Commercial Aviation: Structural Costs Continue to Challenge Legacy Airlines' Financial Performance
Published: 2005-07-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since 2001, the U.S. airline industry has confronted unprecedented financial losses. Two of the nation's largest airlines--United Airlines and US Airways--went into bankruptcy, terminating their pension plans and passing the unfunded liability to the Pension Benefit Guaranty Corporation (PBGC). PBGC's unfunded liability was $9.6 billion; plan participants lost $5.2 billion in benefits. Considerable debate has ensued over airlines' use of bankruptcy protection as a means to continue operations, often for years. Many in the industry and elsewhere have maintained that airlines' use of this approach is harmful to the industry, in that it allows inefficient carriers to reduce ticket prices below those of their competitors. This debate has received even sharper focus with pension defaults. Critics argue that by not having to meet their pension obligations, airlines in bankruptcy have an advantage that may encourage other companies to take the same approach. GAO is completing a report for the Committee due later this year. Today's testimony presents preliminary observations in three areas: (1) the continued financial difficulties faced by legacy airlines, (2) the effect of bankruptcy on the industry and competitors, and (3) the effect of airline pension underfunding on employees, airlines, and the PBGC.
section_title: What GAO Found
paragraphs: U.S. legacy airlines have not been able to reduce their costs sufficiently to profitably compete with low cost airlines that continue to capture market share. Internal and external challenges have fundamentally changed the nature of the industry and forced legacy airlines to restructure themselves financially. The changing demand for air travel and the growth of low cost airlines has kept fares low, forcing these airlines to reduce their costs. They have struggled to do so, however, especially as the cost of jet fuel has jumped. So far, they have been unable to reduce costs to a level with their low-cost rivals. As a result, legacy airlines have continued to lose money--$28 billion since 2001. Although some industry observers have asserted that airlines undergoing bankruptcy reorganization contribute to the industry's financial problems, GAO found no clear evidence that historically airlines in bankruptcy have financially harmed competing airlines. Bankruptcy is endemic to the industry; 160 airlines filed for bankruptcy since deregulation in 1978, including 20 since 2000. Most airlines that entered bankruptcy have not survived. Moreover, despite assertions to the contrary, available evidence does not suggest that airlines in bankruptcy contribute to industry overcapacity or that bankrupt airlines harm competitors by reducing fares below what other airlines are charging. While bankruptcy may not be detrimental to rival airlines, it is detrimental for pension plan participants and the PBGC. The remaining legacy airlines with defined benefit pension plans face over $60 billion in fixed obligations over the next 4 years, including $10.4 billion in pension obligations--more than some of these airlines may be able to afford given continued losses. While cash from operations can help fund some of these obligations, continued losses and the size of these obligations put these airlines in a sizable liquidity bind. Moreover, legacy airlines still face considerable restructuring before they become competitive with low cost airlines.

section_title: Letter
paragraphs: We appreciate the opportunity to participate in today’s hearing to discuss  the financial condition of the U.S. airline industry—and particularly, the  financial problems of legacy airlines. Since 2001, the U. S. airline industry  has confronted financial losses of unprecedented proportions. From 2001  through 2004, legacy airlines reported losses of $28 billion, and two of the  nation’s largest legacy airlines—United Airlines and US Airways—went  into bankruptcy, eventually terminating their pension plans and passing  the unfunded liability to the Pension Benefit Guaranty Corporation  (PBGC). Two other large legacy airlines have announced that they are  precariously close to following suit.
In recent years, considerable debate has ensued over legacy airlines’ use of  Chapter 11 bankruptcy protection as a means to continue operations,  often for years. Some in the industry and elsewhere have maintained that  legacy airlines’ use of this approach is harmful to the airline industry as a  whole, in that it allows inefficient carriers to stay in business, exacerbating  overcapacity and allowing these airlines to potentially under price their  competitors. This debate has received even sharper focus with US  Airways’ and United’s defaults on their pensions. By eliminating their  pension obligations, critics argue, US Airways and United enjoy a cost  advantage that may encourage other airlines sponsoring defined benefits  plans to take the same approach.
