Fitch Report - Rapid Descent: Pensions in the U.S. Airline Industry



Fitch Report - Rapid Descent: Pensions in the U.S. Airline Industry

This report addresses the issue of U.S. airline industry pension obligations within the context of the industry’s broader financial problems, focusing on both sector trends and company-specific issues. The increase in underfunded pension obligations represents an incremental and meaningful financial burden to the airline industry, an industry already crippled by recent turmoil. Those airlines most affected by pension issues are the high-cost network carriers with large defined benefit plans (hereafter referred to as pension plans). These pension obligations compound the financial stress already evidenced in the industry through substantial and continuing operating losses, shrinking asset bases and cash-generation capacity, and balance sheets burdened by greatly enlarged debt levels. As a result of underfunded positions, airlines are likely to face an extended period of heavy required contributions to their pension plans, leading to a further decline in credit quality. A reversal of this situation would occur only in the event of some combination of strong, sustained improvement in both passenger yields and equity market returns.
Underfunded obligations are pertinent not only to those companies operating outside of bankruptcy, but also to those operating within Chapter 11. For those operating outside of bankruptcy, financial stress and the extent of underfunded pension obligations have already, in a number of cases, resulted in active dialogue between the airlines and regulatory authorities as the airlines seek to explore creative solutions to the issue. In the case of US Airways and United Airlines, Fitch believes that it is unlikely that these airlines will emerge from bankruptcy without significant adjustments to their pension obligations. These obligations have the potential to further impair difficult labor negotiations, and heighten the possibility of liquidation.
Although the automotive and steel sectors have received the lion’s share of investor attention with regard to the pension funding issue, the U.S. airline industry is likely to assume a new and prominent place as the industry most at risk for financial fallout resulting from the growing magnitude of its pension-funding problem. Prior to the recent termination of pension plans in the steel industry, former U.S. airline employees represented the largest source of payments by the Pension Benefit Guaranty Corporation (PBGC) resulting from terminated pension plans. Clearly, the airline industry is poised to become a primary focus of PBGC concerns over the next several years.
Major U.S. passenger airlines, with their large unionized work forces and generous labor contracts, as a group faced a substantial pension shortfall as final plan numbers were compiled at the end of 2002. Fitch estimates that the domestic airlines’ funding gap on a projected benefit obligation (PBO) basis likely will exceed $18 billion (based upon current market returns and interest rates). This underfunded obligation has risen dramatically from 1999, when the industry was overfunded (again on a PBO basis) by approximately $1 billion following the long bull market in equities.
Although the pension issue never really goes away, it can be relegated to the back burner in periods of economic prosperity, consistent levels of contributions and/or superior market returns. The airline industry accomplished this in the late 1990s, at a time when industry revenues and profits were at or near their cyclical peak and market returns were strong.
Unfortunately for the major airlines, the pension winds have changed direction since 1999, while at the same time myriad other factors have combined to undermine the operating performance and credit quality of the network carriers. Operating performance for the majors has gone from relatively strong profitability in the late 1990s to losses of a magnitude not seen before in the domestic market. In 2001, major airlines profiled in this piece (excluding those low-cost carriers without defined benefit plans) lost almost $8 billion. Losses of a similar scale were racked up in 2002 as the industry contended with a revenue environment that has shown few signs of
improvement. Even in the event of a rebound in passenger yields and unit revenue, the majors are faced with servicing enlarged, post-Sept. 11 debt levels and associated fixed obligations with shrunken capacity and reduced cash-generation potential. Due to weak market returns and growth in mandated by the Employee Retirement Income Security Act (ERISA) are ratcheting up significantly at a time when the airlines can least afford it. For any company, the minimum required ERISA contributions represent debt-equivalents, and compliance with ERISA requirements is a standard feature of virtually all debt agreements. This already has led to a number of discussions between the airlines and regulatory authorities (primarily the PBGC), in an attempt to create novel approaches to the issue, and these discussions are likely to increase in number and intensity. It is important to note that use of pre-established ERISA credits or any other deferral structure does not resolve the issue — it simply delays, and potentially compounds, the company’s obligation to make up the shortfall.
Airline Pension Trends
When analyzing individual companies’ pension situations it is important to consider them within the context of the industry in which they operate. Several recent trends have emerged with respect to airline industry pension data.
