Fitch: Senate Pension Bill Could Postpone Billions in Airline Funding Requirements.

Business Editors

CHICAGO--(BUSINESS WIRE)--Sept. 24, 2003

A provision in the defined benefit pension reform bill now under consideration by the U.S. Senate could have a large impact on U.S. airline pension funding requirements over the next three years--potentially deferring billions of dollars in cash outflows. At a time when the largest U.S. network carriers face a combined unfunded pension liability in excess of $20 billion, the relief from so-called deficit reduction contributions included in the Senate's version of pension reform legislation--approved by the Senate Finance Committee last week--could help ease airline liquidity pressures dramatically if it survives in Congressional debate over the next several weeks. While another pension bill being considered by the House of Representatives includes no such provision, it is possible that the deficit reduction contribution exemption could be passed into law after a compromise is reached in a House-senate conference committee later this year. Fitch estimates that as much as $2.5 billion in annual pension contributions for the U.S. airlines could be pushed back starting in 2005 as a result of the proposed change.

The House and Senate are expected to act quickly in passing legislation aimed at establishing rules to be used in calculating the level of funding in private employer defined benefit plans. The rules would also determine the size of payments that must be made by employers if the value of pension plan assets drops substantially below the present value of benefits to be paid to retirees and current employees. Much of the debate now centers on the appropriate interest rate to be used in discounting expected future benefit amounts to today's dollars. A discount rate tied to the yield on 30-year Treasury securities now applies, but authorization for that rate expires at the end of the year, forcing Congress to move quickly in passing pension reform legislation. While both the Senate and House bills would allow for a temporary move to peg the discount rate to high-quality corporate bond yields, the Senate bill goes much further in its approach to seriously underfunded plans.

Deficit reduction contributions are made by companies when the market value of assets in their defined benefit plans drops below 80% of the current pension liability to current and future retirees. Accelerated 'catch-up' contributions to plans are then required to ensure that future obligations can ultimately be met, even after prolonged periods when adverse market developments undermine the funded status of all pension plans. For the major U.S. airlines, like companies in many other mature industries, the combination of poor market returns and declining interest rates over the past three years has created a situation in which plan asset values are well below the 80% funding threshold. As of year-end 2002, the pension plans of the six largest U.S. network airlines (American, United, Delta, Northwest, Continental and US Airways) were all funded at less than 65% of the projected benefit obligation (PBO)--a common accounting measure of the pension liability. Since the beginning of the year, however, the industry funding gap has narrowed as a result of strong plan asset returns and an increase in interest rates from the historically low levels seen this spring.

The Senate bill (the National Employee Savings and Trust Equity Guarantee Act), sponsored by Senate Finance Committee Chairman Charles Grassley (R-IA), would exempt companies from making deficit reduction contributions to pension plans for a period of three years beginning after December 31, 2003. Only companies that were not required to make deficit contribution payments during pension plan years beginning in 2000 would be eligible for the funding exemption. Most major airline plans were near fully-funded status in 2000 and would therefore be in a position to take advantage of the exemption. Significantly, the Grassley bill also ties pension plan discount rates to a blended corporate bond yield for three years before a five-year transition period during which a yield curve-based mix of discount rates would be applied in computing pension liabilities. The increase in the discount rate would lower the present value of pension obligations, thereby reducing the level of required cash contributions to plans for all companies.

In the House, Rep. John Boehner (R-OH) has introduced legislation that would temporarily replace the 30-year Treasury bond yield as the benchmark for defined benefit pension plan discount rates. Instead, a corporate bond yield would be used as the benchmark for two years before a permanent solution to the interest rate issue can be developed. The Boehner bill is far more limited in its scope, however, and would not change deficit reduction funding requirements for employer plans that are significantly underfunded. The bill reportedly will be considered on the House floor by the end of the month, and appears to benefit from strong support from a bipartisan group of co-sponsors.

The bulk of the anticipated required airline pension payments over the next few years represent deficit reduction contributions needed to shore up dramatically underfunded positions. In addition to the adverse trends in asset returns and interest rates, the funded status of many big-carrier plans has been further undermined by lucrative labor contracts (signed before the industry downturn) that drove accrued benefit levels higher. Given the aggregate level of underfunding in the industry, the financial impact of a deficit reduction contribution waiver would be profound. Fitch estimates that the Senate deficit reduction measure, if approved by Congress and signed into law, could lower required cash contributions to airline pension plans by as much as $2.5 billion in 2005 alone.

It is important to note that the exemption provisions in the Senate bill would offer only temporary relief for the industry, with a resumption of deficit reduction contribution requirements after plan years beginning in 2006. Should major carriers exploit such an exemption without making contributions, normal accrual of pension liabilities (in the absence of excess market returns) would necessarily lead to a worsening of the pension funding gap by the end of the exemption period. Major carriers would still be forced to consider alternative funding solutions--potentially involving the contribution of non-cash assets--such as equity in non-public subsidiaries--to their plans. Northwest Airlines has already pursued such an option with the approved contribution of shares in its regional airline Pinnacle to fund part of its current plan contribution requirement.

The cash flow and liquidity implications of the airline industry's current underfunded position are particularly severe in light of the continuing financial challenges confronting the largest hub-and-spoke carriers. While revenue trends have improved steadily since April as demand patterns have strengthened, airline balance sheets remain weak as a result of big increases in debt loads and the need to fund large operating losses incurred since early 2001. Even with steady improvement in airline operating profiles resulting from across-the-board cost cutting and better unit revenue trends, carriers face substantially higher claims on operating cash flow through 2006 as a result of large debt repayment needs and required pension plan funding. Moreover, the major network carriers face a growing competitive threat from low-cost carriers which now threaten the ability of the major airlines to raise average fares. Even if a strong cyclical rebound materializes over the next few quarters, low-cost competition will effectively place a cap on industry unit revenue growth, limiting the cash flow generation capacity of the majors and delaying the repair of badly-damaged balance sheets.

Airlines with substantially underfunded plans and major unions continue to lobby for an alternative piece of industry-specific relief legislation known as the Airline Pension Act of 2003 (H.R. 2719), introduced by Rep. Dave Camp (R-MI). The Camp bill, backed vigorously by the Airline Pilots Association (ALPA), would establish a five-year moratorium period during which airlines would be exempt from making deficit reduction payments to their plans. After that period, the unfunded liability would be amortized over 20 years, with interest-only payments required in the first five years after the moratorium. The bill would also reinstate the US Airways pilot pension plan, which was terminated by the airline at the time of its emergence from Chapter 11 bankruptcy in March. The Camp bill takes an industry-specific approach to pension reform that appears unpalatable to many members of Congress in the wake of various federal actions to provide financial support to the industry. At this time, H.R. 2719 appears to lack the broad-based bipartisan support in the House that would be necessary to ensure passage.

The strong support provided for the Camp legislation by ALPA and other unions reflects labor's willingness to consider additional concessions in an effort to safeguard the long-term financial viability of the major carriers. While the Airline Pension Act would remove the near-term cash flow risks of deficit reduction funding, the funding exemption and the extension of the repayment timetable may ultimately raise the risk of plan insolvency. In backing the bill, the pilots and other employee groups are choosing to support the near-term liquidity and capital position of major airlines--potentially at the expense of the long-term funded status of their members' pension plans.