Last year, we reported on the industry’s poor financial condition, the  reasons for it, and the necessity of legacy airlines to reduce their costs if  they are to survive. At the request of the Congress, we have continued to  assess the financial condition of the airline industry and, in particular, the  problems of bankruptcy and pension terminations. Our work in this area is  still under way. Nonetheless, we can offer some preliminary observations  about what we are finding. Our statement today describes our preliminary  observations in three areas: (1) the continued financial difficulty faced by  legacy airlines, (2) the effect of bankruptcy on the industry and  competitors, and (3) the effect of airline pension underfunding on  employees, retirees, airlines, and the PBGC. Our final report, which we  expect to issue in September, will offer additional evidence and insights  on these questions.
U.S. legacy airlines have not been able to reduce their costs sufficiently to  profitably compete with low cost airlines that continue to capture industry  market share. Challenges that are internal and external to the industry  have fundamentally changed the nature of the industry and forced legacy  airlines to restructure themselves financially. The changing demand for air  travel and growth of low cost airlines has kept fares low, forcing legacy  airlines to reduce their costs. However, legacy airlines have struggled to  do so, and have been unable to achieve unit cost comparability with their  low-cost rivals. As a result, legacy airlines have continued to lose money— $28 billion since 2001—and are expected to lose another $5 billion in 2005.  Additionally, airlines’ costs have been hurt by rising fuel prices –  especially legacy airlines that did not have fuel hedging in place.
Bankruptcies are endemic to the airline industry, the result of long- standing structural issues within the industry, but there is no clear  evidence that bankruptcy itself has harmed the industry or its competitors.  Since deregulation in 1978, there have been 160 airline bankruptcy filings,  20 of which have occurred in the last 5 years. Airlines fail at a higher rate  than most other types of companies, and the airline industry historically  has the worst financial performance of any sector. This inherent instability  that leads to so many bankruptcies can be traced to the structure of the  industry and its economics, including the highly cyclical demand for air  travel, high fixed costs, and few barriers to entry. The available evidence  does not suggest that airlines in bankruptcy contribute to industry  overcapacity or that bankrupt airlines harm competitors by reducing fares  below what other airlines are charging. The history of the industry since  deregulation indicates that past liquidations or consolidations have not  slowed the overall growth of capacity in the industry. Studies conducted  by others do not show evidence that airlines operating in bankruptcy  harmed other competitors. Finally, while bankruptcy may appear to be a  useful business strategy for companies in financial distress, available  analysis suggests it provides no panacea for airlines. Few airlines that have  filed for bankruptcy protection are still in business today. Bankruptcy  involves many costs, and given the poor track record, companies are likely  to use it only as a last resort.
While bankruptcy may not harm the financial health of the airline industry,  it has become a considerable concern for the federal government and  airline employees and retirees because of the recent terminations of  pensions by US Airways and United Airlines. These terminations resulted  in claims on PBGC’s single –employer program of $9.6 billion and plan  participants (i.e., employees, retirees, and beneficiaries) are estimated to  have lost more than $5 billion in benefits that were either not covered by  PBGC or exceeded the statutory limits. At termination in May 2005,  United’s pension plans promised $16.8 billion in benefits backed by only  $7 billion in assets (i.e., it was underfunded by $9.8 billion). PBGC  guaranteed $13.6 billion of the promised benefits, resulting in a claim on  the agency of $6.6 billion and an estimated $3.2 billion loss to participants.  The defined benefit pension plans of the remaining legacy airlines with  active plans are underfunded by $13.7 billion (based on data from the U.S.  Securities and Exchange Commission, or SEC), raising the potential of  additional sizeable losses to PBGC and plan participants. These airlines  face $10.4 billion in pension contributions over the next 4 years,  significantly more than some of them may be able to afford given  continued losses and their other fixed obligations. Spreading these  contributions over more years, as some of these airlines have proposed,  would relieve some of this liquidity pressure but would not necessarily  keep them out of bankruptcy because it does not fully address the  fundamental cost structure problems faced by legacy airlines.
subsections: section_title: Legacy Airlines Must Reduce Costs to Restore Profitability
paragraphs: Since 2000, legacy airlines have faced unprecedented internal and external  challenges. Internally, the impact of the Internet on how tickets are sold  and consumers search for fares and the growth of low cost airlines as a  market force accessible to almost every consumer has hurt legacy airline  revenues by placing downward pressure on airfares. More recently,  airlines’ costs have been hurt by rising fuel prices (see figure 1). This is  especially true of airlines that did not have fuel hedging in place.  Externally, a series of largely unforeseen events—among them the  September 11th terrorist attacks in 2001 and associated security concerns;  war in Iraq; the SARS crisis; economic recession beginning in 2001; and a  steep decline in business travel—seriously disrupted the demand for air  travel during 2001 and 2002.