The different approaches U.S. airlines have taken toward employee benefits and pensions provide an interesting backdrop to the existing competitive framework and the erosion of the financial position of high-cost major airlines. The principal difference is whether a company has a defined benefit pension plan or if it relies exclusively on defined contribution 401(k) plans to cover employee retirement benefits. Airlines such as Southwest, AirTran, ATA, JetBlue and America West do not have significant pension plans. As a result, in this cost component these low cost carriers have created a distinct cost advantage when compared to those companies that have pension plans (e.g., American, United, Delta, Continental and Northwest). In many cases this distinction compounds existing differences in operating performance, productivity and non-pension labor costs, resulting in a widening of the competitive gap and ability to service fixed obligations.
Funding Status
The companies profiled in this piece had a combined PBO of approximately $32.4 billion at the end of their respective 1999 fiscal years. This represented their U.S. pension obligation and was offset by a combined $33.1 billion of pension assets. The result at that time was an overfunded status of $0.7 billion (or 102% of obligations).
By the end of fiscal 2001, the sector’s obligations had escalated to $42.4 billion, principally as a result of two factors. First, there was a decrease in the discount rate due to a fall in prevailing U.S. interest rates. This reduction in the discount rate, which ranged from 50–75 basis points (bps), was responsible for approximately $3 billion of the increase in the aggregate industry PBO. The vast majority of the increase in obligations was due, however, to a significant increase in projected benefits resulting from the ratification of substantially richer union contracts. This large increase in the PBO was not offset via either market returns or company contributions. In fact, the asset base for the industry actually fell from $33.1 billion in 1999 to $30.3 billion in 2001. This decrease in assets (due principally to poor market returns), when combined with the increase in obligations, resulted in a $12.1 billion shortfall at the end of the 2001 fiscal year. This represents a 72% funded status. (Please refer to the 1999 and 2001 Airline Sector Data to see each company’s funded status for the respective time period.)
Fitch projects that given recent U.S. equity returns (the Wilshire 5000 index declined by 20.9% in 2002) and overall diversification (Fitch estimates that equities represent 55%–75% of most Fortune 500 pension assets), all companies in the airline sector will see a deterioration in their funded status at yearend 2002. Fitch estimates that this funding gap will increase from $12.1 billion in 2001 to in excess of $18 billion by the end of fiscal 2002. Out of this overall increase in the funding gap, approximately $2.1 billion will be due to a further reduction in the discount rate and $1.9 billion will be due to “normalâ€￾ increases in the PBO. These normal increases basically reflect the netting of the items that annually affect the PBO (principally service cost/interest cost plus the amortization of any changes) against the benefits currently being paid. Fitch also estimates that the companies profiled will lose an additional $2.4 billion in assets due to poor market returns. These changes would bring the funding status to a disastrous 59% level by year-end 2002. This decline is likely to be offset at least partially by additional required company cash contributions, but not to an extent that would alleviate the stress. These figures also incorporate an assumption set that, as a whole, is still relatively optimistic compared to those used in other corporate sectors.
This increase in the underfunded gap will be led by United, Delta, Northwest, and US Airways, with most of them falling at least $1 billion further into the red during 2002, albeit for different reasons. Some likely will end up in that position primarily as the result of asset returns (Delta and American), while others will get there due to obligation-related trends (United).
Ramifications will be extensive, primarily in the form of increasing minimum contribution requirements. (Although far less meaningful, this also will result in substantial charges to book equity, via minimum pension liability charges, which will flow through other comprehensive income [OCI].) Even for those companies in a comparatively strong position in terms of liquidity, balance sheet and operating performance, increasing pension funding requirements come on top of a near-term outlook defined by continuing operating losses, a weak revenue environment, increasing overlap with lowcost carriers, reduced capacity, potentially acrimonious labor relations centering on wage reductions, and escalating fixed financial obligations resulting from elevated and still-growing debt levels.
This situation certainly does not lend itself to open access to external capital with which to address its pension or other financing requirements. As mentioned, for the majors, increased pension funding requirements represent another significant competitive cost disadvantage versus the low-fare airlines characterized by defined contribution, rather than defined benefit, pension plans.
