Hey guys, welcome to the session. We'll get started in just one minute.

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Okay guys, let's get going. Welcome, welcome. My name's Gerard Kelly.

Welcome to this session. Brought to you by Financial Edge Training.

What we're gonna be covering today is pensions and OPEBs OPEBs are other post-employment benefits, often private healthcare.

What are we going to be looking at in this session? Well, we're gonna be looking at types of pension schemes and there are two big ones to look at.

We'll be looking at some pension accounting mechanics, but this has not been aimed specifically at accountants.

This is aiming more towards bankers who want to think about how pensions affect valuation. And that's our real point.

The types of pensions and the pension accounting mechanics is really helping us explain pensions in valuation.

This session's gonna last for about 45 minutes.

You should have access to the Excel file.

Pensions and OPEBs workout Empty has been emailed out.

Alternatively, if you've got access to the chat, I know some of you have access to this Zoom chat, I have put it into the Zoom chat as well and we'll do a couple of workouts there. Also, you can ask questions. If you have access to the chat, you can ask there. Alternatively, if you look on your Zoom, you can look at the question and answer session, the Q&A, and you should be able to ask questions there. Okay, let's get straight into it then.

So we start with our equity to enterprise value bridge. On the right hand side, we start with our diluted market capitalization or our equity and everything else. On the right hand side here, they can be thought of as our sources of funds.

So where did you get all your funding from? I got some of it from equity, got some of it from debt. What did you use it for? I used it for things like EV and cash and short term investments.

But where else might a company have got its, excuse me, where else would it have sourced its funds from? Another item we've got is debt equivalents.

And what we're gonna be looking at today is how pensions in particular pension deficits, how they can be thought of as a source of funds.

Now that's a bit unusual and it's a bit of a tricky thing to get in our heads.

Why is it a debt equivalent? Well, if you think of it, of the bank as a source of funds, I go to the bank, I borrow money.

If I think of equity shareholders as a source of funds, I go to my shareholders.

Hey, can I have some money? And if I think of my employee pension as a source of funds, I should be putting money into it and I haven't put enough into it.

I've effectively borrowed money from my pensioners or from my employees. So a pension deficit, and we're gonna come onto that and what a pension deficit is and why it is, is a source of funds to a company. Okay? But unfortunately it can be tricky in evaluation because it means you owe yet more money to someone else.

Okay, let's start talking though about the two different types of pension.

And the first one we're looking at here is defined contribution.

The second one will be defined benefits. Now, defined contribution, that's the pension that I've got and probably the pension that you guys have.

If you have a pension already, what it is, it's where the company company's contributions that they make, they're going into the pension. They're guaranteed once they go in, they're in.

My pension is with Aviva Financial Edge, my employer, they give money to Aviva. Those contributions, they're guaranteed and once they're in, they're in.

Once the money is with Aviva, that's typically a percentage of my salary.

But the pension there and how well it does, that's dependent on investment performance.

Who bears the risk? Is it financial edge? Is it a Viva? Well, it's definitely not Financial Edge. They wipe their hands a it. They say it's not our problem.

A v vva are trying to invest it on my behalf, but they're still going to be earning their money.

So it's really me who bears the risk.

Now the good thing is now let's imagine we're looking to buy a company.

I'm looking to buy Financial Edge, very expensive company. Very, very, very expensive.

Would I be concerned about the pension that Financial Edge is giving out to its employees like Gerard? No, I would not be concerned at all. Financial Edge have made those payments.

There's no other liability, no issues at all.

So to find contribution, there is no issue for valuation, there's no issue for acquisition targets.

Great. So what is an issue? The issue that we do have is with defined benefits. Pensions, my brother, the lucky devil, has a defined benefit pension.

So what's gonna happen to him is that the contributions coming outta the pension at retirement. To him, they're guaranteed.

So the pen contributions coming outta the pension at retirement are guaranteed.

Tell you what my brother's gonna get.