Low fares have constrained revenues for both legacy and low cost airlines.  Yields, the amount of revenue airlines collect for every mile a passenger  travels, fell for both low cost and legacy airlines from 2000 through 2004  (see figure 2). However, the decline has been greater for legacy airlines  than for low cost airlines. During the first quarter of 2005, average yields  among both legacy and low cost airlines rose somewhat, although those  for legacy airlines still trailed what they were able to earn during the same  period in 2004.
Legacy airlines, as a group, have been unsuccessful in reducing their costs  to become more competitive with low cost airlines. Unit cost  competitiveness is key to profitability for airlines because of declining  yields. While legacy airlines have been able to reduce their overall costs  since 2001, these were largely achieved through capacity reductions and  without an improvement in their unit costs. Meanwhile, low cost airlines  have been able to maintain low unit costs, primarily by continuing to grow.  As a result, low cost airlines have been able to sustain a unit cost  advantage as compared to their legacy rivals (see figure 3). In 2004, low  cost airlines maintained a 2.7 cent per available seat mile advantage over  legacy airlines. This advantage is attributable to lower overall costs and  greater labor and asset productivity. During the first quarter of 2005, both  legacy and low cost airlines continued to struggle to reduce costs, in part  because of the increase in fuel costs.
Weak revenues and the inability to realize greater unit cost-savings have  combined to produce unprecedented losses for legacy airlines. At the  same time, low cost airlines have been able to continue producing modest  profits as a result of lower unit costs (see figure 4). Legacy airlines have  lost a cumulative $28 billion since 2001 and are predicted to lose another  $5 billion in 2005, according to industry analysts. First quarter 2005  operating losses (based on data reported to DOT) approached $1.45 billion  for legacy airlines. Low cost airlines also reported net operating losses of  almost $0.2 billion, driven primarily by ATA’s losses.
Since 2000, as the financial condition of legacy airlines deteriorated, they  built cash balances not through operations but by borrowing. Legacy  airlines have lost cash from operations and compensated for operating  losses by taking on additional debt, relying on creditors for more of their  capital needs than in the past. In the process of doing so, several legacy  airlines have used all, or nearly all, of their assets as collateral, potentially  limiting their future access to capital markets.
In sum, airlines are capital and labor intensive firms subject to highly  cyclical demand and intense competition. Aircraft are very expensive and  require large amounts of debt financing to acquire, resulting in high fixed  costs for the industry. Labor is largely unionized and highly specialized,  making it expensive and hard to reduce during downturns. Competition in  the industry is frequently intense owing to periods of excess capacity,  relatively open entry, and the willingness of lenders to provide financing.  Finally, demand for air travel is highly cyclical, closely tied to the business  cycle. Over the past decade, these structural problems have been  exacerbated by the growth in low cost airlines and increasing consumer  sensitivity to differences in airfares based on their use of the Internet to  purchase tickets. More recently airlines have had to deal with persistently  high fuel prices—operating profitability, excluding fuel costs, is as high as  it has ever been for the industry.
section_title: Bankruptcy is Common in the Airline Industry, but There is No Evidence that it is Harmful to the Industry or Competitors
paragraphs: Airlines seek bankruptcy protection for such reasons as severe liquidity  pressures, an inability to obtain relief from employees and creditors, and  an inability to obtain new financing, according to airline officials and  bankruptcy experts. As a result of the structural problems and external  shocks previously discussed, there have been 160 total airline bankruptcy  filings since deregulation in 1978, including 20 since 2000, according to the  Air Transport Association. Some airlines have failed more than once but  most filings were by smaller carriers. However, the size of airlines that  have been declaring bankruptcy has been increasing. Of the 20 bankruptcy  filings since 2000, half of these have been for airlines with more than $100  million in assets, about the same number of filings as in the previous 22  years. Compared to the average failure rate for all types of businesses,  airlines have failed more often than other businesses. As figure 5 shows, in  some years, airline failures were several times more common than for  businesses overall.
