Private Pensions: Airline Plans' Underfunding Illustrates Broader Problems with the Defined Benefit Pension System
Published: 2004-10-07T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: At the same time that "legacy" airlines face tremendous competitive pressures that are contributing to a fundamental restructuring of the airline industry, they face the daunting task of shoring up their underfunded pension plans, which currently are underfunded by an estimated $31 billion. Terminating these pension plans confronts Congress with three policy issues. The most visible is the financial exposure of the Pension Benefit Guaranty Corporation (PBGC), the federal agency that insures private pensions. The agency's single-employer pension program already faces a deficit of an estimated $9.7 billion, and the airline plans present a potential threat to the agency's viability. Second, plan participants and beneficiaries may lose pension benefits due to limits on PBGC guarantees. Finally, airlines that terminate their plans may gain a competitive advantage because such terminations effectively lower overall labor costs. This testimony addresses (1) the situation the airlines are facing today, (2) overall pension developments, and (3) the policy implications of addressing these issues.
section_title: What GAO Found
paragraphs: The problems posed by the airlines' underfunded plans, while extremely serious in the short term, are only the latest symptom of the decline in the health of our nation's defined benefit (DB) pension system. These problems illustrate weaknesses in the pension system overall and demonstrate that the way plans currently fund and insure pension benefits has to change. Underfunded pension plans are a symptom of the financial turmoil currently facing the airline industry. Industry trends, including the emergence of well-capitalized low cost airlines and other factors, have created a highly competitive environment that has been particularly challenging for the legacy airlines. Since 2000, the financial performance of legacy airlines has deteriorated significantly. Legacy airlines have collectively lost $24.3 billion over the last 3 years. Despite cost-cutting efforts, legacy airlines continue to face considerable debt and pension funding obligations. In this context, a number of legacy airlines have begun to consider terminating their DB pension plans. For example, United Airlines recently announced that it would not make roughly $500 million in contributions to its pension plans this year and US Airways announced that it does not plan to make roughly $100 million in contributions. The problems of underfunded DB pension plans extend far beyond the airline industry. We have highlighted several problems that have contributed to the broad underfunding of DB plans generally, including airline plans. These problems include cyclical factors like the so called "perfect storm" of key economic conditions, in which declines in stock prices lowered the value of pension assets used to pay benefits, while at the same time a decline in interest rates inflated the value of pension liabilities. The combined "bottom line" result is that many plans today have insufficient resources to pay all of their future promised benefits. Other long term trends suggest more serious structural problems to the system, including a declining number of DB plans, a decline in the percentage of participants that are active (as opposed to retired) workers, and other factors. Existing pension funding rules and the current structure for paying PBGC insurance premiums have not ensured that sponsors contribute enough to their plans to pay promised benefits. The current pension crisis facing the airline industry and PBGC, and how the Congress chooses to address that crisis, has wide-ranging implications for airlines and other industries, as well as for pension participants, PBGC, and potentially the American taxpayer. This crisis also illustrates the need for comprehensive pension reform that tackles the full range of challenges crossing all industries and not just airlines. Such a comprehensive reform would include meaningful incentives for sponsors to adequately fund their plans, provide additional transparency for participants, and ensure accountability for those firms that fail to match the benefit promises they make with the resources necessary to fulfill those promises.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the serious challenges posed by  those underfunded pension plans sponsored by certain companies within  our nation’s airline industry. Many of these so-called “legacy” carriers  currently face the daunting task of shoring up their underfunded pension  plans in a highly competitive marketplace, while still dealing with the  after-effects of the events of September 11, 2001. The combination of  several carriers facing current or potential bankruptcy, each with large  underfunded pension plans, presents a threat to the Pension Benefit  Guaranty Corporation (PBGC), the federal agency that insures private  pension benefits, as well as to the retirement security of affected plan  participants and beneficiaries. However, the problems of underfunded  pension plans extend far beyond the airline industry, to steel, automotive  related manufacturing and other sectors of the economy that sponsor  defined benefit (DB) plans.  Thus, policymakers must seek both short-term  and long-term pension solutions that balance the interests of these  industries’ active and retired employees, customers, and stockholders, the  PBGC, and American taxpayers.
In my testimony, I will address (1) the situation the airlines are facing  today, (2) overall pension developments, and (3) the policy implications  for addressing these issues. In short, the problems posed by the airlines’  underfunded plans, while extremely serious in the short term, are only the  latest symptom of the long-term decline in the health of our nation’s DB  pension system. The failure to act promptly and effectively to this growing  challenge will likely leave us with another wave of plan terminations in  other industries down the road, and possibly alter the competitive balance  within the airline industry and in other industries in the future. The  challenges I describe today also suggest that any effective solution be  comprehensive in nature. Such a solution should include meaningful  incentives for adequate plan funding, enhanced transparency for  participants, and strong accountability for those firms that fail to match  the benefit promises they make with the resources necessary to fulfill  those promises.