He's going to get two thirds of his final salary guaranteed paid every year till he dies. So a benefit of a pen, percentage of his salary, he's gonna get 66, uh, 67%, excuse me, 67% times by his final salary.

And that is guaranteed from the day he retires until the day he dies.

He'll be paid that.

And it's that guarantee that's a concern because the company the that pays him, his employer will have to make those pension payments.

And that's the concern. Now, his employer might have a pension fund established to invest the contributions to try and make a bit more of them.

But that pension fund that is guaranteed by the company, guaranteed by the employer, and that's our issue. Anything goes wrong with that pension fund.

My brother still has to be paid his pension.

The employer is on the line to pay it.

That's our risk. Okay, let's go into a little bit more detail on that. So on screen, let me go for the first one. There we go.

We've got two different types of plans here. We've got a funded plan and an underfunded plan.

In our first example up here we've got our corporation.

And for this corporation we're looking at their balance sheets.

And their balance sheet is completely normal balance sheets. It's got assets, it's got liabilities, it's got equity. Nothing strange about it at all.

This corporation is making contributions into a pension fund. So it's making contributions into here.

Now let's just make up some numbers here.

Let's say the value of my brother's pension At the moment, the liability that's owed to my brother, let's say that's worth a hundred.

So we the employer owe Gerard's brother a hundred of a pension. He's gonna be so rich when he retirees, he's gonna be getting about 3 million every year. I'm making up the numbers.

So the company is trying to put pension assets aside to match that obligation or liability.

In this example, the pension assets are worth a hundred.

That is a fully funded defined benefits scheme, a fully funded defined benefits scheme.

Now if I'm looking at an acquirer looking to buy a target and the target has a fully funded defined benefit pension scheme, should I be nervous for the acquirer? Do you really want to buy that? Should I, as a banker, how should I feel? Acquirer should you buy them? Yeah, it's okay.

It's okay.

There's a concern that it might not always be fully funded, but the fact it is funded means the acquirer doesn't have to inject a load of money into the pension.

There's no black hole in the middle of that target that we've got to fill. Do you know what? This isn't going to affect us too much.

So fully funded happy dates, the acquirer is gonna be happy, the target's gonna be happy. We as bankers, advisors, we're gonna be happy, happy dates.

But then we come onto very much the same.

It's just an underfunded plan.

I've got my corporation, again, it's their balance sheet. Same thing, but in their pension fund. Now the liability still a hundred.

Let's make, let's make someone up. Let's say this is my sister.

My sister doesn't exist at all, but let's say it's Gerald's sister.

Gerald's sister is owed a hundred when she, when she retires, she's got a big pension pot of a hundred.

The company has been making contributions into the pension assets, but unfortunately those contributions are only worth 60 at the moment.

Oh no, what we've got is an under funded defined benefit scheme. And that gives us something called a deficit. And that deficit, in this case, it's worth 40.

And we think of that as a debt equivalent item.

A debt equivalent item.

So how does that now go back to the company's balance sheets? It appears as a liability.

So that's our issue. That box there, that 40 is now gonna go into my EV equity bridge. If I go back really quickly, I've now got a great big 40 sticking in here. The more my debt equivalent goes up, oh dear, the more the other numbers are gonna change.

So we have to be cognizant that this affects valuation, it affects the numbers in this bridge.

It's gonna affect how much an acquirer has to pay.

It's a lot of work.

So we have to make sure we get this right and provide our clients with the right information. Okay, so we've got to here.

Great.

So that wasn't un excuse me, that was a funded and an underfunded pension plan.

We've also got another one, which is an unfunded, no pension assets at all.

For my unfunded scheme, I might have a pension liability.

We had our pension liability here.

Let's make it up for my sister pension liability here was a hundred and we said that for my sister, the pension assets were worth 60 with an unfunded scheme. There are no assets.

The employer is not making contributions into this scheme at all.

So that means the entire pension liability now sits on the balance sheet of the acquire of the employer, excuse me.

And that would be the target company.