Expected Returns
Although the current level of expected returns has been what has drawn the most media attention, it is important to note that this assumption is only relevant to the calculation of pension expense (a noncash item). As of fiscal 1999, the airline sector had an average return assumption of 9.82%, relatively high when compared with other industrial sectors. For most companies this high level of expected return is not justified by recent experience and most likely will need to be adjusted over the next several years. Fitch expects these rates to come down to the 8%–9% range
for most of corporate America. As a result, these changes will increase pension expense for the sector (i.e., reduce assumed earnings on pension assets that offset pension expense). Fitch estimates that this hange would reduce the sector’s annual pretax income by approximately $250 million-$500 million (depending upon the rate utilized). Of note, changes to pension expense also will affect income-statement oriented metrics such as EBITDAR coverage ratios.
Discount Rate
An important assumption made by employers as it relates to pension issues is the discount rate. This figure, which usually represents a corporate AA bond benchmark, is the rate used to discount the future pension obligations to determine the PBO. As a result, it plays a significant role in both the funded status and in pension expense (an increase in the obligation results in higher interest expense). In 1999, the aforementioned airlines had an average discount rate of 8.11%. By 2001 this discount rate had decreased to 7.50%. Although it is impossible to determine the exact effect on airline sector obligations (given the magnitude of data and the presence of numerous assumptions), Fitch estimates that approximately $3 billion of the $10 billion increase in sector PBOs between 1999 and 2001 was due to decreases in the discount rate.
Changes in the discount rate affect a company’s reported pension expense and its funding status. This is especially relevant given that a high percentage of companies will have to decrease their discount rates for fiscal 2002 due to lower bond market yields. In fact, several companies have indicated that they intend to take their discount rate down as much as 50 basis points. Fitch estimates that a 50-basis-point decrease in the airline sector discount rate would
increase the sector’s total PBO by approximately $2.1 billion.
It must be noted that although the Statements of Financial Accounting Standards (SFAS) 87 discount rate is not the rate used to discount for ERISA, it theoretically is correlated (with the exception of any widening in perceived corporate risk premium) to that rate, and shifts in the discount rate will pass hrough to the ERISA cash-funding requirements.
Rate of Compensation Increase
The rate of compensation increase is the primary difference between the PBO and accumulated benefit obligation (ABO). As the principal factor differentiating the PBO, it reflects the accounting “going concernâ€￾ assumption. And, as such, is important to the accounting data provided in most financial reporting (which tends to focus principally on a PBO-based presentation). In 1999 the airline industry projected an average rate of compensation increase of 4.43%. By 2001, this rate had increased to 4.85%, reflecting the rich labor contracts signed in 2000/2001. Of particular interest are Northwest (3.9%) and United (4.2%), both of which have low rates built into their PBOs relative to their competitors. It is also important to note that for those companies outside of bankruptcy, recently concluded labor agreements have in most cases contained wage increases well above assumed compensation rates. This results in an upward adjustment of pension obligations as well as increase in direct costs.
Although the rate of compensation increase is not of critical importance to investors, it is indicative of several things. Since ERISA focuses on ABO-like metrics, it is important to be able to adjust the PBO to an ABO basis. Because the rate of compensation increase is the principal driver of the difference between the PBO and ABO, it is important in attempting to derive ERISA cash funding from SFAS 87 accounting. This assumes that the plans are career average plans (which factor in future salary levels) and not flat-benefit plans (which pay a flat rate based
upon years of service). This also assumes that the plans do not include buried cost-of-living adjustments. These plan differences can complicate this rather simple analysis. In short, although the rate of compensation growth assumption has limited usefulness, it can provide assistance in the calculation of the ABO and provide guidance on future wage rates.
Uncharted Ground: United Airlines, US Airways and the Role of the PBGC
Without question, the PBGC will be front-and-center in a number of pending airline situations, and likely will be forced to make decisions that could have a major impact on the future structure of the airline industry — a role it is unlikely to relish. These decisions include the potential takeover of several pension plans and the possible renegotiation of the terms of required contributions.