Before I discuss the airlines more specifically, I want to briefly note the  recent, serious financial challenges posed by underfunded pension plans  in the airline and other industries for PBGC and the agency’s role in  protecting DB pension plans. PBGC’s single-employer insurance program  is a federal program to insure the benefits of the more than 34 million  workers and retirees participating in private and not-for-profit DB pension  plans. While the program is intended to be self-sufficient through  employer premiums and investments, over the last few years, the  program’s finances have taken a severe turn for the worse. In 2000, the  program appeared financially healthy, with the assets exceeding the  current value of its liabilities by $9.7 billion. By March 2004, however, this  surplus had become a $9.7 billion accumulated deficit, largely as a result  of PBGC’s takeover of several large, underfunded pension plans of  sponsors that had gone bankrupt. This represents a $19.4 billion reversal  in PBGC’s financial condition in only 3½ years. As I have noted in recent  testimonies before several congressional committees, we believe the  single-employer program’s long-term ability to sustain itself as a self- funded entity is at risk in its present form. Given the structural problems  facing the agency, in July 2003, GAO placed the PBGC single-employer  pension program on our “high-risk” list of troubled federal programs in  need of ongoing attention by the Congress.
subsections: section_title: Legacy Airlines With Underfunded Plans Face Severe Competitive Pressures
paragraphs: The serious underfunding of many airline company pension plans has been  widely reported. Underfunded pension plans are a symptom of the  financial turmoil the airline industry currently faces. Several industry  trends, such as the emergence of well-capitalized low cost airlines and  reliance on the Internet to distribute tickets, are fundamentally reshaping  the structure of the airline industry. Certain technology trends have served  to provide lower cost alternatives to travel for business purposes, such as  videoconferencing and network meetings. In addition, a series of  unforeseen events, such as the terrorist attacks of September 11, 2001 and  the war in the Middle East, have served to sharply reduce the demand for  air travel in recent years. These and other factors have combined to create  a highly competitive environment, which has been particularly challenging  for the legacy airlines.
As we reported in August, the financial performance and viability of legacy  airlines has deteriorated significantly compared with low-cost airlines  since 2000. Legacy airlines have collectively lost $24.3 billion over the last  3 years, while low-cost airlines made $1.3 billion in profits. During this  time Congress provided the industry approximately $8.6 billion in  assistance.  Airlines responded to these financial challenges by reducing  costs and cutting capacity.  From October 1, 2001 through December 31,  2003, the collective operating costs of legacy airlines decreased by about  $12.7 billion dollars, while capacity fell 12.6 percent.  Of this total, legacy  airlines worked with unions to achieve $5.5 billion in labor cost cuts.  Despite these cost-cutting efforts, low-cost airlines still maintain a  significant unit cost advantage over legacy airlines. Legacy airlines also  face considerable debt and pension funding obligations in the next few  years. Meanwhile, neither legacy nor low-cost airlines have been able to  significantly improve their revenues owing to continued pressure on  airline fares.
In their efforts to cut costs further, despite significant rises in fuel costs,  the legacy airlines have focused on labor costs, since they represent the  single largest operating cost the airlines face. As part of reducing their  labor costs, a number of legacy airlines have begun to consider  terminating their DB pension plans, under current bankruptcy and pension  laws. United Airlines recently announced that it would not make roughly  $500 million in contributions to its pension plans this year. In addition, US  Airways does not plan to make roughly $100 million in contributions to its  remaining pension plans, and stated it would be “irrational” to make  pension contributions during its current bankruptcy court filing.
The potential termination of these underfunded pension plans confronts  Congress with three key policy issues. The most visible is the financial  exposure of PBGC. The agency reports that airline pensions are currently  underfunded by $31 billion. This figure includes $8.3 billion of  underfunding in United’s plans, and $2.3 billion of underfunding for US  Airways. Second, thousands of plan participants and beneficiaries will  lose pension benefits due to limits on PBGC guarantees and certain  provisions affecting PBGC’s insurance program.  Finally, airlines that  terminate their plans may gain a competitive advantage because such  terminations effectively lower overall labor costs. Those lower costs may  also permit some airlines to continue operating that might otherwise be  forced to exit the marketplace.