Now where does this happen? It says on the right hand side here, all the pension or OPEB liability and OPEB stands for other host employment benefits. So pension is a post-employment benefits, but we're looking for other, and the big one that we see is private healthcare, uh, particularly in America.

America say when you retire will pay for your healthcare until you die. Great.

Also many other countries around the world of course, but this can be a very large liability and it's unfunded. Ah, there are no assets set aside. So again, this number is gonna increase our debt equivalent in the EV equity bridge.

So we've got to include that as well.

Now there is a little tax impact that can happen as well.

I do want to take you through that, but I'd really like to have a quick look, um, at a workout. Before we do that, uh, excuse me to look at that.

So we'll see the tax thing in the workouts.

So can we go into the workouts file? Here it is.

And I want to go to the workout valuation tab.

So let me go to there. Pardon me. Make sure all of my shortcuts are working as they should. Here we go.

And let's go straight down to workout six. Here we are.

Let's have a quick read together.

The question says calculate the EV using the information below.

The business operates a defined benefit. Great, that's exactly what we want.

Defined benefit pension plan. Some of it is funded, some of it is unfunded.

The funded plans get tax deduction on a cash basis and the marginal tax base, 25%. I'll come onto that. I'll explain that at the end of the workout.

So we need to come up with the enterprise value for this company, for this target company.

I should point out all of this should be included in things like trading comps as well, transaction comps, et cetera.

So how do I calculate my ev? Well, I start off with the share price, multiply it by the diluted share counts.

I then add on debt minus cash.

That's my starting point. That's the absolute basics. Okay, I haven't finished yet. Then we've got this pension obligation, unfunded pension, obligation funded and pension assets.

These two here in orange, they go together.

My pension assets are related to the funded obligation. They are funding the obligation, can see the pension assets.

Are they enough to fund the obligation? Not quite, not quite enough to fund it. So we're about 300 shorts.

That 300 ish, that's the value for a debt equivalence.

And I'm gonna call it a deficit. So I've got a deficit Of 2851.6 minus the 2510.9.

My deficit at the moment's 336.7, excuse me.

Excuse me. Good dose of hay fever here. Okay, so I need to include that deficit in my EV bridge.

Let's go down, let's update that enterprise value. I want to add in that deficit of 3, 3, 6 0.7.

I still need to make a small change to it in just a minute for tax.

Come back to that.

Great. So I've got almost all of my items included.

The one that we're missing is the pension obligation. Unfunded.

Well that's just a pure debt equivalent.

So I can go down to my calculation again, adds in that pension obligation. Unfunded.

Think of it as debt. Great.

I'm almost done. I'm almost done with my numbers here, but we had some extra information in the question.

The question said the funded plans get tax deduction on a cash basis.

So what does that mean? Well, imagine my brother's employer, they want to put a hundred into my brother's pension fund pension plan. Great. His assets will go up good as they put a hundred in the tax authorities. Say, ah, yeah, that's really good.

Good for you. Thank you. We like you. Um, improving your employee's pension.

We'll give you some tax relief. 25%.

So you put a hundred in, we'll give you 25 back.

So the real cost to the employer is just 75.

So what I want to do is I want to go into my calculation here.

My calculation here, excuse me, and I'm gonna put some brackets around it, but I don't want a hundred percent of it. Like the moment I want to find just 75%.

So I'm gonna multiply it by one minus 25%, got the hardcode that in, and now I'll get my deficit after tax. So my deficit now, if I just update this post-tax, it is 252 and my enterprise value is 6510.6.

Great. I hope that made sense. Cool. If anyone's got any questions for the Q&A, please feel free.

I know not all of you can access it. So I'm really sorry about that.

I'm trying to imagine all the questions you guys would be asking.

Okay, I'm gonna go back into the slides and I'm gonna shoot towards the end of the slides and we'll come back, we'll do a few other things just as as we get there.

But what I really want to work out is this deficit.

Want to show you that deficit and actually do a bit more work in something a little bit more bigger. So let me shoot forward in the slides, skip over a few days, come back, see them later.

And here I'm looking at what looks like a very complicated slide.