With very few exceptions, airlines that enter bankruptcy do not emerge  from it. Of the 146 airline Chapter 11 reorganization filings since 1979, in  only 16 cases are the airlines still in business. Many of the advantages of  bankruptcy stem from legal protection afforded the debtor airline from its  creditors, but this protection comes at a high cost in loss of control over  airline operations and damaged relations with employees, investors, and  suppliers, according to airline officials and bankruptcy experts.
Contrary to some assertions that bankruptcy protection has led to  overcapacity and under pricing that have harmed healthy airlines, we  found no evidence that this has occurred either in individual markets or to  the industry overall. Such claims have been made for more than a decade.  In 1993, for example, a national commission to study airline industry  problems cited bankruptcy protection as a cause for the industry’s  overcapacity and weakened revenues. More recently, airline executives  have cited bankruptcy protection as a reason for industry over capacity  and low fares. However, we found no evidence that this had occurred and  some evidence to the contrary.
First, as illustrated by Figure 6, airline liquidations do not appear to affect  the continued growth in total industry capacity. If bankruptcy protection  leads to overcapacity as some contend, then liquidation should take  capacity out of the market. However, the historical growth of airline  industry capacity (as measured by available seat miles, or ASMs) has  continued unaffected by major liquidations. Only recessions, which curtail  demand for air travel, and the September 11th attack, appear to have  caused the airline industry to trim capacity. This trend indicates that other  airlines quickly replenish capacity to meet demand. In part, this can be  attributed to the fungibility of aircraft and the availability of capital to  finance airlines.
Similarly, our research does not indicate that the departure or liquidation  of a carrier from an individual market necessarily leads to a permanent  decline in traffic for that market. We contracted with Intervistas/GA2, an  aviation consultant, to examine the cases of six hub cities that  experienced the departure or significant withdrawal of service of an  airline over the last decade (see table 1). In four of the cases, both local  origin-and-destination (i.e., passenger traffic to or from, but not  connecting through, the local hub) and total passenger traffic (i.e., local  and connecting) increased or changed little because the other airlines  expanded their traffic in response. In all but one case, fares either  decreased or rose less than 6 percent.
We also reviewed numerous other bankruptcy and airline industry studies  and spoke to industry analysts to determine what evidence existed with  regard to the impact of bankruptcy on the industry. We found two major  academic studies that provided empirical data on this issue. Both studies  found that airlines under bankruptcy protection did not lower their fares  or hurt competitor airlines, as some have contended. A 1995 study found  that an airline typically reduced its fares somewhat before entering  bankruptcy. However, the study found that other airlines did not lower  their fares in response and, more importantly, did not lose passenger  traffic to their bankrupt rival and therefore were not harmed by the  bankrupt airline. Another study came to a similar conclusion in 2000, this  time examining the operating performance of 51 bankrupt firms, including  5 airlines, and their competitors. Rather than examine fares as did the  1995 study, this study examined the operating performance of bankrupt  firms and their rivals. This study found that bankrupt firms’ performance  deteriorated prior to filing for bankruptcy and that their rivals’ profits also  declined during this period. However, once a firm entered bankruptcy, its  rivals’ profits recovered.
section_title: Legacy Airlines Face Significant Near-term Liquidity Pressures, including $10.4 Billion in Pensions Contributions over the Next 4 Years
paragraphs: Under current law, legacy airlines’ pension funding requirements are  estimated to be a minimum of $10.4 billion from 2005 through 2008. These  estimates assume the expiration of the Pension Funding Equity Act  (PFEA) at the end of this year. The PFEA permitted airlines to defer the  majority of their deficit reduction contributions in 2004 and 2005; if this  legislation is allowed to expire it would mean that payments due from  legacy airlines will significantly increase in 2006. According to PBGC data,  legacy airlines are estimated to owe a minimum of $1.5 billion this year,  rising to nearly $2.9billion in 2006, $3.5 billion in 2007, and $2.6 billion in  2008. In contrast, low cost airlines have eschewed defined benefit pension  plans and instead use defined contribution (401k-type) plans.