In the cases of United Airlines and US Airways, it is Fitch’s view that these airlines are unlikely to emerge from bankruptcy without meaningful changes either to their existing pension obligations (potentially in the form of a PBGC termination) or to the timing and/or level of their required funding obligations. US Airways said as much in its recent 8K filing when referencing its request to extend the timeframe on its required contribution:
“The Debtors have not obtained approval of 30-year (or similar) funding under existing law, and therefore it appears that legislation would be required to achieve this result. Accordingly, there can be no assurance that the Debtors will be able to adopt this or a similar amortization of the unfunded pension liabilities. If the 30-year or similar funding is not available, pension plan terminations may be required, which may result in further negotiations with labor groups. Any solution must be accomplished within the timeframe permitted under the Company’s Chapter 11 proceedings.â€￾
Under US Airways’ recently filed reorganization plan, the pension issue was conspicuously cited as remaining open to resolution. In the case of United Airlines, the rejection of its loan guarantee application by the Air Transportation Stabilization Board (ATSB) specifically cited the company’s pension obligations as one of the key factors leading to its decision. In both cases, failure to meaningfully alter these obligations could result in the liquidation of either or both airlines. As previously stated, other airlines have also approached regulatory authorities to explore alternative funding solutions.
Either course of action by the PBGC, termination of the plan or a deferral of payments, likely would have immediate repercussions. Allowing a deferral of payment obligations would rapidly invite other airlines (and a host of other industries with underfunded obligations) to demand similar treatment.
On the other hand, a takeover of plans is sure to result in more difficult labor relations at the affected airlines, with the loss of pensions compounding the pain already inflicted through recently negotiated and/or future-imposed wage concessions. At United for example, senior pilots can earn annual pensions well in excess of $100,000, versus the maximum PBGC annual payout of slightly less than $43,000. In addition to the limit on annual payments, the
assumption of a plan by the PBGC results in the elimination of all “additionalâ€￾ benefits established under plan amendments over the last five years. This would eliminate all the recent improvements (i.e., those begun by United for its pilots in the 2000 contract) that have been one of the two main drivers of the change in many companies’ plan status from fully funded to substantially underfunded (the other being poor market returns). Downward adjustments
in pay scales that have been negotiated at US Airways and that are in process at United can significantly reduce the underfunded liability position. However, in both cases, the vested amount incorporated in the ABO is still a burden that is likely to be too large to be handled and will require intervention.
As both airlines seek further wage and benefit concessions in bankruptcy, pensions are certain to be a major topic of discussion with its unions — particularly with the pilots, where the bulk of the pension obligations lay. In United’s case, the substantial reduction in pension benefits caused by a PBGC termination certainly would not improve the likelihood of cooperatively achieving the wage reductions in the amount and timeframe necessary to meet the onerous terms of the company’s DIP financing. In the event that the wage concessions come first and a potential PBGC takeover comes later, this certainly would not bode well for cooperative labor relations and a quality airline product over the short term as the company seeks to implement the remainder of its restructuring plan.
Further to the United situation, the significant level of minimum contributions required under ERISA, unless resolved, certainly would inhibit the formation of any reorganization plan that would invite new capital into the company.
In both United Airlines’ and US Airways’ cases, the PBGC sits on the creditors committee and will have input into the bankruptcy process. Unlike most other creditors, however, the PBGC has the authority to take unilateral action to protect its interests if it believes that by not acting, the result would be an inevitable increase in its eventual payout. The recent Bethlehem Steel case is a telling example, where the PBGC stepped in, terminated the plan, and assumed the adjusted obligations. In this case, PBGC Executive Director Steven A. Kandarian was quoted as saying: “To safeguard the pension insurance system that protects millions of Americans, we had to act now to prevent even larger losses down the road.â€￾
The PBGC is responsible for insuring benefits to employees covered under defined benefit programs, and hence is obligated to serve the best interests of the covered employees. Given the weak near-term outlook for the industry and the continuing growth in obligations, the PBGC may face a similar decision in the case of these airlines. Given that under US Airways’ recent reorganization plan unsecured creditors are scheduled to recoup only two cents on the dollar, the PBGC may have further incentive to take proactive steps.
United States Government Intervention
The events of Sept. 11, 2001, and the subsequent downturn in the airline industry have resulted in active government intervention in the industry through a variety of means, from outright grants, to insurance, to the establishment of the ATSB loan guarantee program. As such, political influences could add an additional element of uncertainty to the equation. Outside of the potential for conflict with Iraq, this could occur through intervention in the ATSB process, additional legislation, and/or through the actions of the PBGC. It will be interesting to observe how Congress might react to a new “doubledipâ€￾ government assistance scenario in which the government potentially would provide financial assistance through the ATSB loan guarantee program while simultaneously releasing companies from their pension obligations through the termination of existing plans by the PBGC.