Okay? So I'm gonna try and split it up into a couple of sections to make it a bit easier for us to see. So first of all, we're going to have this, excuse me, let's choose the right color here.

We're going to have this yellow section we'll talk about.

And then secondly we'll have this little green section.

And then thirdly, we'll have this blue section.

There we go.

And that helps me to split it up and make it a little bit easier for us to focus on the bits that I want us to focus on. Okay, now we need our information to work out this pension deficit.

That's what I care about the pension deficit.

So how do I find the numbers for my deficits? Well, so far we know that that's going to be our projected benefit obligation minus the value of my pension assets. And we're gonna give that a different name.

Now we're going to call our deficit the funded status.

How funded is your pension? Is it fully funded, underfunded, unfunded? We're now looking at the funded status.

Now we've got some numbers, which is great. If we have a quick look.

2015 here I can see there's a number. Great. 2014 there was a number.

Cool. And it's been very nice.

This particular set of accounts, it's just told us what our funded status is.

We don't always see the words funded status.

We don't always see the word deficits, but this set of accounts absolutely delightful. They've actually said the words fundis status. I've found my deficit already.

But what if we don't have that amount of information? So we don't have this beautiful yellow box. The yellow box is the dream.

Unfortunately we might not have the yellow box. Well, if we can read through what it says in this next section, all pension and other post-employment benefits numbers are embedded in several balance sheet line items and detailed in the footnotes. The footnotes are good.

So I'm going to write in green.

We've got our footnotes here.

The footnotes, we like the footnotes are good.

Keep an eye, keep it. Uh, keep your mind sharp. What are we looking for? We're looking for the obligations versus the assets.

It's all we're after obligations versus the assets to find our deficit.

So what can I see? Oops. What can I see in my footnotes? Well, I can see we've got some assets. Yes. Amazing.

And then I can see I've got some pension liabilities and some more pension liabilities. Yes. Amazing.

And if I add that little green box up, it gets me to my funded status. And my funded status is 5,008. Let me choose a different color. Let's go with orange. This time.

5,892. 5,892.

I've now got my funded status. We just needed to find those assets.

And pension assets and pension liabilities.

They were over here great in the footnotes.

Now you might notice, I can see here, I can see here in the footnotes that we've got a pension just here in this green section.

And I can tell that it's funded, it's underfunded unfortunately.

But I can tell that it, it has some funding because it's got some assets.

Not many. Not many compared to the rather enormous liability.

But it is funded except it's underfunded.

But now let's go to this red section here.

And here we're looking at healthcare and life. That's life assurance.

And I can see there is an are no assets at all.

That means that this is an unfunded healthcare scheme because there are no assets. No assets, okay, that's just the way it is. Got a big, big, big healthcare liability.

It's got an underfunded pension as well.

So we like the footnotes. The footnotes have given us our funded status.

The numbers that I would put into my valuation, I would grab, I would grab my funded status in orange, funded status in orange.

Great stuff.

So what about this section in blue underneath, right, this section in blue. Do my circle again.

There it is. This is information from the balance sheet.

And we don't like the balance sheet for pensions. It's my balance sheet is my unhappy face.

The problem is your pension items are hidden away in the balance sheet. There are loads of different line items you'd think we'd have a look at.

Employee benefit obligations. Hey, 29,000. That feels about right.

If I add up the 5,008 add, add up, the 22.0, it doesn't come to 29,000.

Balance sheets unfortunately are not helping us out here.

Normally I love a balance sheet, love bouncing balance sheet, but not here.

Not for pensions.

So instead the footnotes are normally much easier to use. Okay, I'd love us to have a go at a quick question here.

Have a look at little example.

So let me go straight into my workouts again and I'm gonna jump as this time's workouts 11.

Excuse me for just a moment.

Ok, so workout 11, let's have a read through the following company reports under us gap, that doesn't matter.

Calculate the amount that would be included as a debt equivalent when calculating the ev. So my debt equivalent, I'm going to need to work out my deficit and then I'm gonna want to make that deficit post tax.

