Airline, auto industries: Pension Protection Act leaves door open to bankrupties, mass payouts

Manufacturing News, Source : The Manufacturer US
Published : 27 Feb 2007 17:57

Legacy costs, the common term for worker pension and healthcare benefits negotiated in past collective bargaining agreements, are rising at a rapid pace - driven by weak projected returns on pension portfolios, strong growth in healthcare costs and aging baby boomers tipping the scale between the number of workers supporting each retiree.

Legacy costs have roots in the concept of “cradle-to-grave” care provided to workers by their lifelong employers. Such a system utilized employer-funded pensions to provide retirement income and catastrophic injury coverage for employees, and also ensured workers that they would receive a high level of healthcare coverage upon retirement. One aspect of these legacy costs, the defined-benefit pension plan, guarantees employees a pre-set benefit upon retirement. The amount of the benefit is calculated by multiplying a fixed percentage by the number of years that the employee worked for the company and applying that figure as a percentage of the employee’s final or highest compensation (or some average of the employee’s highest earnings). Defined-benefit plans are managed by the employer, who makes annual contributions to the plan based upon actuarial assumptions designed to ensure that the fund is sufficiently funded to cover its benefit payouts. Plan assets are then invested and the return on the investments determine how much extra, if any, must be contributed by the company to ensure the health of the system. Ideally, the plans provide significant incentive for loyalty on behalf of the employee, but also depend upon steady growth of the company. All too often, however, the underlying assumptions have turned out to be wrong and employees are paying the ultimate price.

The defined-benefit pension is now a heavy weight around the ankles of many companies. Between 2001 and 2005, the Department of Labor estimates that underfunding of pension plans increased from $164 billion to $450 billion. (Being “underfunded” means that the plans’ assets are insufficient to meet their projected liabilities--the pensions owed to current workers and retirees and their survivors.) According to Credit Suisee First Boston, these liabilities are concentrated in relatively few S & P 500 companies, airlines and automobile companies prominent among them.

Two main circumstances led to the increased underfunding of defined-benefit pension plans – declining stock market values and an artificially low interest rate used for discounting pension obligations. These factors, combined with an older, shrinking active workforce dramatically increased the cost of defined-benefit pension plans. Add soaring healthcare costs into the equation, and a huge drain is placed on profitability.

Defined-benefit pensions are present-day corporate burdens, inherited from a past generation of employees and managers that, in severe cases, can jeopardize the very solvency of the company. The burden of legacy costs is concentrated in industries with large union presence, such as the airline and automobile industries. Companies in these industries are at a distinct disadvantage – domestic rivals without pension obligations and increased competitors from foreign nations has made it extremely difficult to continue with “business as usual”.

In the post September 11, 2001 era, and despite a $15 billion federal government bailout, the airline industry continued has continued to experience a great deal of upheaval. The industry as a whole lost an estimated $5 billion in 2004 and an estimated $2 billion more in 2005. Despite travel being back to pre-September 11th numbers, airlines have not made a cumulative profit since 2000. Four of America’s leading airlines – United Airlines, US Airways, Delta Airlines and Northwest Airlines – are in bankruptcy. In each case, the opportunity to shed unaffordable pension and healthcare costs has been a crucial factor in the decision to enter Chapter 11.

When the Pension Benefit Guarantee Corporation (PBGC) moved to terminate United Airline’s four pension plans, it estimated that there were sufficient assets to cover only 42 percent of the airline’s total obligations. Assets were $7.0 billion while liabilities were $17.2 billion. PBGC guarantees will cover $6.9 billion of the $10.2 billion shortfall. The remaining $3.3 billion represents lost benefits to plan participants.

U.S. Airways has faced similar struggles. U.S. Airways’ plans that terminated in 2003 and 2005 had sufficient assets to cover only 37 percent of the liabilities. At the time of termination, assets were $2.9 billion while liabilities were $7.9 billion. PBGC’s guarantee covered $2.9 billion of the $5.0 billion shortfall. The remaining $2.1 billion represents benefit losses.

The United and U.S. Airways pension terminations are pressuring other legacy airline competitors with similar business models to do likewise. The competition from new low-cost carriers such as Southwest (who provide their employees with 401(k) plans, profit-sharing, and stock purchase benefits) have nowhere near the pension liabilities of their higher-cost competitors which enhances this pressure on the legacy carriers. As stated by columnist George Will, “[i]n 2002 the five strongest legacy carriers had costs of $95,500 per employee. Southwest had costs of $59,100…No legacy airline can compete with another that has dumped its pension burdens in the government’s lap.”

