Jim Atkinson, an aircraft inspector at Northwest Airlines, knows a shoddy repair job when he sees one. And that’s what he thinks Northwest employees are getting.
In August, Northwest won federal approval to bolster its three severely underfunded pension plans with stock in a regional airline subsidiary–shares that aren’t publicly traded. The stock’s worth is anybody’s guess, and that concerns Atkinson, who wants a robust pension fund when he retires in about 20 years.
“To finance anything with airline stock seems very risky, given the state of the industry,” said Atkinson, a 13-year veteran who also heads Northwest’s mechanics union.
After three years of stock market declines and record low interest rates, corporate America is confronted with making up an estimated $400 billion in unpaid retirement obligations–and growing.
The companies don’t have that kind of cash. So, instead, they are propping up ailing funds with so-called alternative assets such as timberland, real estate, stock in subsidiaries or hedge fund investments.
Others are getting more creative. Some firms have thrown in everything from a transmission repair franchise to a gold mine, unpleasant surprises for pension regulators who discovered them after taking over some beleaguered funds.
“I’m sure everybody in America who has an underfunded plan is looking around to see what they can contribute,” said Nell Hennessy, president of Fiduciary Counselors Inc., a Washington investment advisory firm that is advising Northwest’s pension plans.
Adding alternative assets to already-rickety pension plans makes retirees and some pension fund experts nervous. That’s because non-cash assets such as timberland or stock that is not trading are tricky to price. And since there are no historical guides to their price over time, it is even harder to estimate a future return on investment, a crucial factor in maintaining adequate pension funding levels.
More worrisome, alternative assets raise the potential for prickly conflicts of interests between companies and their pension funds as they dicker over what assets to add and how much they are worth.
“Companies can manufacture a proper return,” said Ron Ryan, president of Ryan Labs Inc., a New York-based fixed-income investment firm with $19 billion under advisement. “We’ve gone 180 degrees away from what pensions were supposed to be all about: providing benefits.”
At the center of the pension plan crisis–and the debate over alternative assets–are defined-benefit pension plans, which promise fixed payments to retired workers, usually based on years of service and level of salary.
Falling interest rates, which affect pension funding calculations, and declining stock prices have combined to push defined-benefit plans from a $246 billion surplus at the end of 1999 to a $216 billion deficit by the end of 2002 for firms in the S&P 500, according to Credit Suisse First Boston.
Blow to corporate earnings
A pension plan is considered underfunded when its liabilities are 10 percent greater than its assets. Under rules established by the 1974 Employee Retirement Income Security Act, companies are required to make up the shortfall with accelerated “deficit-reduction contributions” when their pensions are less than 90 percent funded.
Cash infusions to underfunded pensions will cut an estimated $11 billion from earnings among the S&P 500 this year, according to a June report from Credit Suisse First Boston.
Underscoring the crisis, the Pension Benefit Guaranty Corp., the government agency that protects the pensions of nearly 44 million workers, said Sept. 4 that defined-benefit plans at financially troubled companies will be underfunded by $80 billion by the end of the year.
About a third of the deficit is concentrated in the airline industry, with much of the remainder held by steel and auto manufacturers–companies with large pools of retirees.
After losing almost $19 billion in the last two years, the nation’s airlines at the end of 2002 had the worst pension deficits of any U.S. industry. Delta Air Lines’ pension is estimated at nearly $5 billion in the red. American Airlines is $3 billion short. At the end of last year, Northwest was $3.9 billion behind in its pension payments.
And United Airlines, in the midst of bankruptcy reorganization, has one of the largest pension deficits–about $4.2 billion at the end of June. United must resolve that gap before it can emerge from bankruptcy protection, expected in the first half of next year.
Unlike Northwest, United has little wiggle room to add alternative assets to its pension plans because pretty much everything the company owns is pledged to creditors. Even United’s Elk Grove Township headquarters building is tied up. United gave the machinists union a lien on the building in lieu of back wages.
So United is pinning its hopes on Capitol Hill. Chief Executive Glenn Tilton was in Washington last week, lobbying for passage of the Air Line Pension Act, a bill that would allow airlines to defer past pension contributions and spread out funding requirements. But few industry experts expect Congress to pass an airline-specific bill when so many industries are facing a crunch.
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United also is pushing to replace the 30-year Treasury bond with long-term corporate bonds as the interest rate benchmark companies use to value future pension fund obligations. The effect: a higher discount rate that would translate into smaller pension liabilities and reduced payments.
