Better Funding Rules Can Help Employers Honor their Pension Promises

After US Airways terminated its pension plan last year, United Airlines went to bankruptcy court seeking to terminate its pension plans. A Chicago bankruptcy judge sanctioned the move on May 10, 2005. With that, $9.8 billion in promised future benefits not covered by the plan’s assets were wiped off United Airlines’ balance sheet. The government-run and employer-funded Pension Benefit Guaranty Corporation (PBGC) will now take over the plans. This makes it by far the PBGC’s largest plan takeover, followed by Bethlehem Steel’s termination of $3.7 billion in 2003 as a distant second. The termination of United Airlines’ plans will add $6.6 billion in unfunded liabilities to the PBGC’s portfolio, after beneficiaries lose the equivalent of $3.2 billion in already earned benefits. In exchange, the PBGC will receive $1.5 billion worth of equities and other securities from the bankrupt airline. Already, Delta Airlines is indicating that it may seek bankruptcy protection, which could also lead to a termination of its pension plans. However, with sensible changes to the rules governing pension funding and bankruptcy negotiations, further massive losses for employees and the PBGC can be avoided.

For employees and retirees at United Airlines, this is a rude awakening. For one, they can no longer earn pension benefits by continuing to work for United. More shocking, they will lose benefits that they have already earned. After all, their pensions were part of their compensation package. Instead of being paid only in wages, United Airlines employees were partly paid by accruing future pension benefits. Now, not all benefits that workers had already earned will survive the termination of the pension plans. Although the PBGC insures pension benefits, it does so only within limits. In United’s case, $3.2 billion of promised benefits will simply be wiped out. That is equivalent to getting paid $30,000 a year and then having the employer ask for $10,000 back every year in the future.

The termination also blows a large hole in the finances of PBGC, an agency which has already been struggling. For three years running, the PBGC has now seen billion-dollar deficits. In 2004 alone, the PBGC saw a loss of $12 billion. The addition of the unfunded liabilities from United Airlines will continue this trend of large losses at the PBGc=

Worse, the fear is that other airlines will follow suit and terminate their pensions. Delta Airlines has already announced substantial losses and may consider termination of its pension plans. Further terminations would not be surprising. With United Airlines having terminated its pensions, other airlines with pension plans are at a cost disadvantage and will also consider whether to file bankruptcy and shed their pension plans. As a result, the PBGC may end up with more unfunded liabilities. The PBGC estimated that by late 2004, all single employer pension plans had a combined underfunding of $450 billion. Clearly, not all underfunded plans will be terminated, but even a handful of larger terminations can depress the PBGC’s finances, either requiring larger insurance premiums or transfers of tax money from the government.

The problem for pension beneficiaries and ultimately for the PBGC is twofold. For one, the recent recession has made it much harder for employers, particularly in the airline industry, to honor the promises made to their employees. Also, the treatment of pension benefits in bankruptcy proceedings make it hard to find workable solutions that will help to keep a pension plan alive when the employer is struggling.

Underlying the current crisis is the combination of economic factors that typically recurs in a recession, but that was much more pronounced in the most recent one. The calculation of today’s value of promised future pension payments – a plan’s liabilities – depends on today’s interest rate. If interest rates fall, liabilities rise. The company has to set aside more money today that can, together with interest, pay for the same amount of future benefits. Interest rates have fallen in twelve out of the last thirteen recessions, but in the latest one they fell further and stayed down longer than in any previous one. That is, pension liabilities rose faster and stayed higher longer than was historically the case. At the same time, asset prices fell because of the stock market crash after 2000. Again, stock prices fall around the time of recession, but not to the same degree as they did in 2001 and 2002.

The large increase in liabilities and the sharp drop in assets happened when employers already had troubles due to the recession. The faltering economic outlook for airlines was exacerbated by a string of extenuating circumstances, including the terrorist attacks of 9/11, SARS, the war in Iraq, and sharply higher fuel prices. As companies entered bankruptcy due to weak earnings, they believed they could no longer meet their obligations for their pension plans.

However, unlike other creditors of a bankrupt firm, pension beneficiaries have no real mechanism to find a workout solution with their employers. The choice for employers is essentially to make all required contributions when they have little money to do so, or to terminate the pension plan. Consequently, airlines began terminating their pension plans. Last year, it was US Airways, this year it is United Airlines.

To avoid the loss of employees’ benefits and massive deficits at the PBGC, two policy steps can be taken. For one, funding rules can be changed, such that pension plan funding will become less susceptible to the ups and downs of financial markets. In addition, the PBGC could be put in a better position in bankruptcy proceedings to protect employees’ benefits.

Pension funding rules set by law reflect the ups and downs of financial markets, which regularly mean lower interest, and hence more liabilities, as well as lower assets, when economic times are bad. Employers consequently are more likely to face larger demands from their pension plans when they can least afford them. The rules can be changed to allow employers to stretch out losses and gains in the valuation of their pension plans, such that they have to make fewer contributions to their pension plans when times are bad and more when times are good. This would improve the outlook for beneficiaries and reduce the chance that pension plans will have to be terminated when times are bad.

In addition, the PBGC could be given more room to negotiate on behalf of beneficiaries when a company is bankrupt. For instance, the PBGC could be given a higher standing in bankruptcy proceedings, which would give companies and other creditors more of an incentive to protect pensions. Instead of or in addition to this change, the rules could be altered to give the PBGC the possibility to negotiate with employers over a workout plan for the required pension contributions. After all, this is what bankrupt companies negotiate with other creditors. For instance, the PBGC could allow employers to stretch out the payments over longer periods of time in exchange for no increases in pension benefits. While beneficiaries may not get all the benefits that they had hoped for, they would likely get more than they would if the plans were terminated. Likewise, the PBGC would see fewer losses than if the pension plans were terminated. After all, employers would still make some contributions to their pension plans.

More than 30 million people directly depend on single employer pension plans, such as the ones that were just terminated at United Airlines. The problems underlying such terminations are well understood and could be addressed. Without a serious effort toward reforming rules governing pension funding and the standing of the PBGC in bankruptcy proceedings, future large-scale terminations are more likely than not.

Christian E. Weller is senior economist at the Center for American Progress.