Additionally, the assumption of two or three airline pension plans easily could result in the depletion of the PBGC’s reserves (assets minus liabilities), which stood at about $7.7 billion as of year-end 2001. This figure is prior to assuming an estimated $6 billion in obligations from the steel industry alone in 2002. A depletion of PBGC funds could create a situation in which premium increases would be required to narrow the agency’s funding gap. Although operating at a deficit would be nothing new to the PBGC, the frequency and magnitude of recent and prospective terminations could invite further congressional scrutiny.
The Companies
This section includes an overview of the pension issues facing eight large U.S. airlines (seven of which have defined benefit plans). Please note that much of this analysis is based upon SFAS 87 financial reporting and is, therefore, subject to fluctuations caused by that accounting guidance. Of particular note is that reported asset returns are not necessarily reflective of actual asset returns due to smoothing. As indicated in Fitch’s previously published pension reports, it can be difficult to determine how the actuarial and accounting assumptions flow through
the SFAS 87-based accrual accounting. This is especially true when trying to determine cash funding requirements. As such, this report represents Fitch’s views based on existing information on each company’s pension plans and overall business outlook. Unless stated otherwise, underfunded figures are referred to on a PBO basis. Readers may contact the analysts (listed on page 1) for additional information. Actual data regarding 2002 plan performance and funded status will become available over the next few months due to market demand during earnings release season and as companies release 10-K reports with complete pension footnotes.
The company comments section includes:
Total Estimated Funding Gap as of Dec. 31, 2002, - $18.9 Billion.
• Strengths/weaknesses including comments on publicly disclosed financials/assumptions.
• Fitch’s view on the company’s future pension issues.
• Future pension issues, including an assessment of risk factors. This item considers funding status, funding strategy, relative comparisons of assumptions, operating history (i.e., cash generation capability) and balance sheet criteria (specifically cash on the balance sheet), in an
attempt to assess the risk to the company’s financial status as a result of its pension plans. It
must be noted that this assessment is not made relative to other airlines, but rather represents an absolute assessment compared to other domestic corporate names.
Alaska Air Group, Inc. (Alaska Airlines) - Although Alaska Airlines faces many of the same
operating challenges that confront its high-cost network airline competitors, Alaska is somewhat
different in that it does not face considerable risk related to pension plan funding. Strengths include:
• Pension plan has the highest percentage funding in the sector (90% at the end of 2001 and an
estimated 79% at the end of 2002). Alaska faced an estimated underfunded obligation of approximately $120 million at the end of 2002.
• Asset performance in 2001 of – 4% was among the best in the industry. This is probably due to
lower level of risk in the portfolio, as indicated by 1999 asset performance that was below the industry average.
• The presence of $663 million of cash and short-term investments (third quarter 2002) on the
balance sheet provides some mitigation of current funding risk.
• Fitch estimates that Alaska will not be required to fund under ERISA until 2004.
• Relative to its peers, Alaska has contributed more to its plans in the last two years as a percentage of assets (total of $50 million or 11% of current plan assets).
• Reasonable assumptions (2001) include a discount rate of 7.25% (lowest in the sector) and
an assumed rate of compensation increase assumptions of 5.4%.
• Unlike its high-cost competitors, Alaska has continued to report nearly break-even operating
results in 2002. This provides the carrier with additional flexibility in directing some cash
toward pension funding in future years.
• One of the few companies whose book equity ($836 million as of third quarter 2002) is not
seriously at risk as a result of pension-related charges. The airline announced on Jan. 6 that it
would take a year-end non-cash charge of $80 million related to changes in its minimum
pension liability. This represents less than 10% of book equity.
Weaknesses include:
• An expected return assumption of 10% that looks ambitious given recent market experience.
Fitch’s view is that Alaska Airlines’ pension is currently a manageable obligation. Fitch assumes that Alaska will continue to fund to at least 2001 levels ($45 million) for the foreseeable future.
AMR Corp. (American Airlines) - Up until 2002, American faced a pension funding gap
that was somewhat smaller than those of its major airline competitors (approximately 74% funded at the end of 2001). This was a function of flat asset returns in 2001 and the company’s contribution of $121 million to its plans in that year. Fitch estimates that AMR’s pension plans will be about 60% funded at the end of 2002.