However, pension funding obligations are only part of the sizeable amount  of debt that carriers face over the near term. The size of legacy airlines’  future fixed obligations, including pensions, relative to their financial  position suggests they will have trouble meeting their various financial  obligations. Fixed airline obligations (including pensions, long term debt,  and capital and operating leases) in each year from 2005 through 2008 are  substantial. Legacy airlines carried cash balances of just under $10 billion  going into 2005 (see figure 7) and have used cash to fund their operational  losses. These airlines fixed obligations are estimated to be over $15 billion  in both 2005 and 2006, over $17 billion in 2007, and about $13 billion in  2008. While cash from operations can help fund some of these obligations,  continued losses and the size of these obligations put these airlines in a  sizable liquidity bind. Fixed obligations in 2008 and beyond will likely  increase as payments due in 2006 and 2007 may be pushed out and new  obligations are assumed.
The enormity of legacy airlines’ future pension funding requirements is  attributable to the size of the pension shortfall that has developed since  2000. As recently as 1999, airline pensions were overfunded by $700  million based on Security and Exchange Commission (SEC) filings; by the  end of 2004 legacy airlines reported a deficit of $21 billion (see figure 8),  despite the termination of the US Airways pilots plan in 2003. Since these  filings, the total underfunding has declined to approximately $13.7 billion,  due in part to the termination of the United Airline plans and the  remaining US Airways plans.
The extent of underfunding varies significantly by airline. At the end of  2004, prior to terminating its pension plans, United reported underfunding  of $6.4 billion, which represented over 40 percent of United’s total  operating revenues in 2004. In contrast, Alaska reported pension  underfunding of $303 million at the end of 2004, or 13.5 percent of its  operating revenues. Since United terminated its pensions, Delta and  Northwest now appear to have the most significant pension funding  deficits—over $5 billion and nearly $4 billion respectively—which  represent about 35 percent of 2004 operating revenues at each airline.
The growth of pension underfunding is attributable to 3 factors.
Assets losses and low interest rates. Airline pension asset values dropped  nearly 20 percent from 2001 through 2004 along with the decline in the  stock market, while future obligations have steadily increased due to  declines in the interest rates used to calculate the liabilities of plans.
Management and labor union decisions. Pension plans have been funded  far less than they could have on a tax deductible basis. PBGC examined  101 cases of airline pension contributions from 1997 through 2002, and  found that while the maximum deductible contribution was made in 10  cases, no cash contributions were made in 49 cases where they could have  contributed. When airlines did make tax deductible contributions, it was  often far less than the maximum permitted. For example, the airlines  examined could have contributed a total of $4.2 billion on a tax deductible  basis in 2000 alone, but only contributed about $136 million despite  recording profits of $4.1 billion (see figure 9). In addition, management  and labor have sometimes agreed to salary and benefit increases beyond  what could reasonably be afforded. For example, in the spring of 2002,  United’s management and mechanics reached a new labor agreement that  increased the mechanics’ pension benefit by 45 percent, but the airline  declared bankruptcy the following December.
Pension funding rules are flawed. Existing laws and regulations governing  pension funding and premiums have also contributed to the underfunding  of defined benefit pension plans. As a result, financially weak plan  sponsors, acting within the law, have not only been able to avoid  contributions to their plans, but also increase plan liabilities that are at  least partially insured by PBGC. Under current law, reported measures of  plan funding have likely overstated the funding levels of pension plans,  thereby reducing minimum contribution thresholds for plan sponsors. And  when plan sponsors were required to make additional contributions, they  often substituted “account credits” for cash contributions, even as the  market value of plan assets may have been in decline. Furthermore, the  funding rule mechanisms that were designed to improve the condition of  poorly funded plans were ineffective. Other lawful plan provisions and  amendments, such as lump sum distributions and unfunded benefit  increases may also have contributed to deterioration in the funding of  certain plans. Finally, the premium structure in PBGC’s single-employer  pension insurance program does not encourage better plan funding.
