Fitch: New Pension Rules Could Hurt Already Hurting Airlines

As if the airline industry wasn't already beset by all sorts of problems already, get this:

Fitch Ratings is providing the following commentary on the US Senate's passage last week of a broad pension funding reform bill that includes targeted relief for the largest US airlines. The Senate legislation, which passed by a vote of 86-9, now must be reconciled with a House of Representatives bill that also includes airline industry relief provisions. Pending the outcome of House-Senate conference committee negotiations to determine the final form of the bill (assuming no White House veto), it now appears likely that significant changes will be made in the required cash funding of the major airline's defined benefit pension plans in 2004 and 2005. Fitch believes that the proposed funding rule changes, while easing near-term liquidity pressures on major US airlines, simply defer existing cash obligations, posing long-term credit risks by magnifying the improvement in airline operating performance necessary to meet potentially larger pension plan funding requirements in 2006 and beyond.

While the passage of the pension relief legislation does not immediately affect Fitch's current debt ratings of the largest US airlines with defined benefit plans, it does pose long-term credit risks by pushing out required pension plan contributions for those carriers with the most seriously underfunded employee plans -- in particular, United, Northwest, American and Delta. Provisions in both the Senate and House versions of the legislation would reduce dramatically the level of accelerated "catch up" payments to underfunded plans -- known as deficit reduction contribution (DRC) payments. The Senate bill passed yesterday would reduce required DRC payments by 80% in 2004 and 60% in 2005. A House bill, passed last October, would authorize DRC payment reductions of 80% in both years.

It is important to emphasize that the DRC waivers in 2004 and 2005 would not eliminate the requirement to meet the long-term obligations of the major airlines to their employees over the long term. Rather, it would simply defer the requirement to make accelerated payments during a period when the overall funded position (assets minus liabilities) may ultimately worsen as a result of large existing underfunded gaps. Even with actual market returns exceeding assumed historical average returns, the steady accrual of pension liabilities will make it difficult to narrow the funding gap appreciably. In a moderate market downturn, moreover, asset values could deteriorate and plan funding would suffer as a result of the shortfalls in DRC funding.

Absent DRC payments over the next two years, the difference between the value of plan assets and liabilities to current and future retirees is likely to grow, putting a greater long-term funding burden on carriers at the point when DRC waivers are lifted. This poses a very serious threat, after 2005, that greater levels of cash will be required to shore up underfunded plans. This could ultimately impede the process of debt reduction and balance sheet repair during a period when profitability and operating cash flow generation for the major carriers, under intensifying pressure from low-cost competitors, may be weak.

Over the near term, modest increases in interest rates would act to moderate growth in airline pension liabilities. Further, reductions in wage rates achieved by the restructured carriers -- notably United and American -- will limit growth in pension payouts to employees as a result of changes in 'final average earnings' formulas that determine the size of most airline employee pensions. Still, the depleted asset bases of the major carrier plans -- eroded further in some cases by recent 'lump sum' payouts to retiring employees -- will require consistently high returns to eliminate the need for DRC payments by the end of the decade.

As envisioned by the carriers with the larges pension funding gaps, the DRC relief would provide time for better market fundamentals -- higher pension plan asset returns and higher interest rates -- to shore up the funded position of defined benefit plans over the next two years. The funded status of big carrier pension plans had been undermined in the 2000-2002 period as a result of weak returns on equities (making up more than 50% of assets in most US corporate pension plans) and steady declines in the interest rates used to calculate the present value of pension obligations to current and future retirees. The combined impact of low asset returns and low interest rates drove major carrier plans from a marginally over-funded position in 2000 to an aggregate underfunded liability in excess of $20 billion (on a projected benefit obligation or PBO basis) at the beginning of 2003.

In the absence of a solid industry revenue rebound that fuels significant improvements in major carriers' operating cash flow this year and next, airlines with seriously underfunded plans may find themselves in an untenable funding position by 2006. This should provide carriers with the most competitive cost structures (e.g., American and Continental) incentives to make discretionary cash contributions to their pension plans even after the DRC relief legislation is passed.

FMI: www.fitchratings.com