Strengths include:
• The presence of $2.8 billion of cash and short-term investments (third quarter 2002) on the
balance sheet provides some mitigation of current funding risk. However, the relatively high cash balance will be used in large part to fund large and continuing operating losses, depriving the company of the flexibility to use cash in the funding of pension plans.
• American had the highest asset return (0%) in 2001. Given the markets, this represented exceptionally strong performance. However, we believe that the company’s 2002 asset returns
will fall well short of previous levels.
• A reasonable assumption set (relative to the rest of the industry), including a discount rate of 7.5% and an estimated rate of return of 9.5% (below the sector average).
Weaknesses include:
• American has given no firm guidance on the anticipated cash funding requirements it faces in
2003; however, the size of the anticipated charge to book equity in fourth quarter 2002 (near
$1 billion) suggests that minimum required contributions must be made. Fitch believes that
American will be forced to aggressively fund its plans beginning no later than 2004, and
anticipates that annual required contributions at that point (assuming no large contributions prior
to that date) will exceed $400 million.
It is clear that American’s inability to generate strong operating cash flow, a result of high operating costs and prolonged weakness in the industry revenue environment, will keep the company from making substantial discretionary cash pension contributions in the next few quarters. For American and its high cost competitors, pension funding requirements represent additional cash obligations (above and beyond ballooning debt and lease obligations) that
can be funded only if consistent and substantial improvements in cash-flow generation can be
Continental Airlines Inc. - Although the magnitude of Continental’s obligation ($1.5 billion) and its underfunded liability ($587 million at year-end 2001 and an estimated $730 million at year-end 2002) pose challenges, Continental is relatively well-positioned compared to some other players in this sector.
Strengths include:
• Asset performance of (7%) in 2001 was slightly better than the industry average.
• Relative to its peers, Continental has contributed more to its plans in the last two years (total of $308 million or 32% of current assets). The company used part of the proceeds ($150 million) from the initial public offering (IPO) of its ExpressJet regional airline unit to fund its plan in
• One of the more reasonable assumption sets (for 2001) in the industry, including a discount rate of 7.5%, an estimated rate of return of 9.5% and an assumed rate of compensation increase
assumptions of 5.13%.
Weaknesses include:
• Relatively low cash balances (forecasted at $1.2 billion at year-end 2002) limit Continental’s capacity to fund aggressively.
• Excluding US Airways, Continental in 2001 had the most underfunded (on a percentage basis) pension in the group at 62% on a PBO basis. Fitch estimates that the level of funding could fall to 56% at year-end 2002. Continental has noted in recent financial disclosures that 2003 minimum cash funding of the plan will exceed $200 million.
• Continental’s liquidity position will remain challenging in spite of the fact that its operating
losses are smaller than those seen at the other major carriers. Poor operating cash flow in 2003,
coupled with a minimum cash balance requirement of $500 million, will limit Continental’s financial flexibility in addressing pension funding issues.
• Continental has estimated that the increase in its minimum pension liability will result in a charge to equity of between $225 million and $375 million on the year-end 2002 balance sheet.
This compares with shareholders’ equity of $1.1 billion as of third quarter 2002.
Required pension plan contributions, along with other fixed financing obligations, are limiting Continental’s financial flexibility at a time when operating performance remains weak. Relative to other major airlines with larger obligations (Northwest, American and Delta), Continental faces a more constrained liquidity position. We believe the company will have to continue to fund aggressively for the foreseeable future. Fitch would anticipate annual required contributions to exceed $200 million over the next four years.
Delta Air Lines, Inc. - Much of Delta’s pension problem appears to be the result of an overly aggressive asset mix and poor plan returns. This conclusion is supported by the company’s disclosure in September that it will be forced to take a charge to other comprehensive income of between $700 million and $800 million.
Subsequent to that disclosure, Delta has indicated that the size of its ABO as of Sept. 30, 2002, was still uncertain and the magnitude of the year-end charge has not been determined. Higher pay scales and pension funding costs associated with the airline’s 2001 pilot contract also are putting upward pressure on the benefit obligation.