The cost to PBGC and participants of defined benefit pension terminations  has grown in recent years as the level of pension underfunding has  deepened. When Eastern Airlines defaulted on its pension obligations of  nearly $1.7 billion in 1991, for example, claims against the insurance  program totaled $530 million in underfunded pensions and participants  lost $112 million. By comparison, the US Airways and United pension  terminations cost PBGC $9.6 billion in combined claims against the  insurance program and reduced participants’ benefits by $5.2 billion (see  table 2).
In recent pension terminations, because of statutory limits active and high  salaried employees generally lost more of their promised benefits  compared to retirees and low salaried employees. For example, PBGC  generally does not guarantee benefits above a certain amount, currently  $45,614 annually per participant at age 65.  For participants who retire  before 65 the benefits guaranteed are even less; participants that retire at  age 60 are currently limited to $29,649. Commercial pilots often end up  with substantial benefit cuts when their plans are terminated because they  generally have high benefit amounts and are also required by FAA to retire  at age 60. Far fewer nonpilot retirees are affected by the maximum payout  limits. For example, at US Airways fewer than 5 percent of retired  mechanics and attendants faced benefit cuts as a result of the pension  termination. Tables 3 and 4 summarize the expected cuts in benefits for  different groups of United’s active and retired employees.
It is important to emphasize that relieving legacy airlines of their defined  benefit funding costs will help alleviate immediate liquidity pressures, but  does not fix their underlying cost structure problems, which are much  greater. Pension costs, while substantial, are only a small portion of legacy  airlines’ overall costs. As noted previously in figure 3, the cost of legacy  airlines’ defined benefit plans accounted for a 0.4 cent, or 15 percent  difference between legacy and low cost airline unit costs. The remaining  85 percent of the unit cost differential between legacy and low cost  carriers is attributable to factors other than defined benefits pension  plans. Moreover, even if legacy airlines terminated their defined benefit  plans it would not fully eliminate this portion of the unit cost differential  because, according to labor officials we interviewed, other plans would  replace them.
section_title: Concluding Observations
paragraphs: While the airline industry was deregulated 27 years ago, the full effect on  the airline industry’s structure is only now becoming evident. Dramatic  changes in the level and nature of demand for air travel combined with an  equally dramatic evolution in how airlines meet that demand have forced a  drastic restructuring in the competitive structure of the industry. Excess  capacity in the airline industry since 2000 has greatly diminished airlines’  pricing power. Profitability, therefore, depends on which airlines can most  effectively compete on cost. This development has allowed inroads for low  cost airlines and forced wrenching change upon legacy airlines that had  long competed based on a high-cost business model.
The historically high number of airline bankruptcies and liquidations is a  reflection of the industry’s inherent instability. However, this should not  be confused with causing the industry’s instability. There is no clear  evidence that bankruptcy has contributed to the industry’s economic ills,  including overcapacity and underpricing, and there is some evidence to  the contrary. Equally telling is how few airlines that have filed for  bankruptcy protection are still doing business. Clearly, bankruptcy has not  afforded these companies a special advantage.
Bankruptcy has become a means by which some legacy airlines are  seeking to shed their costs and become more competitive. However, the  termination of pension obligations by United Airlines and US Airways has  had substantial and wide-spread effects on the PBGC and thousands of  airline employees, retirees, and other beneficiaries. Liquidity problems,  including $10.4 billion in near term pension contributions, may force  additional legacy airlines to follow suit. Some airlines are seeking  legislation to allow more time to fund their pensions. If their plans are  frozen so that future liabilities do not continue to grow, allowing an  extended payback period may reduce the likelihood that these airlines will  file for bankruptcy and terminate their pensions in the coming year.  However, unless these airlines can reform their overall cost structures and  become more competitive with low cost competition; this will be only a  temporary reprieve.
This concludes my statement. I would be pleased to respond to any  questions that you or other Members of the Subcommittee may have at  this time.
For further information on this testimony, please contact JayEtta Hecker  at (202) 512-2834 or by e-mail at heckerj@gao.gov. Individuals making key  contributions to this testimony include Paul Aussendorf, Anne Dilger,  Steve Martin, Richard Swayze, and Pamela Vines.
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