I would like to emphasize three important facts that should put the  airlines’ current problems in perspective. First, this is not the first time we  have witnessed the simultaneous struggles of the airline industry and  airline pension underfunding. As a former Acting Executive Director of  PBGC and Assistant Secretary of Labor for Pension and Welfare Benefit  Programs in the 1980s, I monitored similar issues plaguing major air  carriers at the time. Since then, we’ve seen PBGC take over a number of  badly underfunded plans including Pan American, Eastern, Braniff, and  TWA. More recently, in early 2003, US Airways’ Pilots Plans terminated,  presenting a claim of $754 million to the single-employer program. Second,  the airlines’ experience illustrates the speed with which a pension funding  crisis can develop. In 2001, PBGC reported that as a whole the air  transportation industry had more than enough assets to cover the  liabilities in its pension plans. Yet just 3 years later the industry threatens  to saddle PBGC with its biggest losses ever from plan terminations.  Finally, serious pension underfunding is not confined to the airline  industry. Of the 10 most underfunded pension plan terminations in PBGC’s  history, 5 have been in the steel industry, an industry that has faced  extreme economic difficulty for decades. Looking ahead, in addition to  airlines, automotive related firms may present the greatest ongoing risk to  PBGC, with over $60 billion in underfunding as of 2003. Thus, while there  are unique circumstances that have contributed to the airlines’ competitive  and pension troubles, they unfortunately are not alone.
section_title: Pension Problems Extend Broadly
paragraphs: We have highlighted several potential sources of problems in the pension  system that have contributed to the broad underfunding of DB pension  plans generally, including airline plans. Single-employer pension plans  have suffered from a so-called “perfect storm” of key economic conditions,  in which declines in stock prices lowered the value of pension assets used  to pay benefits, while at the same time a decline in interest rates inflated  the value of pension liabilities. The combined “bottom line” result is that  many plans have insufficient resources to pay all of their future promised  benefits. While these cyclical factors may improve and reverse some of the  pension underfunding, other trends suggest more serious structural  problems to the single-employer insurance program’s long-term viability.  These include a declining number of DB plans, a decline in the percentage  of participants that are active (as opposed to retired) workers, and a rise  in alternative retirement savings vehicles, such as defined contribution  (DC) plans, which provide retirement benefits with more portability but  which transfer the investment risk from the employer to the employee.  In  addition, as the PBGC takeover of severely underfunded plans suggests,  the existing pension funding rules have not ensured that sponsors  contribute enough to their plans to pay all the retirement benefits  promised to date. Also, while the current structure of insurance premiums  paid by plan sponsors to PBGC requires higher premiums from some  underfunded plans, in many cases these were not enough of an incentive  for firms to fund their plans sufficiently.  Furthermore, certain provisions  of PBGC’s current guarantee and recovery provisions also need to be  reviewed and possibly revised.
The current pension crisis facing the airline industry and PBGC illustrates  the need for comprehensive pension reform that tackles the full range of  challenges across all industries, not just airlines. Such a comprehensive  reform would focus on incentives, transparency, and accountability.  Reforms must include meaningful incentives for sponsors to adequately  fund their plans.  They must provide additional transparency for  participants, and ensure accountability for those firms that fail to match  the benefit promises they make with the resources necessary to fulfill  them. The airline industry’s funding problems also highlight the difficulties  in addressing these problems during difficult economic times for an  industry. These difficulties limit the feasible policy options for pension  reform because many firms have fewer resources to support required plan  contributions. Therefore, pension reform should attempt to improve  incentives for firms to contribute more to their pension plans during good  economic times, when they are more likely to be able to afford such  contributions. Also, reform needs to consider the voluntary nature of  pensions. After all, employers do not have to offer pensions, and reforms  that may be deemed to be onerous might drive healthy plans out of the  system.
Nevertheless, firms should be held accountable for paying promised  pension benefits to their workers. Along these lines, reforms should  reconsider PBGC’s current premium rate structure to take into account  the plan sponsor’s financial condition, the nature of the pension plan’s  investment portfolio, and the structure of the plan’s benefit provisions  (e.g., shutdown benefits or pension offset provisions). Charging more truly  “risk-related” premiums could increase PBGC’s revenue while providing  an incentive for plan sponsors to better fund their plans. However,  significant increases in premiums that are not based on the degree of risk  posed by different plans may force financially healthy companies out of  the defined-benefit system and discourage other plan sponsors from  entering the system.