Strengths include:
• Delta announced in November that it is rolling out a cash-balance pension plan for its non-union employee groups (all but the pilots). The substitution of individual employee retirement
accounts for defined benefit payouts likely will reduce the magnitude of outlays for retirees with more seniority. The company has estimated that the cash-balance plans could save up to
$500 million over the next five years. The low degree of unionization at Delta is atypical among the major airlines. As a result, over the near term, Fitch does not expect widespread conversion of defined benefit plans to cash balance plans across the industry.
• In 1999, Delta had the highest asset return (22%) in the industry. This is indicative of an
aggressive asset allocation and would lend itself to a rapid recovery if the equity markets come
back strongly over the next few years (assuming the asset allocation in the plans remains
Weaknesses include:
• One of the weaker assumption sets, including a discount rate of 7.75% (highest in the sector), an estimated rate of return of 10% (above the sector average) and an assumed rate of compensation increase assumptions of 4.67% (below the sector average).
• Asset performance in 2001 of –15% is among the worst in the sector (and would be among the
worst across the industries reviewed by Fitch as well).
• Other than United, Delta has the largest absolute funding gap ($2.4 billion at year-end 2001). Unless the asset mix has changed, Fitch estimates that this gap will widen by more than
$1 billion in fiscal year 2002.
• Fitch estimates that there is substantial book equity risk, as reflected in the company’s recent
disclosure that a charge of up to $800 million could be taken in fourth quarter 2002.
Although Fitch does not anticipate that Delta’s pension issues will result in short-term financial
distress, it is clear that pension funding severely limits Delta’s financial flexibility. Together with substantial increases in balance sheet debt and off balance-sheet aircraft lease exposure, the pension funding gap represents yet another claim on cash flows that can only be comfortably met if the company returns to profitability and sustained positive operating cash flow.
The airline has indicated that cash funding requirements of up to $250 million must be met by
first quarter 2004. This represents a substantial claim on cash flow during a period when operating performance is likely to remain very weak.
Northwest Airlines Corp. - Northwest faces a significant pension challenge but has the advantage of a superior liquidity position in comparison with the other high-cost majors. The company faces significant near-term cash funding requirements, and has proposed some alternative funding mechanisms to conserve cash in 2003 and 2004.
Strengths include:
• The presence of $2.5 billion of cash and short-term investments (third quarter 2002) on the
balance sheet provides some mitigation of current funding risk.
• Asset performance in 2001 of –7% was slightly better than sector average.
• Along with Continental, Northwest has seen better operating performance and a smaller cash
bleed as a result of lower unit operating costs than Delta, American and United. Northwest is
likely to be one of the first major airlines to return to profitability when the revenue
environment improves significantly.
Weaknesses include:
• The weakest assumption set (for 2001) in the industry with a discount rate of 7.5%, an estimated rate of return of 10.5% (highest in the sector), and an assumed rate of compensation
increase assumptions of 3.9% (lowest in the sector).
• Substantial funding gap ($2.3 billion).
• Fitch estimates that there is substantial book equity risk This is reflected in the airline’s recent
disclosure that a non-cash charge in excess of $700 million is likely at year-end 2002 to reflect
a widening of the funding gap.
Although Fitch does not anticipate that Northwest’s pension issues will result in short-term financial distress, it is clear that pension funding needs will represent a further large claim on cash flows in the critical 2003-2004 period, when operating performance is likely to remain weak. The company has noted that it has a remaining plan year 2002 ERISA funding requirement of $223 million that it hopes to fund through a contribution of Pinnacle
Airlines, Inc. (Northwest’s regional airline unit) stock in lieu of cash. An application to make this non-cash contribution has been made to the Department of Labor. In addition, anticipated plan year 2003 mandatory contributions that could exceed $400 million may be deferred if the IRS grants a temporary funding waiver. Northwest applied for this waiver on Nov. 5.
Southwest Airlines Co. - Southwest Airlines stands out among the largest U.S. carriers as the only one without a defined benefit pension plan. Instead, Southwest relies upon defined contribution plans and employee profit-sharing as sources of long-term employee income security that do not drive mandatory cash contributions by the company.
Along with its low operating cost structure, the absence of a defined benefit program serves as a
significant competitive advantage for the company in its effort to maintain profitability and strong operating cash flow in a challenging industry revenue environment.
