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Airlines: The Washington Beat; An Update on Pension Issues With PBGC
Susan Donofrio: Phone No. 212-803-7015
Airlines: The Washington Beat; An Update on Pension Issues With PBGC
Susan M. Donofrio (212) 803-7015 sdonofrio@fulcrumgp.com
Salvatore Vitale (212) 803-7019 svitale@fulcrumgp.com
November 23, 2004
Details: Pension liabilities continue to be an important issue for U.S.
industries, with airlines particularly impacted. The PBGC reported in November a 2004 fiscal year deficit in its insurance program for single-employer-sponsored pension plans of $23.3 billion, a sharp swing from the $9.7 billion surplus reported in 2000. What was disturbing is the revelation that PBGC now estimates that its "reasonably possible exposure" to potential plan terminations has exploded to $96 billion, from $82 billion a year earlier. A reform of the current system appears to be inevitable as a result, in our opinion, and is indeed one of the top Republican priorities. Underscoring the centrality of the airline industry in this turmoil, airline pensions are currently under-funded by $31 billion. This amount includes United and US Airways, which are $8.3 billion and $2.3 billion under-funded, respectively.
Figure 1 below shows the quick and sizable deterioration of PBGC's net position in its single-employer program from 2000 to 2004 after a number of years of financial health and stability.
The U.S. airline industry is not the only industry that has contributed to the PBGC shortfall. The steel industry is another, accounting for 5 of the 10 most under-funded plan terminations in PBGC history. Rounding out the list of industries with the greatest ongoing risk to PBGC is the auto industry, with over $60 billion in under-funding as of 2003 according to the GAO.
Figure 2 below lists the principal categories of possible exposure by PBGC to potential plan terminations. The agency based this on credit quality and current pension plan under-funding of $5 million or more.
The current "safety net" of PBGC: PBGC currently has the ability to borrow
$100 million from the U.S. Treasury in order to cover insufficient funds used to pay the benefits of plans it is taking over. Given multi-billion dollar deficits, this amount appears to be woefully inadequate, in our opinion. The bankruptcy of PBGC could be the result if taxpayers or the government don't come to its rescue. The outcome would be a severe reduction or total loss of pension payments to workers.
How did this happen so quickly? Answer: "A Perfect Storm": The deterioration in the state of U.S. employer-defined benefit pension plans has been especially marked given the short time frame over which it has occurred. The reason is that defined benefit pension plans have fallen victim to a perfect storm of events since 2000. More specifically, the decline in the stock market (reducing plan assets and return assumptions on plan assets), the decline in long-term interest rates (inflating the present value of future obligations), and the increasing proportion of retirees collecting benefits relative to workers have combined to quickly deteriorate the state of US employer defined benefit pension plans. Adding to the travails of the legacy airlines was depressed traffic in the aftermath of 9/11 attacks and the rapid increase of competition from low-fare airlines. The result was that the legacy airlines have lost $24 billion over the last three years. This dwarfed government assistance of $8.3 billion during the same time period.
In its review of the issues surrounding the present pension crisis, the
Government Accounting Office (GAO) identified several problems and
disincentives inherent in the current structure of PBGC and employer-defined
benefit pension plans. These include:
* The current rule barring companies from over-funding their plans during
periods of economic prosperity.
* The current premium rate structure that fails to account for the sponsor's financial health (premiums should be risk related).
* The moral hazard created by PBGC: Sponsors are likely to deemphasize pension funding as a financial priority because they know that PBGC will bail out their plans. In certain cases, bankruptcy laws may even encourage companies with severely under-funded plans to file for Chapter 11 as a way to shed their pension obligations.
* Lump-sum distributions: Current rules may create incentives for employees to take lump-sum payments, which exacerbates PBGC's shortfall. Employees who believe PBGC will not be able to cover its full benefits have an incentive to take a lump-sum payment, which only increases PBGC's shortfall.
A Short-Term Fix:
In 2004, Congress passed two bills providing short-term assistance (effective through 2005) while broader pension reform issues are discussed. One addressed the interest rate that can be used (within a band of 10%) to calculate the current liability of a company's defined benefit pension plan. This used to be the discontinued 30-year Treasury bond interest rate and is now a blend of corporate bond index rates. The other bill provided for some limited relief from deficit contribution payments for airline and steel companies.
Current Longer-Term Reform Proposals Being Discussed:
We believe the outsized importance of these liabilities to the long-term
viability of the legacy airlines warrants a review of the various reform
proposals currently under review. We think any proposal will inevitably entail a combination of reduced retiree benefits and/or higher company funding and premiums.
One plan that has been proposed in the House of Representatives by Rep. John
Boehner (R-OH) to address some of these issues sets forth six specific measures that would strengthen defined benefit pension plans. These include:
* Use a permanent interest rate: The use of a permanent interest rate to
increase the accuracy of required funding calculations. This step would
ensure that company plans are adequately funded by removing much of the
guesswork inherent in selecting the appropriate interest rate at which to
discount projected obligations.
* Require companies to fully fund their plans: Current federal rules limit companies from over-funding their plans during periods of attractive
investment returns and earnings (to preclude the inherent tax benefit), while compelling them to increase contributions during periods of weak
returns and earnings. This appears to undermine the financial stability of
a company.
* Reduce funding volatility: Companies can currently skip contributions
during periods of high earnings if they meet minimum funding requirements,
which can hurt the funding status of a plan over time. In addition, extra
contributions should be required of a company that has systematically
under-funded plans.
* Companies should not be allowed to over-promise: Companies should not make employees promises they cannot keep. More specifically, an adequately
funded plan should be a precondition to a company's granting of benefit
increases. Management should also be required to be fully straightforward
to its employees regarding the status of their benefits.
* Increase disclosure: Employees should receive more meaningful and timely
disclosure of the financial state of their pension plans.
* Defined benefit plans should continue to include hybrid plans. Hybrid
plans such as cash balance pension plans should remain a viable part of the
defined benefit plans.
In addition, Boehner believes there are other ideas worth considering, such as giving employee pension plans higher priority to other unsecured creditors during bankruptcy proceedings.
Our conclusion for equity airline investors: Negative in its present form.
Our conclusion is that we think the current proposal presented by Rep. John
Boehner (R-OH) is good for workers since it provides for greater transparency as well as greater protection of pension benefits. In its current form, it may not however be good for equity holders of the legacy carriers (AMR Corp., Continental, Delta and Northwest in our universe (all currently rated BUY)).
This is because the cost of these pension plans would become more and more
shackled to the company without any type of financial relief in the form of
deferred payments, temporarily reduced contributions, or a larger amortization schedule. This could actually push more of them into bankruptcy. Equity holders would then likely be left holding an empty bag since debt holders are paid first during bankruptcy and these airlines have very high levels of debt.
Indeed, their average debt-to-capitalization ratio was 127% at the end of 3Q04.