As bad as the pension situation is for the airline industry, it is worse for the automotive industry. According to a Wall Street Journal report, the airline industry’s combined $31 billion underfunding pales in comparison to the auto industry’s estimated shortfalls.

In recent years, a number of automotive parts manufacturing companies have filed for bankruptcy protection including Delphi Corporation, Collins & Aikman, Federal-Mogul, Tower Automotive, Oxford Automotive, and J.L. French. Delphi, once a part of General Motors, and a company with $28 billion in annual sales in 2004, was forced to seek bankruptcy protection in 2005, making it one of the largest bankruptcy cases of a manufacturing company in history. At the time its bankruptcy petition, Delphi’s obligations to its retirees - $12.8 billion in the form of pensions and $9.6 billion in health insurance, life insurance and other retirement benefits – were underfunded by nearly $14 billion. Delphi and the other companies within this industry are being squeezed between rising prices for raw materials, foreign competitors that use low-cost workers, continuing pressure from customers on product price, and declining demand as the automobile manufacturers have lost market shares and cut back production. In this environment, it has become impossible to continue to meet the increasing legacy costs.

Delphi’s Chairman and Chief Executive Officer, Robert Steve Miller, has said the company cannot stand up to non-union competitors if it has to pay such high wages and the kind of benefits union members now enjoy. He called the defined-benefit pension plans an “anachronism.”

While the automotive parts manufacturing companies are in a bind to meet their legacy costs, their customers, the car manufactures, are facing a major crisis. These companies simply do not have enough current active employees to support the legacy costs of their retirees.

It is estimated that General Motors spent over $5 billion in 2005 on healthcare alone, or an additional $1,500 for each car it made. Much of this expense is for the benefit of nearly one million retired employees. The Big Three (General Motors, Ford and the Chrysler Group) have a total of 370,000 active employees. The Automotive Trade Policy Council calculated that its members supported more than 800,000 retirees. While General Motors states that its current pension-fund liabilities are fully funded, industry analysts believe that the company’s pension obligations are underfunded to the tune of $31 billion. General Motors is not alone; Ford also faces massive problems from legacy costs.

In response to the legacy cost crisis, Congress recently undertook important legislative initiatives. Passed by both the House and the Senate on August 4, 2006, and signed into law on August 17, 2006, the Pension Protection Act of 2006 replaces the prior rules governing the funding of single-employer defined benefit pension plans with a new standard keyed to the plan’s funded status. The general principle is that a defined-benefit plan’s required contribution equals the present value of benefits earned by participants during the current year plus the amount needed to amortize any funding shortfall over no longer than seven years. The Act provides that companies with seriously underfunded defined-benefit plans must contribute at a faster rate and face certain restrictions, such as a ban on increasing benefits. Moreover, the Act is significant in that it contains specific provisions for the airline industry.

Airlines in bankruptcy proceedings that have frozen their pension plans, an act that stops participants from getting new benefits, receive an extra ten years to meet their funding obligations – a provision which provides immediate relief to both Northwest Airlines and Delta Air Lines. Other airlines could use those provisions if they freeze their pension plans. Two airlines with active defined-benefit plans, American Airlines and Continental Airlines Inc., nevertheless get ten years after the new funding rules go into effect to meet their obligations, three years longer than other companies.

Critics say the Act is too little, too late. They believe the Act will only delay the demise of underfunded defined-benefit pension plans and fosters the replacement of such plans with defined-contribution plans.

While the Act will certainly help defer the immediacy of the growing problem the airline and automotive industries face, only proactive steps taken by companies will ultimately prevent an onslaught of bankruptcy filings. Companies must reduce other fixed costs through worker buyouts and renegotiations of labor contracts as Ford Motor Company has recently done, while working to recapture market share and maintain sufficient revenue. This is a difficult first step but a necessary one – without it, and without a corresponding increase on returns in plan asset investments, failure is certain; it will not be a question of if, but when? Whether the airline and automotive companies can survive long enough, while making these tough decisions, is unknown. For those that do not, the option to seek bankruptcy protection may be the only way to address the debilitating legacy costs. Recent history suggests that this means another generation of workers will suffer from billions of dollars of lost benefits.

Steven M. Yoder is a director and shareholder at The Bayard Firm and part of the Firm's Bankruptcy Group. This article first appeared in the February 2007 issue of The Bankruptcy Strategist.

Comments on this story

click here to add a comment

Loading