UAL Corp. (United Airlines) - United faces a significant pension funding challenge as it seeks to lower its costs and reorganize under Chapter 11 bankruptcy protection. The airline’s underfunded pension obligation ($2.5 billion at year-end 2001 and an estimated $4.0 billion at year-end 2002) is among the highest in the industry. Until its contractual wage rates are lowered and pension funding formulas overhauled, the gap between plan assets and future benefit obligations is likely to present a major cash flow obstacle for United as it seeks to emerge from Chapter 11.
Strengths include:
• Reasonable assumption sets, including a discount rate of 7.5%, an estimated rate of return of 9.5% (below average) and an assumed rate of compensation increase assumptions of 4.2% (low
for the sector).
• The flexibility to address benefit formulas as part of contract restructuring in the Chapter 11
process. Although this would not affect vested obligations, it would reduce the significant future
component incorporated in the obligations.
Weaknesses include:
• Substantial funding gap ($2.5 billion) that probably will widen by $1.5 billion at year-end
• Benefit formulas negotiated under the 2000 pilot contract and the 2002 mechanic/ramp/agent
workers contracts that drive unsustainable increases in future funding obligations. Wage reductions to date have been difficult to achieve, and further wage reductions certainly will prove
no easier. A potential termination of the pension plan would only exacerbate poor labor relations.
• In the absence of a government-sanctioned overhaul of required contributions or a
termination by the PBGC, Fitch would anticipate annual cash funding requirements for United in
excess of $500 million under pre-bankruptcy contract provisions.
As previously stated, Fitch believes that United will serve as an important test case for the PBGC. Only US Airways faces a task comparable to United’s in finding a funding solution that limits annual cash outlays and lowers benefit formulas for employees.
US Airways Group, Inc. - As with United, US Airways is in an unusual situation due to its August 2002 bankruptcy filing. This, to some extent, obscures some of its pension funding issues. In the end, the PBGC and the bankruptcy process will determine what will happen
with US Airways’ pensions. On Dec. 21, the airline noted in a press release concerning its reorganization plan that its underfunded obligation stood at approximately $3.1 billion and that this remains an “uncertainâ€￾ or “unresolvedâ€￾ issue in its efforts to emerge. This compares with a year-end 2001 PBO of $5.5 billion.
Strengths include:
• US Airways had the best set of assumptions in the industry (for 2001) including a discount rate
of 7.5%, an estimated rate of return of 9.5% (below average) and an assumed rate of compensation increase assumptions of 6.4% (highest in the sector).
• Bankruptcy presents opportunities to rationalize and/or eliminate US Airways’ pension plans.
Weaknesses include:
• Even after new wage deals have been ratified and operating costs restructured, the company
will require changes to the timing of its required contributions or a termination by the PBGC. A
termination could affect the working relationship it has achieved with its labor unions during a
period of steep wage reductions.
• Worst 2001 asset performance in the sector at –16%.
• Substantial funding gap ($2.3 billion) that will probably widen by $800 million in fiscal 2002. Fitch believes that pension issues at US Airways, as in the case of United, will be resolved only through some form of involvement with the PBGC as the airline seeks to emerge from bankruptcy protection by spring 2003. One risk that US Airways faces is that the funding restructuring does not go far enough to make the company a viable business after emergence from Chapter 11. The other “nonconsensualâ€￾ option would involve a plan termination and assumption by the PBGC, which would lower the airline’s cash contribution requirements post emergence.
The airline sector’s pension problem is perhaps the most dire in corporate America. The combination of substantial funding shortfalls and very poor operating performance endangers almost every company in this sector (at least those high-cost majors that have a defined benefit pension plan). The pension issue serves as yet another example of an area in which
low-cost, non-traditional carriers like Southwest and JetBlue have a meaningful competitive advantage over their high-cost network carrier rivals.
In summary, the pension dilemma is exacerbating the financial stress already being experienced in the airline industry, and is unlikely to be resolved in the short term due to the weak operating environment. Although the extent of the pension problem can be moderated somewhat by an increase in interest rates and/or increases in equity markets over the next several years, this would not relieve the problem of significantly higher required contributions during that same period. In the absence of a strong and sustained rebound in airline profitability, a turnaround in the stock market and regulatory accommodation by the relevant government bodies, required contributions will continue to drain the high-cost airlines of much needed liquidity.
For reference on the pension issue and terminology, please see Fitch’s previous report titled “Pensions in a Post-Bubble Economyâ€￾ (dated Sept. 12, 2002). The report can be found on Fitch’s Web site at ‘’.