And we're told assume the marginal tax rate is 36% and the pension contributions are tax deductible.

So let's have a look at what we've been given. And this is a footnotes.

We love footnotes.

Let's have that smiley face again. Good.

And I can see that we've been given a change in benefit obligation.

I've got my benefit, excuse me, I've got my obligation at the beginning of the year.

And then we had service cost being added interest, it went up again.

Went down a little bit. Went up a bit.

And we eventually got to our benefit obligation at the end of the year.

That's what we like.

That's our pension liability. Okay, so I've got my pension liability. What about my pension assets? Well, here are my assets. Oh good, I've got 'em at the beginning of the year.

Great. Then they went up a little bit, had a bit of return on them, then they went up a bit more. Employer made contributions, BOL of the assets. That's great. Some benefits were paid. Went down, which then got us to the assets at the end of the year. And again, that's a number that we want.

Now this set of accounts has been very nice.

They've even used the words funded status. Again, we don't always see that, but that's very kind of them to help us out with that.

So I now need to use these numbers underneath.

So my pension obligations were 117.3.

My pension assets.

My pension assets, 79.5.

I'm going to make it negative 79.5 cause I want to find the difference.

My pension deficit is the difference between the two.

And now, oh, I still need to take off the tax.

So remember my brother, his employer pays a hundred into his pension.

Wow. And the tax authorities say, well done, you, we'll give you 25 back. Or in this case, excuse me, it's actually 36, we're gonna give back. There it is. So you pay a hundred in, we'll give you 36 back. So we need the 64.

So I'll take 37 multiplied by one minus the 36%, that's the 64%.

And our tax adjusted pension deficit is 24.2.

That then also becomes the debt equivalent.

Great.

We're smashing these pension deficits working out these funded status and we're working out how this affects our valuation. Mm. Winning at pensions. Good.

So I want to do a quick summary slide. Oh no, excuse me. I, I need to do one more thing before the summary slide.

We've worked out the EV bridge, we've worked out how pensions affect the EV bridge.

We've worked out how to get to that pension deficit and we've worked out that sometimes you can tax deduct it.

The EV bridge done.

If I were thinking about an EV multiple such as EV over ebit, I am feeling confidence. Tick.

I know how to calculate my ev. Yes, yes, yes. Good.

But what about the ebit? Is my EBIT definitely going to be correct? And we do have a little bit of a concern here.

Let's go back into the slides. Let's have a look at the issues with the income statements. Here we go.

What we're gonna do here, we don't have an income statement on the screen, but what we've got is that little beginning ad subtract thing.

So from the last question, my pension obligation, we saw that my pension obligation here in the top half here, it was going up and up and down and up due to lots of different reasons.

Got the same thing on the slide here. B is my beginning, the beginning value of my projected benefits. So that's my obligation.

And then we might see that that goes up. We might add to that.

And there are two particular things here that I care about.

This service cost and the interest cost.

We don't really need to understand the others. These two, these two are a little important.

The service cost says for every year that an employee works, they increase their pension, they receive at the end.

And with my brother, do you remember he's gonna be paid two thirds of his final salary.

That's only if he works for 40 years. So every year he works, he gets closer and closer to that. Two thirds I think starts at like kinda 20%.

Gradually gets up to 67%.

So every year extra he works, he gets more pension.

And that's called a service cost.

As my brother provides his services. So his employer, the employer will put more into his pension. That's cool.

There's nothing wrong with that. So we're gonna add that on, add the service cost. But another thing you might notice is up at the top where it says the beginning number, it's my beginning obligation, but it's the present value of that obligation.

What we do when an employee is young, we present value their obligation.

And as they gradually get older, as the years go by, we we unwinds that discount, that present value.

So every year gradually gets bigger and bigger and bigger and bigger until they retire. We need to do that here.

The interest cost is that discount unwinding the present value.

Present value of the obligation is being undiscounted. It's being unpleasant, valued. We need to find the future value that needs to be added as well. That's fine. Nothing wrong with these.

