBITDA that already bears the deficit contributions. If a buyer works from cash EBITDA after the 4.5 of annual repair payments, it has already reduced the value by 36.0 at 8.0x; deducting the deficit as well charges the seller twice. The consistency test is the same as for every debt-like item, set out in how much disputed debt-like items move the price: either the cost sits in the earnings the multiple is applied to, or it sits in the bridge, never both. The full list of items that cross from enterprise to equity value is in what goes in the bridge from enterprise value to equity value.
The book runs an equity bridge with a pension switch among its disputed items, with the buyer's and seller's columns side by side, in the free workbooks for this case.
Deduct the present value of the contributions the scheme will actually need, after the tax relief the target can actually use, and check that the multiple was not applied to earnings that already bear them. Here that is 20.96, against an argued range of 18.00 to 38.00, with 3.10 more at stake if the trustees shorten the plan after the deal.
Yes, a defined benefit deficit is normally treated as a debt-like item and deducted from enterprise value, because the buyer inherits the obligation to fund it. The argument is about the amount: on the illustrative £150.0 million deal the deduction ranges from £18.00 million to £38.00 million depending on the basis, 16.4 to 34.5 per cent of the £110.0 million equity value before the pension.
Usually yes, if the target pays tax, because deficit contributions are deductible. At a 25 per cent rate, the illustrative £4.5 million a year recovery plan costs £3.375 million after tax, and the tax relief is worth £6.99 million in present value. If the target has losses, the relief arrives later or not at all, and the deduction moves back towards the pre-tax £27.94 million.
There is no single market rule, but the present value of the agreed recovery plan after tax relief is the most defensible: it is the cash the buyer will pay. On the illustrative case it is £20.96 million, between the seller's IAS 19 net figure of £18.00 million and the buyer's gross funding figure of £38.00 million. Buyout, at £70.00 million, is relevant only if a buyout is planned.
This article is one calculation from Closing the Deal. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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