“We believe relief is achievable in time for us to exit bankruptcy on schedule,” said United spokesman Rich Nelson.
Meanwhile, all eyes have been on Northwest since the Eagan, Minn.-based airline won Labor Department approval last month to contribute shares of a wholly-owned subsidiary, Pinnacle Airlines Corp., to its pension funds.
The proposal deeply divided Northwest’s unions. Those representing mechanics, ramp workers and flight attendants opposed it. The pilots union, fearing the company might be pushed into bankruptcy if the company were forced to prop up the fund with cash, came out in favor.
To avoid conflicts of interest in valuing Pinnacle stock, Northwest’s pension funds hired Fiduciary Counselors, which then hired aviation consulting company Eclat Consulting to estimate Pinnacle’s worth. The answer: about $340 million as of January.
Since then, Northwest has contributed 1.9 million shares, or about 13 percent, of Pinnacle’s stock to satisfy about $44 million of its $223 million funding requirement for 2002. The company has the option to add more Pinnacle stock in place of cash for 2003 and 2004.
Pinnacle applied for an initial public offering with the Securities and Exchange Commission last year, but no offering has been scheduled. In fact, some critics warn the offering may never occur, or the stock could be priced lower than Northwest had planned.
Under the exemption Northwest was granted, if the stock falls below the contribution value, the pension plans can sell the shares back to Northwest for a guaranteed price.
Northwest’s plan to use Pinnacle stock “created a buzz in the pension community,” said Ann Combs, deputy secretary of the Labor Department’s Employee Benefits Security Administration. But she said that exemptions for non-cash contributions to pensions have been rare to date.
“Over the last 20 years, there have probably been a dozen or so exemptions,” said Combs.
Among the most prominent exemptions: In 1994, General Motors Corp. was permitted to contribute shares of a former subsidiary, Electronic Data Systems Corp. And now-defunct Pan American World Airways was granted permission to allocate interests in leases on a terminal at New York’s Kennedy airport in 1989.
The airline industry isn’t alone in the use of alternative assets. Pittsburgh-based United States Steel Corp. has applied to the Labor Department to fund a portion of its estimated $700 million pension deficit at the end of this year with 170,000 acres of timberland in Alabama. The company says it is conducting a valuation of the timberlands, which stretch across five counties near Birmingham, and were acquired as part of the 1907 purchase of Tennessee Coal, Iron & Railroad Co.
The timberland is valued at roughly $100 million, said company spokesman John Armstrong.
And some pension experts agree that if the companies continue to feel the pinch of underfunded pension plans, formally expanding the list of alternative assets permitted in retirement funds may be necessary.
“It may make sense to expand out the asset class,” says David Zion, senior accounting analyst at Credit Suisse First Boston in New York.
Pension experts caution that even alternative assets cannot save the most seriously underfunded plans.
US Airways, which filed for bankruptcy in August 2002, sought permission this year to terminate its pilots’ pension plan. The plan was so deep in the red, the company said, that making required contributions eventually would force US Airways into liquidation.
US Airways’ pilots, who had agreed to steep cuts in their pension benefits, protested, arguing that their pension plan was almost fully funded, according to the limited disclosures required of the company. In March, a judge rejected their pleas, and the plan was terminated and turned over to the Pension Benefit Guaranty Corp.
It turned out the US Airways pilots and its management were right, according to PBGC officials. On a current liability basis, the pilots’ pension plan was 94 percent funded in 2001. But the plan was only 33 percent funded on a termination basis, with total underfunding of $2.5 billion. The pilots say their pensions may be reduced by 30 percent to 70 percent.
“It is no wonder that the US Airways pilots were shocked to learn just how much of their promised benefits would be lost,” Steven Kandarian, executive director of the PBGC, told the House Education and Workforce Committee on Sept. 4.
Payment extensions sought
Alternative assets aren’t the only tactics companies are using to limit cash contributions to their pension plans. Over the past three years, the Internal Revenue Service has received quadruple the number of requests for waivers that enable firms to delay pension payments, said Carol Gold, IRS director of employee plans. Waiver requests rose to 61 through Aug. 31, up from 12 in 2000.
In April, Northwest received a waiver to postpone the $454 million payment due this year. Under IRS terms, Northwest can pay the amount over five years beginning in April 2004. United plans to apply for similar relief.
For Jim Atkinson and thousands of other future retirees, that could mean more pension fund repair jobs ahead.