section_title: Pension Policy Issues Have Broad Implications
paragraphs: The rules of the current pension system, and any attempts to reform these  rules, carry wide-ranging implications for airlines and other industries, as  well as pension participants and beneficiaries, the PBGC, and potentially  the American taxpayer. When PBGC takes over a pension plan from a  bankrupt sponsor, participants can lose some of their promised pension  benefits because PBGC guarantees may be capped. For 2004, PBGC pays a  maximum monthly benefit of about $3,700 to a 65-year old pension  participant; for younger participants, the guarantee declines, such that a  55-year old is guaranteed only $1,664 monthly. In addition, recent benefit  increases and early retirement subsidies can also be reduced based on  PBGC’s guarantee structure. For the agency itself, continued takeovers of  severely underfunded plans make the eventual bankruptcy of PBGC an  increasingly likely scenario. In the event that PBGC has insufficient funds  to pay the benefits of plans it has taken over, it has the ability to borrow  $100 million from the U.S. Treasury. This amount represents only a small  fraction of the single-employer program’s $9.7 billion deficit as of March  2004. Congress would likely face enormous pressure to “bail out” the  PBGC at taxpayer expense. If Congress decided not to fund a bailout of  PBGC, pension participants and retirees would likely face drastic cuts in  their pension benefits.
Congress should consider the incentives that pension rules and reform  may have on other financial decisions within affected industries. For  example, under current conditions, the presence of PBGC insurance may  create certain “moral hazard” incentives—struggling plan sponsors may  place other financial priorities above “funding up” its pension plan  because they know PBGC will pay guaranteed benefits. Firms may even  have an incentive to seek Chapter 11 bankruptcy in order to escape their  pension obligations. As a result, once a sponsor with an underfunded  pension plan gets into financial trouble, existing incentives may  exacerbate the funding shortfall for PBGC.
This moral hazard effect has the potential to escalate, with the initial  bankruptcy of firms with underfunded plans creating a vicious cycle of  bankruptcies and plan terminations. Firms with onerous pension  obligations and strained finances could see PBGC as a means of shedding  these liabilities, thereby providing them with a competitive advantage over  other firms that deliver on their pension commitments. This would also  potentially subject PBGC to a series of terminations of underfunded plans  in the same industry, as we have already seen with the steel and airline  industries in the past 20 years.
Overall, despite a series of reforms over the years, current pension funding  and insurance laws create incentives for financially troubled firms to use  PBGC in ways that Congress did not intend when it formed the agency in  1974. PBGC was established to pay the pension benefits of participants in  the event that an employer could not. As pension policy has developed,  however, firms with underfunded pension plans may come to view PBGC  coverage as a fallback or “put option” for financial assistance. Further,  because PBGC generally takes over underfunded plans of bankrupt  companies, PBGC insurance may create an additional incentive for  troubled firms to seek bankruptcy protection, which in turn may affect the  competitive balance within an industry. This should not be the role for the  pension insurance system.
Certain rules that affect funding for underfunded plans of troubled  sponsors can also create perverse incentives for employees that aggravate  a plan’s underfunding. To the extent that participants believe that the  PBGC guarantee may not cover their full benefits, many eligible  participants may elect to retire and take all or part of their benefits in a  lump sum rather than as lifetime annuity payments in order to maximize  the value of their accrued benefits. In some cases, this may create a “run  on the bank,” exacerbating the possibility of the plan’s insolvency as assets  are liquidated more quickly than expected, and potentially leaving fewer  assets to pay benefits for other participants. As previously noted, it can  also create incentives for workers to retire prematurely, creating potential  labor shortages in key occupations for the firm. We have seen aspects of  these effects in some airline pilots’ reaction to the deteriorating financial  condition of their employers and pension plans.
Further, current rules may create an incentive for financially troubled  sponsors to increase benefits, even if they have insufficient funding to pay  current benefit levels. Currently, sponsors can increase plan benefits for  underfunded plans, even in some cases where the plans are less than 60  percent funded. Thus, sponsors and employees that agree to benefit  increases from an underfunded plan as a sponsor is approaching  bankruptcy can essentially transfer this additional liability to PBGC,  potentially exacerbating the agency’s financial condition. These represent  just a few of the many issues that deserve the attention of the Congress.  We have and will continue to perform work in this area in an effort to  assist the Congress.
The current problems plaguing many pensions in the airline industry  should be seen as symptomatic for the pension system overall and should  demonstrate that the way we currently fund and insure pension benefits  has to change. Ignoring this warning would serve to adversely affect  employers who continue to sponsor DB plans, workers and retirees who  depend on those pension plans, and American taxpayers who may be  asked to pay for these benefits in the future.
Finally, the tragic events of September 11, 2001 combined with other  factors are not only having an adverse affect on the financial condition of  the airline industry, they are also affecting the financial condition of the  Federal Aviation Administration’s Airport and Airway Trust Fund. This is a  matter beyond the scope of this hearing that the Committee may want to  address in the future.
I would be happy to take any questions the Committee might have.
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