All the pension experts are looking at me like, Jared, this is fine. This is normal. What's the issue? The issue is on those two numbers, is on those two, the service and the interest cost. And it's on the right.

It's on the left hand side here. Those two items are included.

Let's get the right color here are included as expenses in earnings on the income statement.

So the service cost goes in the income statement, the interest cost goes in the income statement. Great.

Goes to the income statement, goes to the income statement. Nothing wrong with that. Completely normal is the income statement.

The service cost goes into opex.

When we're looking at US gap, OPEX is operating expenses, interest costs goes in the finance costs. Great.

So this is saying that my, in the us my EBIT is going to include the service cost.

My EBIT includes service cost and that's good. That's what we like. My brother worked another year, he's owed some more money that's that's operating. That's good.

So where does it go? A little bit wrong under I F R S. It may go wrong. It doesn't have to, but it may.

Let's have a read.

Companies can choose where to record these costs.

So under I F R S E, EBIT may include my service cost, which would be great.

So EBIT may include the service cost, that's fine. I'm gonna put a big smiley face next to that. That's good.

But it may also include my pension interest.

Okay? And that's not ebit.

If we're here in Britain, you'd say that's just not crickets, okay? It's not how the game is played.

We've ended up with interest maybe going into EBIT under I R s. Oh no, what a disaster. It's not the way it's meant to happen.

Okay? So we just need to be aware, just need to be aware this might happen if the company's doing that, you want the service cost, that's okay. You don't want the interest cost.

So if I'm thinking about my EV EBIT multiple, again, my EV now includes my debt equivalent.

That's good.

EV includes my debt equivalent for pension deficits and my EBIT sick may need pension interest be cleaned out, may need the pension interest to be cleaned out.

May need pension interest to be cleaned. There we go.

Cool. And that's the income statements.

So I've got one summary slide to bring all of this together now by skip, skip, skip, skip. Here it is slide 11.

We need to look at all of our valuation adjustments.

And this flow chart is really helpful. It's very, very helpful for, for summarizing everything, asking the questions and giving us a solution to each question.

So first of all, it says that we need to calculate the funded status from footnotes assets minus obligations.

That's exactly what we've got over here under status, uh, obligations minus assets. I said the wrong way around.

Now a curious question here. What if the the plan assets are greater than the obligation? Well that's an overfunded pension scheme. That's awesome. Hey, that's brilliant.

Could I just ha take that overfunding, that surplus? Could I have it as cash? No, no, no, no, no. We just ignore it.

A plan surplus is not treated as a cash equivalent.

Okay? So just need to be aware of that.

Just make sure you're not stealing money from that pension.

Let's assume my plan assets are not greater than my obligation normal.

That means I've got some kind of deficits. Good.

You may need to make two adjustments. First of all, on the balance sheets, you need to include the debt equivalent. Yep, got that. There's no problem with that. That's my deficits. And that deficit, I may have to take the deficit and make it post tax, which means multiply it by one minus the marginal tax rate.

Alternatively, if I can't make it post-tax, then you just take the full unfunded amounts.

Unfunded. Were healthcare, healthcare obligations typically unfunded, no tax deduction there. We need the full amount going in.

So my debt equivalent is either the deficits post-tax or just the entire unfunded deficits, no tax.

And then that last thing we need to look at is under I F R S.

You have to ensure that EBIT only includes pension service cost, not the interest.

Interest should people below EBIT closings the title, earnings before interest.

If your pension interest has gone in there, get it out.

And that gets us all the way through pension.

So I hope you found that useful guys.

We've adjusted our EV equity bridge and we've adjusted ebit.

This video will be going onto our website on Felix, under the Felix live section on the front page on Monday.

So if you want to watch this again, you absolutely can. Uh, we've got another run of this in about two hours time.

So feel free if you're watching this live and you think, do you know what? I really just want to see that a little bit Again, feel free to come along. Otherwise guys, I hope you found that useful.

I hope to see you on another Felix Live really soon. Goodbye.